One of the classic problems buyers have when trying to get business financing or acquisition financing for a business they want to purchase, is that the financial statements don’t accurately reflect (or easily reflect) the true profitability of the company or the amount of net cash flow future owners will have available to them.
This is because the seller disguised his or her drawings with expense items that don’t clearly show whom the benefactor was of the cash paid by the company.
Whether the expenses are legitimate deductions or not are another matter.
But the seller’s tax planning (or tax avoiding strategy) ends up showing a picture where the company’s profits are minimal to avoid paying corporate or business income tax.
To compensate for this historical approach to tax planning, I’ve seen different sellers prepare their last completed fiscal year end financial statements prior to putting the business up for sale to show a significant profit in the hope that this will be sufficient evidence of true profitability for the buyer and potential third party sources of debt financing.
And while the buyer may be convinced of the real cash flow via the last year’s numbers alone, sources of business financing will likely remain skeptical.
Its not unusual that for an acquisition loan, a lender will ask for five or six years of the seller’s past financials to gain a better understanding of the profit and cash flow trend line.
Business brokers will call me and explain how they have “recast the financials” to more accurately show how much disposable income is available for debt service and owner drawings.
While on the surface, I have no doubt there is credence to these numbers, there are unsubstantiated by an unbiased third party and will likely not be considered by a lending source unless third party verification comes into play.
This is can be a real dilemma for the seller in that if he or she was tax planning in the grey area, they don’t want anything documented that could come back to haunt them.
But if the financial statements as written do not provide sufficient support for debt servicing, then it can be difficult to sell the business as buyers requiring financing (which tends to be most buyers) will have a hard time putting the necessary capital together.
Its hard to say what the best approach is as ultimately the goal of the seller is to pay as little income tax as possible before and after the sale of the business.
This is where the business finance aspect of your exit strategy comes into play.
Its well advised to think through all potential scenarios for selling two or three years in advance of putting the business up for sale.
In order to achieve an optimum sale price, solid cash flow is going to be required to prove out any cash flow multiplier.
Choosing a tax strategy that provides minimal if any taxable earnings may not only lend to a much lower potential selling price, but it may leave the seller as the only financing option for the purchase if third party financing is required.
The key to developing a proper exit strategy is to work with an experienced business finance professional who can work through the various potential scenarios with you so that a path with a higher probability of success (and lower probability of tax) can be laid.
Its late Friday afternoon and I’m getting a bit cute with my terminology. When I speak of dough here I mean the financing required to complete a business acquisition. When I speak of the deal, I’m talking about the purchase and sale agreement between the buyer and the seller.
One of the key reasons that business acquisition financing can be so tough to secure is because of the which comes first dilemma.
From the buyer and seller points of view, if they have a basic letter of intent signed up between them, then the assumption is that financing should be able to be secured before proceeding further.
From a prospective lender or investor point of view, until there is a binding purchase and sale agreement in place, there will not likely be a commitment for financing issued due to the fact that the source of financing a) doesn’t want to complete all its due diligence before an actual deal is binding and b) doesn’t know exactly what they’re financing until the final agreed upon terms and conditions of purchase and sale are known.
The buyer doesn’t want to spend money on due diligence unless he/she knows they can get financing. The buyer and seller together don’t want to pay their lawyers to hammer out an agreement of sale without knowing if the financing will work out.
The lender doesn’t want to commit time and resources to assessing the financing application until there is a completed deal.
In many cases, the deal goes nowhere as nobody wants to go first.
From the lender or investors point of view, I clearly understand where they are coming from. Yes, they can initially screen the deal and provide a term sheet outlining what they could potentially do if an agreement for sale was finalized and all the related due diligence supported a positive financing decision.
But to expect a commitment to fund prior to full review and the completion of a purchase and sale agreement is a tad bit unrealistic.
The resulting stand off goes nowhere and the deal is called off.
So how do you avoid destroying a perfectly good deal that, like most deals, requires some amount of outside financing?
First and foremost, its up to the buyer and seller to get comfortable with 1) the buyer’s ability to finance the deal and 2) the acquiring business’ ability to support and repay a financing facility.
