The Ten (10) Best Exit Strategy Questions an Advisor Can Ask A Business OwnerJanuary 2007
A Starting Point
The time has come to begin planning the event in a business owner’s life that once seemed so distant. The owner’s savvy advisor has broached the subject and offered to assist in the process. Said owner may be reluctant and may not know how or when he wants to exit the business, but he agrees to take that first step and get the ball rolling. It’s the beginning of an important partnership that will carry the owner into retirement. And it must be handled with careful attention to detail. Where to start?
The process requires awareness of Exit Strategy techniques and resource coordination. Organized thought is an advisor’s greatest ally in this fragmented and complex planning area. The most effective way of organizing the process is by asking a series of key questions.
Before beginning, remember that an entrusted advisor is in a truly privileged position to guide the business owner through this process. After all, the business in question is more than a job; it’s a way of life. This privilege is, however, a natural extension of the often very personalized ‘advice-giving’ relationship between advisor and client. Advisors do not need to become experts in Business Owner Exit Strategies. The objective is not to master the art of Mergers and Acquisitions as a prelude to becoming dealmakers. The objective is to initiate conversations on a delicate topic that is of paramount importance to that business owner, to inquire into areas of concern and to provide information relevant to those issues.
Often advisors believe that a business owner either knows how to exit their business, or that the business exit is someone else’s responsibility (or, rather, opportunity). This is a misperception. Business owners are in fact at a loss for a consistent, trustworthy source of information. Become that source and an advisor has made himself indispensable to the client. That brings us back to the issue at hand–where to get started.
“We begin with the most important question of all, ‘What Does the Business Owner Want’?”
Asking great questions is the hallmark trait of a trusted advisor. Questions that are on point with a client’s concerns demonstrate an advisor’s understanding and respect for the individual and set a proper foundation for the client-advisor relationship. Taking the role of a facilitator, a trusted advisor can open the conversation with any of the questions listed in this Paper and, without being (or claiming to be) an expert in Exit Strategies, can assist their business owner clients with the most complex financial transaction of their lives.
Question #1: What Do You Want To Accomplish With Your Business Exit Strategy?
We begin with the most important question of all, ‘What Does the Business Owner Want’?
One might at first dismiss such a basic inquiry. Consider that the answer to this question lies at the core of every decision the owner has ever made. He went into business to get what he wanted out of life; he’ll exit the business to get what he wants out of retirement. In order to find the best possible exit strategy, the process must begin and end with what the owner wants. This seemingly innocuous question will often kick off a surprisingly long and meaningful dialogue. The business owner will begin to see the advisor as a trusted source of information, one that understands his needs on a deep and personal level.
This understanding comes from a detailed study of who the business owner is (see White Paper, Business Exit Strategy Planning: A Growth Niche). Remember that according to the 2002 Census Bureau’s Characteristics of Business Owners (CBO) Survey, approximately 50% to 55% of U.S. business owners are boomers, many of whom are now in their forties (40’s) and fifties (50’s). It’s no wonder that retirement planning is becoming synonymous with Exit Strategy planning. Most of these owners equate retirement with ‘what they want’. And what many want is ‘time and money freedom’.
However ‘time and money freedom’ means different things to different people. At this point, a business owner might asks himself, “What am I going to do with all that time?” This is an individual who has likely poured a great deal of passion and energy into the business. Therefore, the transition of a business owner (not entrepreneur– see White Paper, The Business Owner versus The Entrepreneur) into the next phase of life can be difficult and frustrating. The owner may have only thought whimsically about what he wanted to do in retirement, whether it be playing golf every day, moving to a different part of the country, or even starting up another business. Now, the owner needs to clearly define his objectives so an exit strategy can be designed to achieve them.
This is where a knowledgeable advisor can provide guidance – someone to listen to concerns and discuss the options. By focusing the owner on the question of ‘what do you want?’, the advisor steers the process toward an end that provides both ‘time and money freedom’ and an idea of what to do with that freedom. A discussion of objectives should create the foundation of the planning process.
Question #2: Do You Know The ‘Range Of Values’ For Your Business?
