Month: September 2022

A business sale is not a “one size fits” all situation. The details that apply in a specific situation will not all be the same. Before proceeding further, it’s important to step back a bit and look at the big picture for business sales in a variety of circumstances. Not all business sales are for the same reasons, and the circumstances of the sale can have a big impact on how a sale should proceed.

What KIND of Buyer is it?

Before considering the various sale situations, it helps to consider the KIND of buyer. In almost all cases the buyer will be either another company or an individual.

If the buyer is another company then it is likely the buyer will be able to run the business successfully. The buyer’s ability to pay may be fairly secure. Training the buyer may not be critical, but assistance with customer retention after the sale may be critical. The buyer may be more sophisticated, or at least have more sophisticated advisors. Consideration for the sale may include some form of performance based incentives (i.e., an “earn-out”).

If the buyer is an individual, training the buyer may be even more important than assisting with customer retention. Since the buyer’s ability to run the business successfully may not be as certain as it would be if the buyer were another company with a proven track record, the cash and/or collateral the buyer brings to the table may be a major factor in the sale.

The Most Common Sales Situations

These are the most common sales situations. Whether you are a buyer or a seller, one of these situations most likely fits you. Additional details applicable to each are covered later in subsequent articles.

Very Small Business – This is the most common business sale situation

• Sometimes referred to as “Mom & Pops”, “Main Street Businesses”, etc.
• Most of these businesses do not actually sell.
• This is usually a sale to an outside individual (an “External Sale”).
• Sometimes (although rarely) the sale will be to an insider (an “Internal Sale”).
• It is rare to have an employee with both the interest and the ability.
• The person needed can sometimes be recruited.
• Can often be creatively structured as a win/win, even if the buyer has little money.

Somewhat Larger Small Business – External Sale

• More likely to sell than a Mom & Pop, but many never do.
• Internal Sale
• Easier to structure than for a Mom & Pop, but still difficult to find the right successor.
• Family Sale
• The IRS has insanely complex rules designed to make sure they get all the tax revenue they think they are entitled to. Which is A LOT.
• Will most likely need an appraisal to support the price.

Divorce

• Often VERY contentious, with expensive appraisal and attorney fees, and the eventual price and terms set by a judge.
• Can sometimes be greatly simplified with advance legal planning (such as Shareholders Agreements).

Partner Buyout

• Can also be contentious.
• Can sometimes be greatly simplified with advance legal planning (such as Shareholders Agreements).

Sale for Health Reasons

• If the seller is in ill health but not clearly dying
• Time is not as critical as for a dead or dying seller.
• Potential buyers may try to take advantage of the situation.
• The seller’s help with the post-sale transition may be affected.
• If the seller is still alive but clearly dying
• A sale planned to occur upon death can sometimes be arranged.
• This has the potential to save a LOT of tax.

Seller (business owners) has passed away

• The company may be in turmoil.
• Can be VERY difficult to find a buyer.
• Tax issues can be VERY complex.

Financially Distressed Sale

• If the business is in trouble, the buyer will need to see a way to fix the problem, or a sale will not happen.
• Often involves simply liquidating the assets and walking away.
• May be forced by the company’s lenders.

Sale to a Large Buyer

• Likely to be fairly sophisticated buyers.
• Likely to include an “earn-out” as part of the “price”.
• Publicly traded buyers
• May involve tax-advantaged strategies involving the buyer’s stock.
• Large, closely held buyers
• May be easier to attract than a publicly held buyer.

Start-ups

• Often done with personal funds.
• If funding is from family and friends, then their ownership must be decided.
• If Venture Capital is involved, then complexity goes way up.
• Usually only available if the upside potential is very high.
• Initial Public Offerings (“IPO’s”)
• Basically, this is selling part of the company to the public in the form of company stock.
• Often involves venture capital at an earlier stage.
• VERY complex.

Employee Stock Option Plan (ESOP)

• Very complex and expensive.
• Can have significant tax advantages.
• Might have motivational effect on employees.
• Not as popular as initially expected when these were created.

Very Small Businesses

These businesses are sometimes referred to as “Mom & Pops”, “Main Street Businesses”, etc. Although each company is small with only a few employees, they represent a huge part of the goods and services available in our economy, and are the embodiment of the American Dream for many people.

Attempted sale of these businesses is the most common business sale situation. Unfortunately, most of the time they never actually sell. Some estimates are that only one in seven of these businesses will actually sell once they are listed for sale. Many more simply shut down once the owner decides to move on to something else.

Unrealistic expectations on the part of the seller, particularly the value of the company, are one of the reasons blocking sale of many of these companies.

The value of these companies is NOT the value of the company to the seller, which may be quite high. Instead, the maximum value is limited by the cost a potential buyer would incur to start a similar business instead. That means the value may be determined by the value of the equipment, plus something extra for the “running start” available to the buyer from buying the existing business instead of starting a similar operation from scratch.

Formal valuation approaches based on the net present value of expected future cash flow, net of reasonable compensation to the owner, often do not apply. Instead, rules of thumb based on some multiple of sales plus the value of the equipment acquired are often used. These rules of thumb have even been published in a book, theBusiness Reference Guide, The Essential Guide to Pricing Businesses and Franchises, compiled annually by Tom West and available through Business Brokerage Press and available on the web at www.bbpinc.com. (One of the authors of the article you are reading right now is one of the contributors to this book.)

It is important to remember that these rules of thumb are GENERAL rules, and may not be valid for a specific situation. It is also important to remember that these rules of thumb were developed based on businesses that actually sold. That means they are biased in favor of the most attractive businesses offered for sale. The businesses that never sell have very little impact on these rules of thumb.