Short of getting a commitment or even a straight answer from a prospective lender or investor, the next best thing is to talk to a business financing specialist and get a third party opinion of the likelihood that financing can be arranged.
If the buyer and seller don’t want to take this step, then they can commence to try and bang out a purchase and sale agreement and make it conditional on financing, pay their lawyers for their time, and hope it all works out.
The key here is that the onus is on both the buyer and seller to work together to get the deal done. Even if a lender were to go first, there could still be gaps in the financing requirements that need to be filled by a combination of the buyer and the seller, so their ongoing collaboration is going to be essential to create a win/win scenario that isn’t going to cost them an arm and a leg to figure out.
Regardless of the size of a business for sale, there are similar elements that need to be covered off. As the size and related complexity of the business grows, there will be more service providers interested in providing you with services to aid the process.
Lets face it, when business sales get into the millions of dollars, there will be cash available to pay for fees, so more service providers throw their hats into the ring to potentially become one of your advisers.
There are the obvious advisers such as your accountant and lawyer, but there are also business valuation experts to help establish the sales price, business optimization experts to help increase the value of the business prior to sale, taxation specialist that can help with more complex tax savings strategies that may be beyond the expertise of your own accountant, business brokers who put your business up for sale and market your business to buyers, financing specialists that advise you how to make the business more finance-able for the buyer, investment consultants that want to help you optimize the future value of the proceeds you get out of the business, and so on and so on.
These various services can each be provided by a specialist or sometimes one individual can fulfill multiple roles. There are also merger and acquisition firms that bring all the pieces together so its more of a one stop shop to consider.
If you spend any amount of time talking to all these experts, you’re head will start spinning from the multitude of issues they raise leaving you wondering how anyone successfully sells their business without losing their mind in the process.
Here are some survival tips to consider when selling a business.
First, its always good to start at the beginning. Evaluate your existing advisers to see how they stack up to the challenge ahead. Just because you’ve had the same lawyer or accountant for 20 years doesn’t mean they can provide the level of service you require for this very specialized and sometimes complex transaction.
Lawyers and accountants all specialize in different areas. If your lawyer and accountant do not specialize or at least have significant experience helping their clients sell businesses, then you’re going to have to find individuals that do. Many times people have a comfort level and confidence level in certain individuals and want them to assist regardless of the need. I can only say that I definitely don’t want a foot specialist to perform open heart surgery on me and the same type of logic applies to the specialties and abilities of your key advisers.
Here’s another way of looking at it. If you engage someone to help you that is not well versed in all the ins and outs of a sale transaction, you’re likely going to have an adviser who is going to take an ultra conservative approach in order not to risk making a mistake. When selling a business, you need advisers who are skilled at working through all sorts of issues that can arise. There is definitely an art of the deal and you want to be working with deal makers, not people who have great intentions without the requisite experience. Remember that if the deal falls apart one time or many, they are still going to send you a bill for all the time they spend. So make sure you’re investing in someone that really knows what their doing with respect to selling a business.
Existing advisers tend to have networks of other professionals that can lend a hand in areas they are not focused on. So even if they are not themselves the best resource for you, they could very well lead you to a qualified referral that you can have some confidence in versus starting from scratch.
You may also want to consider working with a business consultant or firm that specializes in business sales support. After all, selling a business is a project management exercise, so unless you’re planning to project manage all aspects yourself, you are going to need some help covering off all the key areas that can kill the deal or destroy value for you.
The use of advisers should be looked at as an investment whereby whatever you pay out for help will provide you with a solid return from the money you get to keep from the sale. So every adviser or service you consider should be able to clearly show you how an investment in their efforts will provide you with a positive return.
If what they offer cannot be easily quantified into real value in simple terms, then pass. Valued advisers understand that they must provide you with a return on your investment to them. Unfortunately, many of these service providers don’t have this mindset, so you’re going to have to weed out the ones that don’t so you’re not wasting time and money.
Remember that having a good team will not only get your business sold faster, but also increase what you put in your pockets.
By starting with the selection process, and putting in the effort towards drafting the right players for your team, you will greatly increase your probability of a successful sales process.