This is a touchy subject and one that should be broached carefully. Many business owners do not realize that privately-held businesses are valued on a ‘point in time’ basis. These ‘securities’ are not traded on an active market, making the ‘class’ of buyer much more important to the valuation. The buyer, often one of few if not the only contender, wields considerable power over the transaction compared to an individual (one of many) buyer of a public security. Let’s walk through an example:
“A private business does not have one single value.”
Jimmy Jones has run a kitchen design and installation business for the past twenty (20) years. He is sixty (60) years old sees his grandchildren growing up before his eyes. He wants to spend more time with them. So he starts to plan an exit from his business. Jimmy has seen other businesses sell out to larger companies in the industry. However, the solution isn’t as simple as that. Jimmy’s son, Jerry, works for the business. What’s to become of him if Jimmy sells to a larger company? Jerry’s position and the financial security of his family are at stake. A transfer of shares to Jerry might be the answer, as long as Jimmy can retire with his financial security intact.
Jimmy begins planning his Exit Strategy by determining ‘what he wants’. He sits down with his financial advisor and writes down his top two priorities: 1) he wants to achieve ‘time and money freedom’ outside the business and 2) he would like Jerry to succeed him. Keeping these objectives in mind, client and advisor together calculate Jimmy’s projected cost of living in retirement. The amount of payments Jimmy receives from the business must at least meet this projection. An internal transfer to Jerry is unlikely to result in the highest possible value since Jimmy will want his son to prosper as much as possible, as long as he achieves his objectives. On the other hand, Jimmy can sell to an Industry Buyer, who might pay a higher selling price based purely on the company’s profitability and return on capital. In this simple (but common) example, Jimmy’s choice of transferee will determine the business’s value.
The point is that a private business does not have one single value. Different transfer techniques will yield different values (see White Paper, Range of Values for Different Exit Strategies). The importance of understanding this range of values cannot be underestimated. It allows Jimmy to make an informed decision based on what he truly wants out of his exit strategy.
This is a great example of how an Advisor doesn’t need to be an Expert. Without being a ‘valuation expert’, an advisor can still engage in – and add a tremendous amount of perspective and value to – a ‘Range of Values’ conversation.
“The ability to provide options is a powerful concept. It lends a feeling of control over the future.”
Question #3: Do You Understand All Available Business Exit Options?
Let’s continue with our example about Jimmy’s kitchen design company. An Advisor will naturally ask the question, ‘Is Jimmy aware that selling the business is only one (1) of many options available to him?’ The ability to provide options is a powerful concept. It lends a feeling of control over the future. When an advisor understands the many different ways to transfer a business, he can explore this with the owner in an informed and detailed manner. The owner will find comfort in talking to someone about something that has likely hovered in the back of his mind for years. In fact, most business owners think about exiting their businesses every day.
Many worry about the impact of their exit on the stakeholders in the business. They want to accomplish their personal objectives but they also want to take care of the people who have helped them achieve success. It’s not an easy feat to accomplish without considering the various alternatives. So let’s take a look at the options an advisor might discuss with a business owner. (See White Paper, The Transfer Spectrum).
Owners can transfer their privately-held business via seven (7) primary channels:
- Outsider (stay on with Company)
- Outsider (retire from Company)
- Initial Public Offering
Surprisingly, most owners are only familiar with option #6 – Sell to an Outsider for the most money and retire from the business. But this isn’t a ‘one size fits all’ business. It’s a personal, individual decision and an outright sale isn’t for every owner. A savvy adviser never assumes that a privately-held business owner is only looking for the most money from the Exit. In fact, many business owners have strong emotional and family ties to the business. They would rather see their legacy prosper through family ownership than fill their own pockets.
An informed advisor can lay out the options available and create a plan that fulfills the objectives determined by Question #1, ‘what does the business owner want’. This can be an enlightening part of the discussion. An owner who felt boxed into a corner can now feel liberated and enthusiastic about the process. In the end, it will make for a satisfying experience and end result.
Question #4: Have You Calculated The Risk Factor Of Your Business?