Ultimately, the value of these businesses is determined just like the value of any other business: What a willing buyer and willing seller agree on. Both sides must see it as in their best interest to do the deal, or it will not happen. In other words, it must be a win/win or it will not happen.

One way to sell these businesses is to arrange an internal sale. The key to this is finding a person(s) who has the necessary skills and entrepreneurial drive. Entrepreneurs are often harder to find than the people with the necessary skills. For companies that do not already have that person, it may be possible to recruit them based on the possibility of their buying the company in the future.

Sales of this type can be arranged even for buyers who do not bring much of their own money to the table. Finding advisors who can assist with this can be challenging as well.

Somewhat Larger Small Businesses

Once a business has grown past the “Mom & Pop” size, it may be a bit easier to sell. There is no generally agreed minimum size for this, but these businesses often have ten or more employees.

Many of these businesses are only marginally profitable, and will be priced using similar methods to their smaller cousins. Those that are profitable enough will be priced based on the adjusted profits a buyer can reasonably expect in the future. The key to their sale will be the ability of the buyer to continue operating the business profitably in the future, which often means the seller will need to help with the transition.

Much of the literature on buying and selling a closely held business is focused on businesses this large or larger, and assumes the buyer will be either an outside individual, or another business. Little attention is paid to the possibility of an inside sale.

These businesses are easier to arrange internal sales for than their smaller cousins, although it is still rare to see this done. Finding entrepreneurs is always hard, and few advisors understand the issues enough to help.

Divorce

A divorce often means half the business must, in effect, be sold to the spouse who runs it. If both spouses worked in the business prior to the divorce, one of them most likely will seek employment elsewhere.

The biggest question in these sales is usually price. Terms tend to be based on asset trade-offs, with cash paid for whatever value cannot be offset by other assets. Bank financing is sought as necessary to provide the cash. Appraisals are used to establish value, with a judge determining the final result if the appraisers used by each side differ in their opinion of value.

Advance legal planning, including agreement on how value will be determined, can help simplify the process dramatically. Most owners are aware of the possible use of a pre-nuptial agreement but do not have one. Less well known is that a proper Shareholders Agreement can simplify the divorce issues, including valuation, by quite a bit.

Shareholder/Partner Buyout

Buying out a fellow shareholder/partner may or may not be a contentious process, but it is still likely to involve disagreement over value. EVERY multi-owner business should have a Shareholders Agreement (or equivalent) to address the multitude of issues that need to be spelled out in advance in this situation. How value will be determined, as well as the terms for a buyout, is just one of the topics that should be covered in this agreement.

This is a huge topic with its own article later in this series.

Sale for Health Reasons

Many sales are triggered because the owner is in ill health but not clearly dying. The seller has a very good reason to want to sell, but is not under pressure to do so immediately. These sales are very similar to any other sale for a similar business except the seller may not be able to provide as much help during a transition. If an internal sale is desired there may not be enough time to recruit key employees, and longer term planning may not be an option.

If the seller is facing a potentially terminal disease, the sale will be much more complex. Seller assistance post-sale is much more problematic, thus lowering the value to a potential buyer. Likewise, the business itself may be suffering from neglect by the owner because health matters take priority. The seller will be at a disadvantage in negotiations as well, since potential buyers may sense the seller HAS to do the sale.

Tax planning for the seller’s heirs may play a major role for a seller facing a terminal illness. The tax issues include potential estate taxes, plus potentially dramatic differences in how the sale itself will be taxed.

It is possible to plan a sale in advance, with the sale itself being deferred until the seller’s death. As a protection to the buyer, the sale generally includes a “no later than” sale date, and may include provisions for the buyer to operate the business prior to that date as well. In the right circumstances this can reduce taxes substantially, provided the sale itself is structured properly. The technical elements in the sale structure for this situation may be quite different than for a typical sale.

Financially Distressed Sale

Some businesses are put up for sale as a last ditch attempt to avoid bankruptcy or being forced to shut down. In some cases the business will go through a formal bankruptcy process, with the court eventually approving a plan to reorganize the business or mandating the business be liquidated if a credible plan to return the business to profitability cannot be developed.

If an outside buyer is sought, the potential buyer will need to see a way to fix the problem causing the financial distress, or the buyer will not buy. Sometimes this will involve buying only the profitable parts of the business, leaving the difficult parts behind. This can also lead to unexpected legal complications on both sides of the sale, so be sure to include experienced legal counsel in the process.

If no way can be found for a buyer to solve the underlying problems, or the profitable portions of the business (if any) cannot be sold separately, then the business is unlikely to be salable as a going concern. In that event the business will most likely be forced to simply sell off its assets, apply the proceeds to its liabilities, and then go away. If liabilities remain and the owner is legally liable for them, the owner may have to personally make up the shortfall.

Sale to a Large Buyer

Larger buyers are likely to be another company, often in the same industry. They generally have the ability to run the acquired business successfully, and are often more sophisticated that the typical individual buyer.

These buyers are not typically interested in “Mom & Pop” businesses. The “price” they are willing to pay is likely to include a portion of the consideration in the form an “earn-out” based on performance of the acquired company after the sale. If the buyer is a publicly traded company, the sale may sometimes include use of the buyer’s stock to help improve the tax effects on the seller, and to reduce the cash required by the buyer.

Start-ups

Starting a company is often done with personal funds and does not involve sale of part of the company. If family and friends are used to help with funding then a loan will be required, or the other investors must have some equity in the company (or both).