Considerations When Selling…Or Buying

Important questions to ask when looking at a business…or preparing to have your business looked at by prospective buyers.

• What’s for sale? What’s not for sale? Does it include real estate? Are some of the machines leased instead of owned?

• What assets are not earning money? Perhaps these assets should be sold off.

• What is proprietary? Formulations, patents, software, etc.?

• What is their competitive advantage? A certain niche, superior marketing or better manufacturing.

• What is the barrier of entry? Capital, low labor, tight relationships.

• What about employment agreements/non-competes? Has the seller failed to secure these agreements from key employees?

• How does one grow the business? Maybe it can’t be grown.

• How much working capital does one need to run the business?

• What is the depth of management and how dependent is the business on the owner/manager?

• How is the financial reporting undertaken and recorded and how does management adjust the business accordingly?

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Copyright: Business Brokerage Press, Inc.

A Buyer’s Quandary

Statistics reveal that out of about 15 would-be business buyers, only one will actually buy a business. It is important that potential sellers be knowledgeable on what buyers go through to actually become business owners. This is especially true for those who have started their own business or have forgotten what they went thorough prior to buying their business.

If a prospective business buyer is employed, he or she has to make the decision to leave that job and go into business for and by himself. There is also the financial commitment necessary to actually invest in a business and any subsequent loans that are a result of the purchase. The new owner will likely need to execute a lease or assume an existing one, which is another financial commitment. These financial obligations are almost always guaranteed personally by the new owner.

The prospective business owner must also be willing to make that “leap of faith” that is so necessary to becoming a business owner. There is also the matter of family and personal responsibilities. Business ownership, aside from being a large financial consideration, is very time consuming, especially for the new business owner.

All of these factors have to be weighed very carefully by anyone that is considering business ownership. Buyers should think carefully about the risks – and the rewards. Sellers should also put themselves in a buyer’s position. The services of a professional business broker or intermediary can help determine the relative pros and cons of the transaction.

The Confidentiality Agreement

When considering selling their companies, many owners become paranoid regarding the issue of confidentiality. They don’t want anyone to know the company is for sale, but at the same time, they want the highest price possible in the shortest period of time. This means, of course, that the company must be presented to quite a few prospects to accomplish this. A business cannot be sold in a vacuum.

The following are some of the questions that a seller should expect a confidentiality agreement to cover:

  • What type of information can and can not be disclosed?
  • Are the negotiations open or secret?
  • What is the time frame for which the agreement is binding? The seller should seek a permanently binding agreement.
  • What is the patent right protection in the event the buyer, for example, learns about inventions when checking out the operation?
  • Which state’s laws will apply to the agreement if the other party is based in a different state? Where will disputes be heard?
  • What recourse do you have if the agreement is breached?

Obviously, executing an agreement does not mean a violation can’t occur, but it does mean that all the parties understand the severity of a breach and the importance, in this case, of confidentiality.

While no one can guarantee confidentiality, professional intermediaries are experienced in dealing with this issue. They are in a position to understand the extreme importance of confidentiality in business transactions as well as the devastating results of a breach in confidentiality. A professional intermediary will require all legitimate prospects to execute a confidentiality agreement.

A confidentiality agreement is a legally binding contract, enforceable in a court of law. It establishes “common ground” between the seller, who wants the agreement to be extensive, and the buyer, who wants as few restrictions as possible. It allows the seller to share confidential information with a prospective buyer or a business broker for evaluative purposes only. This means that the buyer or broker promises not to share the information with third parties. If a confidentiality agreement is broken, the injured party can claim a breach of contract and seek damages.

© Copyright 2015 Business Brokerage Press, Inc.

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What a Buyer May Really Be Looking At

Buyers, as part of their due diligence, usually employ accountants to check the numbers and attorneys to both look at legal issues and draft or review documents. Buyers may also bring in other professionals to look at the business’ operations. The prudent buyer is also looking behind the scenes to make sure there are not any “skeletons in the closet.” It makes sense for a seller to be just as prudent. Knowing what the prudent buyer may be checking can be a big help. A business intermediary professional is a good person to help a seller look at these issues. They are very familiar with what buyers are looking for when considering a company to purchase.