Before deciding who should buy the business, an owner must determine how a Buyer will perceive the risk of owning the entity. This risk factor serves two (2) purposes: 1) It is a key driver of business valuation and 2) it measures the owner’s total wealth (i.e. ‘How much of the owner’s total wealth is locked up in the concentrated, illiquid investment).
Business owners generally do not recognize the true risk factor of their businesses until an outside buyer (or valuation report) explains it to them. Why would they? For years they’ve simply run the business. The risk factor is inherent, not something private business owners measure on a regular basis, like profit margins or cost projections.
“If an owner does not accurately assess the risk of his business, the transaction can fall dead in the water because Buyer and Seller can’t agree on a price.”
Let’s explain this a bit more. Business owners are by their very nature risk takers. They live and breathe the day-to-day operation and hone their instincts about which risks are worth taking. Then, along comes someone who wants to ‘step into the shoes’ of that owner. In order to generate similar returns from the business, an outsider will make their own assessment of the overall risk factor. This will determine what they are willing to pay for that business.
All too often, an outsider’s opinion of the risk factor does not match the business owner’s perception. This creates disagreement regarding the value of the company. The variance in value can be defined as the difference between ‘Owner Value’ (what the business is worth in the Owners’ eyes), and ‘Investment Value’ (what an objective assessor of the business will determine its risk factors to be). Remember that the buyer is acting in his own best interest by discounting (lowering) the price he will pay for the business based on its perceived risk factor. In other words, the higher the risk, the more return on capital the buyer will require. This is why the return on capital of the business is such an important measurement (see White Paper, The Business as an Investment vs. the Piggy Bank Syndrome).
If an owner does not accurately assess the risk of his business, the transaction can fall dead in the water because Buyer and Seller can’t agree on a price. The owner often walks away with the belief that the buyer is playing hard ball. The experience might be negative enough to send him back to work in hopes that a few years down the line, he might find a more reasonable buyer.
Clearly, this situation needs a referee. An objective party who understands the business owner on a deeper level and can tactfully dispel any misperceptions. As an informed and prepared facilitator, an advisor can explain the potential ‘Value Gap’ ahead of time and save the business owner time and money. The key is to understand the issue in the planning phase and address it accordingly, whether it be a shift in the method of transfer or a review of the client’s financial objectives. Either way, a constructive discussion of risk results in a smoother exit and a satisfied client.
The Math Behind the Multiples
It is helpful for an advisor to know certain industry jargon and practices so to better explain the valuation process to the business owner. Many owners are familiar with ‘trading multiples’ of businesses in their industry—they use them to assess their net worth in a ‘back of the napkin’ fashion. But they do not understand what the multiple represents and whether it’s applicable (see White Paper, The Meaning of Multiples).
One standard of measuring the value of a publicly traded company is the Price-to Earnings (P/E) Ratio. This is simply the per-share price of the company divided by the per share earnings of that company. This Multiple of Earnings allows an investor to compare one investment opportunity against another. It essentially levels the playing field. While we aren’t dealing in public securities here, the basic concept is the same. Privately-held business valuation is based on a multiple of earnings (or cash flows).
Another way to value a company aside from the P/E method is to apply an Enterprise Value to EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) multiple. EBITDA is a measure of profits normalized to disregard all activities that don’t relate to operating the business. For example, an average business in a given industry might sell at five (5) times EBITDA. This really means that the risk inherent in the transaction is an implied annualized return of twenty (20) percent.
An understanding of multiples helps the business owner see how his business might be valued and how the way in which he runs the business might affect that valuation. For instance, if the owner is not growing the business by the risk measurement (which is technically the cost of capital), then the operation is stagnant and not creating wealth. The business owner is simply ‘living out of the business’.
The concept of risk could take days to fully explore. But that’s not the idea here. The key is to provide a general framework of knowledge. This can minimize disagreements between Buyer and Seller and help an owner enter into negotiations with realistic expectations.
Question #5: Have You Developed An Income Replacement Strategy To Satisfy Your Lifestyle After The Business Exit?
Lifestyle considerations are of paramount importance to the Exit Strategy. The business owner intends to live a certain way in retirement and needs a certain amount of income. A sale or transfer of his company will leave him with either a large one-time payment or some form of continuing payment beyond what is received at the Closing. In the first scenario, the ‘liquid’ or ‘publicly traded’ Capital Markets need to provide a stream of income that replaces the income received from the business or Private Capital Markets – hence, an ‘Income Replacement Strategy’ is required. A few sub-questions need asking:
- Does the business owner have any experience with investments?
- Is there any awareness that a stock and bond portfolio can be designed to provide income to that investor?
- Has that business owner calculated the net-of-tax costs of his lifestyle after the business exit?
The life of a private business owner brings independence and financial freedom. These are well-deserved perks, considering the courage and hard work it takes to build and run a private business. However, it is all too easy to treat the business as a personal “piggy bank”. This means that the business pays for many personal expenses. For example, a company car is not always used for ‘business travel’, and the family’s evening out for dinner sometimes finds its way onto the corporate charge card.
“A typical owner hasn’t determined the true economic value of his business. Nor does he know how much in assets he needs to retire comfortably.”
Let’s take a look at an example. The owner of SLE, INC. drives a company car. Sometimes he uses it for “business travel”…but not always. The company makes lease payments of $500.00 per month. At the end of the business’ fiscal year, the owner and accountant decide how to allocate business vs. personal use of the car. The business use portion is deductible as a corporate expense. But, regardless of the amount that is deducted, the business owner is accustomed to running that lease payment (and insurance payments, and fuel payments, and maintenance costs) through the business. The owner has come to rely upon the business as his “piggy bank” to pay for ordinary everyday personal expenses. To understand the impact of this particular expense, one must determine how much pre-tax money the business owner needs to satisfy the same automobile payment after exiting his business.
Consider the following calculations:
In order to replace the auto allowance ‘income’ from the business, a business owner– only spending interest income (not ‘dipping into’ principal)–will need more than $100,000 in investable assets, earning 6% per year, to make the same payment.
To calculate the interest income required for the replacement auto allowance expense, divide the annual payment by 1 minus the business owner’s tax rate: $ 6,000.00/0.65 = $9,231.00
Then, divide the interest income required by the rate of return achievable: $ 9,231.00/0.06 = $153,850.00
To conclude, an investment of $153,850.00 in investable assets is required to produce enough after-tax income to satisfy the car payment after the exit from the business. It is important to note here that this calculation does not account for growth in any investment, changes, or particulars, of tax laws; nor does it account for rising inflationary pressures in car lease payments. These issues, however, should in no way diminish the utilitarian nature of this exercise. The calculation should be performed for all expenses covered by the “piggy bank”. The owner can then understand the amount of “liquid” proceeds (or continued income stream) that is required to fulfill an Income Replacement Strategy.
Despite the importance of this process, many business owners do not come to the deal table armed with essential and valuable advice regarding the key elements of a successful business exit strategy. A typical owner hasn’t determined the true economic value of his business. Nor does he know how much in assets he needs to retire comfortably. In effect, this handicaps him in the face of a buyer who will offer the minimum possible value and not a penny more. All too frequently, the owner “cancels” the deal and reverts to running the business so he can enjoy the “lifestyle” benefits that he and his family have come to depend upon. His “time and money freedom” has slipped away due to incomplete planning. Advisors, however, are in a unique position to step in and raise the owner’s awareness of the situation before it’s too late. Preparations can be made so that the exit strategy proceeds smoothly and reaches a mutually satisfactory end for buyer and seller.
Since Taxes tend to play a vital role in these calculations, we naturally want to ask the following question:
“If they (business owners) only spend one (1) percent of their annual Company Revenues on advisory fees for this once-in-a-lifetime transaction, the personal and financial well-being of owner and family will be better off for it.”
Question #6: Have You Considered The Taxes And Fees Due At The Closing, And Beyond?