Here are some examples of things that a prudent buyer will be checking:

Finance

Is the business taking all of the trade discounts available or is it late in paying its bills? This could indicate poor cash management policies.
Checking the gross margins for the past several years might indicate a lack of control, price erosion or several other deficiencies.
Has the business used all of its bank credit lines? Does the bank or any creditor have the company on any kind of credit watch?
Does the company have monthly financial statements? Are the annual financials prepared on a timely basis?
Management

Is the owner constantly interrupted by telephone calls or demands that require immediate attention? This may indicate a business in crisis.
Has the business experienced a lot of management turnover over the past few years?
If there are any employees working in the business, do they take pride in what they do and in the business itself?
Manufacturing

What is the inventory turnover? Does the company have too many suppliers?
Is the business in a stagnant or dying market, and can it shift gears rapidly to make changes or enter new markets?
Marketing

Is the business introducing new products or services?
Is the business experiencing loss of market share, especially compared to the competition? Price increases may increase dollar sales, but the real measure is unit sales.
When business owners consider selling, it will pay big dividends for them to consider the areas listed above and make whatever changes are appropriate to deal with them. It makes good business sense to not only review them, but also to resolve as many of the issues outlined above as possible.

What is the Value of Your Business? It All Depends.

The initial response to the question in the title really should be: “Why do you want to know the value of your business?” This response is not intended to be flippant, but is a question that really needs to be answered.

  • Does an owner need to know for estate purposes?
  • Does the bank want to know for lending purposes?
  • Is the owner entertaining bringing in a partner or partners?
  • Is the owner thinking of selling?
  • Is a divorce or partnership dispute occurring?
  • Is a valuation needed for a buy-sell agreement?

There are many other reasons why knowing the value of the business may be important.

Valuing a business can be dependent on why there is a need for it, since there are almost as many different definitions of valuation as there are reasons to obtain one. For example, in a divorce or partnership breakup, each side has a vested interest in the value of the business. If the husband is the owner, he wants as low a value as possible, while his spouse wants the highest value. Likewise, if a business partner is selling half of his business to the other partner, the departing partner would want as high a value as possible.

In the case of a business loan, a lender values the business based on what he could sell the business for in order to recapture the amount of the loan. This may be just the amount of the hard assets, namely fixtures and equipment, receivables, real estate or other similar assets.

In most cases, with the possible exception of the loan value, the applicable value definition would be Fair Market Value, normally defined as: “The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” This definition is used by most courts.

It is interesting that in the most common definition of value, it starts off with, “The price…” Most business owners, when using the term value, really mean price. They basically want to know, “How much can I get for it if I decide to sell?” Of course, if there are legal issues, a valuation is also likely needed. In most cases, however, what the owner is looking for is a price. Unfortunately, until the business sells, there really isn’t a price.

The International Business Brokers Association (IBBA) defines price as; “The total of all consideration passed at any time between the buyer and the seller for an ownership interest in a business enterprise and may include, but is not limited to, all remuneration for tangible and intangible assets such as furniture, equipment, supplies, inventory, working capital, non-competition agreements, employment, and/or consultation agreements, licenses, customer lists, franchise fees, assumed liabilities, stock options or stock redemptions, real estate, leases, royalties, earn-outs, and future considerations.”

In short, value is something that may have to be defended, and something on which not everyone may agree. Price is very simple – it is what something sold for. It may have been negotiated; it may be the seller’s or buyer’s perception of value and the point at which their perceptions coincided (at least enough for a closing to take place) or a court may have decided.

The moral here is for a business owner to be careful what he or she asks for. Do you need a valuation, or do you just want to know what someone thinks your business will sell for?

Business brokers can be a big help in establishing value or price.

A “Pig in a Poke"

Once a buyer has negotiated a deal and secured the necessary financing, he or she is ready for the due diligence phase of the sale. The serious buyer will have retained an accounting firm to verify inventory, accounts receivable and payables; and retained a law firm to deal with the legalities of the sale. What’s left for the buyer to do is to make sure that there are no “skeletons in the closet,” so he or she is not buying the proverbial “pig in a poke.”

The four main areas of concern are: business’ finances, management, buyer’s finances, and marketing. Buyers are usually at a disadvantage as they may not know the real reason the business is for sale. This is especially true for buyers purchasing a business in an industry they are not familiar with. The seller, because of his or her experience in a specific industry, has probably developed a “sixth sense” of when the business has peaked or is “heading south.” The buyer has to perform the due diligence necessary to smoke out the real reasons for sale.