The promise of a simple and hassle free Business Exit is provocative. Many business owners are more than willing to buy into the do-it-yourself version. The owner approaches the process with the idea that he’ll know the right deal when he sees it. This owner stands to waste a tremendous amount of time negotiating a transaction – and sharing confidential information with a buyer – only to arrive at a ‘net-financial result destination’ that was highly predictable right from the beginning. If it isn’t satisfactory, the owner is back to square one. Such an unfortunate situation can be avoided by investing the time and money to plan ahead.
From a planning perspective, if a business owner has figured out the amount of ‘liquid’ assets they will need to retire comfortably, they can and should go a step further to determine how much of the closing price – or series of deferred payments – will actually go into their pocket. Taxes and fees are the two key considerations in this analysis.
The good news is an advisor doesn’t need to be a tax expert to provide general guidance. The more complex tax concerns can be referred to someone who holds accounting and/or tax attorney qualifications. However, tax issues can be categorized into general areas so that advisors can take preventative measures to avoid certain predictable problems. (See White Paper, Buyers Buy Assets, Not Stock and White Paper, C’ Corporation Sales versus ‘S’ Corporation Sales.
Anyone in business for themselves (or someone else for that matter) understands the correlation between wealth and cost control. Consulting and/or advisory fees often fall into a discretionary category that can be tightened when necessary. In particular, if a business owner is looking to sell the company, he may want to tighten the reigns to attract a buyer and a higher valuation. It’s tempting to take short cuts.
We’ve discussed at length the need to be proactive (see White Paper, Business Exit Strategy Planning: A Growth Niche). Baby Boomers are approaching retirement age and the number of owners looking to sell is growing exponentially. This glut may make it increasingly difficult to find Buyers and may put downward pressure on valuations. The prudent owner is getting up to speed on the issue and taking steps now to ensure a smooth business exit. Keep in mind what happens when the ‘knock in the car engine’ is ignored. It’s not pretty. And neither is a poorly planned business exit, in which an owner may receive a lower value than expected, pay more in taxes than they should have and as a result watch their wealth shrink.
One of the best investments an owner can make is in the planning of their business exit. If they only spend one (1) percent of their annual Company Revenues on advisory fees for this once-in- a-lifetime transaction, the personal and financial well-being of owner and family will be better off for it.
Question #7: Do You Know That Deal Structuring Can Have A Serious Impact On The Net, After-Tax Amount That You Receive For Your Shares?
If you were selling a house, the Buyer would tender all of the agreed upon selling price at the Closing. Thereafter, your remaining (if any) Mortgage debt would be paid with the proceeds, and your deed and title to the property would transfer to the new owners. But what if your buyer asked to pay the purchase price over a number of years? And what if they agreed to assume your exiting debt? Or what if the buyer did not want to buy the house (per say) but only the assets of the home? Or what if it was possible to sell only a piece of the home – ‘I’ll take two (2) bedrooms and the garage while you continue to live in the other sections’ – how would that piece be valued?
Although these scenarios are not practical for home sales, they are available – and common – in the sales of businesses. Additionally, unlike a home sale purchase, not every buyer is created equal. Some will value certain aspects of a business more than others.
Deferred payments versus ‘up front’ payments – a.k.a. ‘seller financing’
Generally speaking, smaller sales – valued at less than $3,000,000 – are ‘structured’ transactions, meaning that the Buyer will ask the Seller to finance (or take back a Note, with interest) on a large piece of the purchase price. So, by comparison to our Home Sale analogy, the Exiting Business Owner is not likely to get all of the money at Closing.
Internal transfers or ‘sales’ to ‘insiders’ – i.e. employees, co-owners, and family – are almost always ‘structured’ transactions and are often designed to achieve favorable personal tax and cash flow results. This means that Deal Structuring is almost synonymous with ‘internal’ transactions. Assessing the tax consequences of ‘structured’ transactions is beyond the scope of this paper. However, it is worth noting that an advisor can help a business owner think about the idea that he will not get all of the cash at the Closing, and then empower him to consider how much he is willing to ‘self-finance’ (see White Paper, Seller Financing, How Much and How to Secure It) based on personal needs and ‘like transactions’ in the industry.
Is the Buyer Offering an Asset Purchase or a Stock Purchase?
A Business Owner may not realize that a Buyer has the option of purchasing assets and not the stock of a corporation. Even service companies, with very few ‘hard assets’ (i.e. desks, computers, etc.) can execute Asset Transactions. In this scenario, a large portion of the purchase price is allocated to Goodwill (see White Paper, Purchase Price Allocations for Service Companies – the Goodwill Calculation). When ‘Assets’ are sold, instead of ‘Stock’, the transaction potentially shifts tax characterizations as well as post-transaction liabilities.
‘Outside’ Buyers will generally favor the purchase of Assets, not Stock, of the Company because Asset Transactions, as a general rule, limit the liability and therefore the risk of the Buyer.
“The highest possible value isn’t always the end game for every business owner.”
Let’s explore this a little further. Privately-held businesses enjoy the benefit of not having to disclose their ‘doings’ to anyone that is not on a ‘need to know’ basis (such as a lender, or a spouse). By contrast, publicly traded companies must disclose a regulated set of information on a regular basis through standardized reports. Based on a relative lack of information and transparency, a Buyer will be reluctant to purchase the Stock of a privately-held business. The reason is that someone who buys Stock, also purchases (legal terminology, ‘by operation of law’) all known and unknown liabilities of that Company, thereby increasing the risk of ownership. When a Buyer purchases only the Assets of a Company, some additional protection is provided against the ‘unknown’ liabilities of the Seller.
The significance of this fact is that each transaction may be taxed and documented differently. Therefore, it is helpful for a business owner to know in advance what type of transaction a Buyer is looking to execute. And, the Advisor who can quarterback this conversation is assisting in protecting additional wealth (by assessing and reducing tax burdens) and engaging the business owner to think about future or ‘tail’ liabilities that may impede that business owner’s lifestyle in retirement.
Majority Sale vs. Minority Sale of Stock
The idea of a partial exit strategy is something many business owners might consider. Often, they want to take a step back and gain some ‘time and money freedom’ but they still want to have a hand in the operation. What are the options?
A Business Owner has the choice of selling / transferring a controlling, or a minority, non-controlling interest in the Company. Many times, a business owner will structure a minority transfer of stock in the Company in order to reward valuable employees (i.e. family members) or to reduce Estate Tax exposure (see White Paper, Exit Strategies and Estate Taxes).
This is a very powerful conversation to have with a business owner that employs family members. Remember, the highest possible value isn’t always the end game for every business owner. Those who work with family may be particularly interested in selling a non-controlling, minority share (see White Paper, Using ESOPs in the Exit Strategy Process). This way, the business owner can extract liquidity and still have a hand in the business. These ‘partial Exit Strategies’ are very powerful planning tools and can make a tremendous difference to the ‘on the fence’ business owner.
“The illiquid nature of the business could force a quickie sale in order to ‘pay’ the estate tax bill, resulting in a fire sale situation. The owner’s net worth takes a hit not once, but twice.”
Question #8: Are You Aware Of The Estate Tax Consequences To Your Business And Other Assets?
Business owners have worked hard all their lives, probably harder than most people, with the idea that their accumulated wealth would go to their beneficiaries, not the government. In the absence of proper planning, estate taxes can cut deeply into the pie. Many advisors already offer estate planning advice, which can provide a natural segue into an Exit Strategy conversation.
Two (2) key pieces of information are necessary to any estate tax discussion:
- The dollar amount of the owner’s current estate tax exposure.
- The distribution of assets, including shares of stock in the business (i.e. who’s name are they in?).
The first piece requires a fairly simple calculation. The federal estate tax rate for 2007 is currently 45%. This estate tax rate is applied to all assets that exceed a $2,000,000 threshold (per individual). Let’s examine a business owner with $11,000,000 in assets, including a business worth $9,000,000, $1,000,000 in liquid assets and a house worth $1,000,000 (no mortgage debt). In this example, the owner’s entire business value is exposed to the 45% federal estate tax rate (assuming this business owner is not married). The dollar amount of this estate tax exposure example is $4,050,000! That’s a big chunk of change. To compound the issue, the illiquid nature of the business could force a quickie sale in order to ‘pay’ the estate tax bill, resulting in a fire sale situation. The owner’s net worth takes a hit not once, but twice.