Business’ Finances: The following areas should be investigated thoroughly. Does the firm have good cash management? Do they have solid banking relations? Are the financial statements current? Are they audited? Is the company profitable? How do the expenses compare to industry benchmarks?

Management: For a good quick read on management, the buyer should observe if management is constantly interrupted by emergency telephone calls or requests for immediate decisions by subordinates? Is there a lot of change or turn-over in key positions? On the other hand, no change in senior management may indicate stagnation. Are the employees upbeat and positive?

Buyer’s Finances: Buyers should make sure that the “money is there.” Too many sellers take for granted that the buyer has the necessary backing. Sellers have a perfect right to ask the buyer to “show me the money.”

Marketing: Price increases may increase dollar sales, but the real key is unit sales. How does the business stack up against the competition? Market share is important. Does the firm have new products being introduced on a regular basis.

By doing one’s homework and asking for the right information – and then verifying it, buying a “pig in the poke” can be avoided.

Company Weaknesses

Take two seemingly identical companies with very similar financials, but one of the companies was worth substantially more than the other company.  One company will sell for $10 million “as is” or some changes can be made and the same company can be sold for $15 million. Following is a partial list of potential company weaknesses to consider in order to assess a company’s vulnerability.

Customer Concentration:  First, one has to analyze the situation.  The U.S. Government might be considered one customer but from ten different purchasing agents.  Or, GM might have one purchasing agent but be directed to ten different plants.  One office product manufacturer with $20 million in sales had 75% of its business with one customer…Staples.  They had three choices: 1. Cross their fingers and remain the same; 2. Acquire another company with a different customer base; or 3. Sell out to another company.  They selected the third choice and took their chips off the table.  The acquirer was a $125 million competitor which was unable to sell to Staples, so after absorbing the smaller company, the customer concentration to Staples was only about 10% ($125m + $20m=$145m of which $15 million was sold to Staples or 10+%).

Single Product: Perhaps the most famous example of a single product acquisition is when General Motors overtook Ford’s single product, the Model A, with Alfred Sloan’s brilliant concept of a different model for people with different financial thresholds.  Henry Ford’s stubbornness to stay with one product (Model A) almost cost the company its existence.

Regional Sales/Limited Marketing:  Companies with parochial focus have limited capabilities to grow other than within their own domain.  A widget company with national and international sales has substantially greater prospects to grow than one limited to its own region.

Aging Workforce/Decaying Culture:  Skilled workers in certain trades, such as tool and die shops, are not being replaced by the younger generation.  This is a sign that the next generation will not provide the companies with a skilled workforce in certain industries.

Declining Industry:  Some companies are agile enough to completely change their industry, such as Warren Buffet’s Berkshire Hathaway and Fashion Neckwear Company which completely changed from neckties to polo shirts.

Pricing Constraints/Rising Costs: Companies who sell a commodity product often lack pricing elasticity and are unable to pass on their increased costs to their customers.  For a while, the steel industry was in this predicament, but through massive industry consolidation and a booming demand from China, the situation changed.

CEO Dependency/No Succession Plan: Many middle market companies have successfully been built up by the founder/entrepreneur/owner and some critics call these individuals a “one-man-band” for good reason.  These superman types tend to dominate most aspects of the company, but this is no way to build a sustainable business long term.  Furthermore, these CEOs usually have not created a succession plan.

Maximizing Value

If the owners of a company, many of whom may be outsiders, want to increase the value of their investment, they should, through the Board of Directors, try to overcome the company’s weaknesses.  On the other hand, the CEO may not be either capable or motivated to do so.  The alternative is to implement a CEO succession plan, preferably with the cooperation of the current CEO.  Kenneth Freeman’s thesis in “The CEO’s Real Legacy” (Harvard Business Review, Nov 2004) is that the CEO’s real legacy is implementing a succession plan.

Freeman advises:

“Your true legacy as a CEO is what happens to the company after you leave the corner office.

“Begin early, look first inside your company for exceptional talent, see that candidates gain experience in all aspects of the business, help them develop the skills they’ll need in the top job…

“During good times, most boards simply don’t want to talk about CEO succession…During bad times when the board is ready to fire the CEO, it’s too late to talk about a plan for smoothly passing the baton…Succession planning is one of the best ways for you to ensure the long-term health of your company.”