We’ve examined a simple, straight calculation of estate tax exposure. However, the distribution of stock in an entity can change the picture considerably. Is the stock held in the business owner’s name, in a trust, or in another entity? An understanding of this distribution and how it might be tweaked can go a long way toward managing estate tax liabilities.
There are many ways to reduce ‘estate tax exposure’. Some examples are ‘gifting programs’, transfers/sales of minority interests, sales to an ESOP, and transfers into other entities. Some of these techniques include discounts in share values, while others are designed to simply remove the business asset from the business owner’s name. Alternatively, a business owner can purchase life insurance (ideally in an Irrevocable Life Insurance Trust) to pay the estate tax bill. In practice, a combination of techniques is most effective. Key to remember is that the estate tax issue is a crucial piece of the exit strategy planning process. Without it, the owner and his heirs risk unnecessary erosion of family wealth.
Question #9: Have You Identified The Legal Agreements You Will Need To Sign To Complete The Transaction?
Similar to the sale of a house, the Closing is where it all happens. The owner will want to come in prepared, with an understanding of the key documents he’ll sign and what they mean for him after the Closing. Some of the more common documents include:
Stock / Asset Definitive Purchase Agreement
This is the agreement that transfers the ownership of the Company. It includes the Parties, Price, Terms, Representations and Warranties of the Seller as to the condition of the business, and certain Indemnifications for the Buyer’s protection
Most buyers of businesses are buying into the owner’s existing business relationships. Let’s say said owner cashed the check for the sale of the business, ‘went down the road’ and opened up a competing business under a different name. This would render the transaction somewhat moot from the buyer’s point of view. A non-compete is a symbolic gesture by the Exiting Business Owner; it demonstrates a willingness to truly exit the business.
“Advisors can help their Exiting Business Owners understand these agreements, visualize the Closing, and ask any questions they may have ahead of time.”
Loan Agreement – Seller Financing Arrangement
For smaller transactions (less than a few million dollars in Value), a portion of the selling price is likely to be ‘deferred’. And, the Exiting Business Owner typically finances a portion of that ‘Loan’ to the Buyer. An owner will want to know up front the type of interest rate he can expect to receive. Many are actually pleased to ‘be the bank’ in these transactions because taxes are deferred and interest is earned on the amounts owed. Of course, the security of those payments is a critical factor, so the Buyer should be able to demonstrate financial stability.
Buyers will often ask to place a certain amount of the Purchase Price in an Escrow Account. This Account entitles the Exiting Business Owner to receive that money, if and only if, certain representations or conditions of the business prove to be accurate. A typical holding period for escrow funds could be eighteen (18) months. Whereby, during this time period, the new Buyer has an opportunity to get fully involved in the running of the business and verify the Exiting Business Owners’ claims. This is an added level of protection for a Buyer. An Exiting Business Owner needs to know this amount of money will not be received at the Closing and plan accordingly.
When a buyer takes over, the Exiting Business Owners’ ‘personal’ knowledge of the operation may still come in handy. The Buyer may ask the Owner to ‘stay on’ and participate in a ‘neat and orderly transition’ of the business. Under such an arrangement, the Exiting Business Owner becomes an employee or independent contractor for the business. The Buyer can even use this consulting agreement to pay a portion of the Purchase Price to the Exiting Business Owner.
Preparation is of utmost importance at this stage. Advisors can help their Exiting Business Owners
understand these agreements, visualize the Closing, and ask any questions they may have ahead of time. Adequate preparation ensures that all issues have been addressed and the business exit proceeds without interruption.
“Who is going to do this deal?”
Question #10: Have You Chosen A Service Provider To Manage The Transfer?
This is a critical question for any Business Owner and an important part of building an advisory team to assist with the Exit Strategy. Once all of the strategy work is done and all of the questions are asked and answered, the natural next question is ‘Who is going to do this deal?’ Different types of transactional intermediaries are listed and described below:
Local Business Brokers & Websites
Local business brokers handle the transfer of companies of all sizes, up to a few million dollars in sales. These firms place priority on ‘high volume’, in that they mostly provide a ‘listing service’ that matches sellers of small businesses with individual buyers – i.e. people who want to either leave corporate America to run their own business or entrepreneurs who have already sold one business and are looking to buy and grow another one.
Local M&A Advisors
Clusters of service providers exist in virtually ever city that will help a business worth more than a few million dollars find a buyer. These M&A ‘boutiques’ are generally well informed of what constitutes a well-executed transaction. They research potential buyers and often submit them to the seller for approval before ‘listing’ a company. They will also work to maximize the sales price by measuring the ‘synergies’ of a deal and arguing, on behalf of the seller, that the Buyer share in the synergies that are acquired.
Regional Boutiques M&A Firms
Every major city offers Regional Firms that transact business sales worth [generally] more than $10,000,000. These Firms will have Class A office space, professional administrative assistance, as well as associates and research staff that assist with transaction execution. The Principals of these Regional firms often come from bulge bracket, investment banking backgrounds and have chosen to recapture their ‘time and money freedom’ by doing their own deals. They handle larger and therefore fewer transactions, resulting in a more personalized approach.
These larger service providers may specialize in six (6) or seven (7) ‘focus industries’ in which they have developed transactional experience and relationships. This model relies heavily upon referrals from happy clients and other service providers, so their ‘closing ratios’ become very important. In other words, many of these groups are genuinely interested in ensuring the market-ability of any business they agree to sell and that the business owner walks away happy.
Regional and National ESOP Firms
ESOP firms service the needs of business owners who choose an ‘internal’ transfer by Employee Stock Ownership Plan, ESOP. They specialize in advising clients on the tax ramifications of an ESOP as well as Valuation metrics. In addition, these firms coordinate the often large team of professional advisors involved in an ESOP transaction.
National M&A Firms
Only a few Mergers & Acquisitions firms operate on a National Level. These firms sell businesses with values between $25,000,000 and $100,000,000. A National firm can offer greater and sometimes better quality resources than local and regional firms in the research and marketing of a transaction. For instance, National firms have enough resources to cover all industries and provide an individual team of professionals for every transaction.
‘Mid Market’ Investment Banks
The ‘mid market’ investment banks are professionally managed, cover most if not all of the U.S., and handle transaction sizes between $30,000,000 and $500,000,000. These firms are often affiliated with a banking operation and can issue stock for a publicly traded company. Additional resources include ‘retail’ brokerage division associates and ‘equity research’ departments that report on publicly traded companies in certain sectors. By providing research coverage on a given industry, the Investment Bank can offer expertise on the dynamics of that industry and possibly generate superior relationships, both of which can help find the right buyer for a company.
‘Bulge Bracket’ Investment Banks
The largest of the US [and Global] Financial Institutions generally have investment banking groups that service the corporate finance needs of Fortune 500 Companies. These firms [generally] do not handle transactions worth less than $100,000,000, and they commonly handle Initial Public Offerings (IPOs) and Mergers and Acquisitions of Companies in the multibillion dollar ranges.
While considering all the possible service providers, an Exiting Business Owner should look for the following:
- Quality of service
- Industry expertise
- Attention to detail
- Ample resources relative to deal size
- Advantageous relationships
Once the list is narrowed down to the best service provider, the owner will want to interview the team leader to ensure that the ‘what do I want’ objectives from Question #1 are clearly understood. The Advisor can play a key role here in attending this meeting as a representative of the Business Owners’ interests. After all, the advisor is the one individual who is squarely in the owner’s corner.
Our top ten (10) questions to ask exiting business owners should give an advisor confidence in beginning the exit strategy planning process with a business owner client or prospect. This paper provides a roadmap for the complex and bumpy journey of exit strategy planning. A proactive approach to the process not only benefits the owner and his ultimate business exit, it also helps to build an even stronger advisor-client relationship.