Both buyers and sellers should assess the company’s weaknesses.  While some weaknesses are difficult to overcome, especially in the short term, one potential weakness that is very easy to overcome is to implement a succession plan…especially during the company’s good times before things go bad and it’s too late.

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Buying or Selling a Business: The External View

There is the oft-told story about Ray Kroc, the founder of McDonalds. Before he approached the McDonald brothers at their California hamburger restaurant, he spent quite a few days sitting in his car watching the business. Only when he was convinced that the business and the concept worked, did he make an offer that the brothers could not refuse. The rest, as they say, is history.

The point, however, for both buyer and seller, is that it is important for both to sit across the proverbial street and watch the business. Buyers will get a lot of important information. For example, the buyer will learn about the customer base. How many customers does the business serve? How often? When are customers served? What is the make-up of the customer base? What are the busy days and times?

The owner, as well, can sometimes gain new insights on his or her business by taking a look at the business from the perspective of a potential seller, by taking an “across the street look.”

Both owners and potential buyers can learn about the customer service, etc., by having a family member or close friend patronize the business.

Interestingly, these methods are now being used by business owners, franchisors and others. When used by these people, they are called mystery shoppers. They are increasingly being used by franchisors to check their franchisees on customer service and other operations of the business. Potential sellers might also want to have this service performed prior to putting their business up for sale.

 

When to Create an Exit Strategy

There is the old saying that the time to develop an exit strategy is the day you open for business. Sounds good, but it’s not very realistic. Further, it also isn’t very optimistic. On the day you open for business, thoughts about how you get out of it aren’t pleasant, or helpful, thoughts. However, as you get the business to a place where you have a bit of extra time to plan, you will find that the things you need to do to improve your business are some of the very things you will need to work on to plan an exit strategy.

You can’t predict misfortune, but you can plan for it. One never knows when an accident or illness will force one to sell. When the drive to your business becomes filled with dread, maybe it’s time to consider selling. The following ideas will improve your business, even if you’re not currently considering selling. Dealing with these areas will also supply the information a buyer will most likely be looking at when the time does come to sell.

Buyers want cash flow.

This, at least on the surface, is the thing a potential buyer will want to look at.

Appearances are important.

You may think everything about the business looks fine, but the two letters on the neon sign that don’t work indicate to a possible buyer that the seller may have lost interest in the business, causing them to also wonder what else doesn’t work or has been neglected.

There is probably more value than you think.

Business owners often don’t look at things that do create real value such as: customer lists, secret recipes, specialized computer systems, programs, customer loyalty programs, etc.

Eliminate the surprises.

Make sure the lease is transferable and that your landlord is willing to cooperate.  Resolve that issue with town hall.  Resolve the problem with that angry customer. Minor problems and issues will often raise their ugly heads during sensitive times, spooking a possible buyer. So, the time to resolve them is before going to market.

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Five Kinds of Buyers

Buyers are generally categorized as belonging to one of the following groups although, in reality, most buyers fit into more than one.

The Individual Buyer

This is typically an individual with substantial financial resources, and with the type of background or experience necessary for leading a particular operation.

The individual buyer usually seeks a business that is financially healthy, indicating a sound return on the investment of both money and time.

The Strategic Buyer

This buyer is almost always a company with a specific goal in mind — entry into new markets, increasing market share, gaining new technology, or eliminating some element of competition.

The Synergistic Buyer

The synergistic category of buyer, like the strategic type, is usually a company. Synergy means that the joining of the two companies will produce more, or be worth more, than just the sum of their parts.

The Industry Buyer

Sometimes known as “the buyer of last resort,” this type is often a competitor or a highly similar operation. This buyer already knows the industry well, and therefore does not want to pay for the expertise and knowledge of the seller.

The Financial Buyer

Most in evidence of all the buyer types, financial buyers are influenced by a demonstrated return on investment, coupled with their ability to get financing on as large a portion of the purchase price as possible.

Almost all the purchasers of the smaller businesses fall into the individual buyer category. But most buyers, as mentioned above actually fit into more than just one category.

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© Copyright 2013 Business Brokerage Press, Inc.