I’ve been on a roll lately talking about business acquisition financing and many of the things that need to be considered to secure this hard to pin down form of financing.
Even if business financing is not required and the buyer can pay in cash, there is still no guarantee the deal will be finalized, although its going to be significantly easier to close without having to worry about securing capital.
So putting sources of funds aside, what is the key to closing the purchase and sale of the shares or assets of an existing business?
In all the deals I have been involved in or observed, I can easily come up with what I believe is the #1 key to success, and that is for the buyer and seller to jointly project manage the deal to its successful completion.
While that may seem a tad obvious to some, here is a better way to describe what I’m trying to say.
The Buyer And Seller Have To Become Blood Brothers.
There I said it. As corny as that may sound, its the best way I can describe not only how important their interaction is with each other, but also the degree of comfort and trust that needs to develop between them during the buy/sell process.
Once the Letter of Intent is signed, they need to get out the hunting knives, draw out a little blood on their palms, and bond the deal.
What this ritual symbolizes is the understanding that has now been forged between the two parties which can be summarized as follows:
Putting aside issues related to financing or unforeseen events and disclosures, deals fall apart because there are too many cooks brewing the stew.
Both sides will have advisers such as accountants, lawyers, financial advisers, business consultants, insurance agents, etc. The larger the team, the less likely the deal will close without the buyer and seller staying engaged in the process.
Both sides will likely have to deal with a certain number of outside parties dictated by the composition of the deal. This can include licensing agencies, bonding companies, appraisers, environmental consultants, suppliers, customers, employees, unions, and so on and so on. As the number goes up, probability of success goes down.
In essence, the buyer and seller need to project manage their deal to completion. Too often one or both sides do not appreciate what this can entail and the result is the deal can get away from them.
By definition, a project manager understands all the tasks required, how they inter relate, any interdependency among tasks or events, time lines, and so on. Unfortunately for many deals, buyer, seller or both do not get very involved after the initial negotiations have been completed and if anything tend to step back and let the advisers take over.
Aside from project management, both sides also need to remain the decision makers. Deals tend to have a certain amount of twists and turns as the details get pounded out. With every curve in the road, there may require an adjustment or compromise on one side or the other. Advisers can be very good at providing their opinions for issue resolution, but their advise may also end up killing the deal.
As decision makers, the buyer and seller need to receive all valid input regarding various issues and decide if any particular issue is something that can be worked through or an outright deal breaker.
A good example of this is during the drafting of purchase and sale agreements. Each side’s lawyer’s job is to protect their client and get them the best deal possible. When the lawyers from both sides are taking a win/lose approach, trying to out due the other side with clever clauses and demands, the deal tends to go back and forth until the eventual impasse is created.
Its at this point where the buyer and seller have to look at the areas of disagreement, consider all advise, and make their own decision as to how an issue or issues will be resolved.
I’ve seen sellers overly disconnected with the process through up their hands and say, “I’m not a lawyer, so if my lawyer says it has to be this way or that, I have to go along with what he says”, basically making the lawyer the decision maker.
A blood brother to the deal would seriously consider what their lawyer has to say, talk to the other side if appropriate as well as other advisers that could add value to the situation, and then make their own decision whether to proceed or not.
If buyer or seller agrees to proceed against an adviser’s advise, the adviser involved must then find a way to make the deal work (be a deal maker) in keeping with the wishes of the person paying their bill.
This is one of the more common points where deals blow up, but there can be many others. As the number of people involved goes up, so do the levels of inaccuracies and misunderstandings that occur not to mention the lengthening of time lines.
And remember, most if not all the advisers are getting paid whether the deal gets done or not, so it truly is in both the buyer’s and seller’s interests to stay on top of what’s going on.
Obviously no amount of involvement can guarantee success, but the odds are greatly increased when the coordination of the overall project details are being well managed, the misunderstandings are kept to a minimum, and the advisers are directed to find ways to make the deal work versus blowing it up.
Every business will change ownership someday. Some will have internal family succession plans while others will just decide one day to place the business up for sale.
But when is the best time to sell a business?
If you follow some of the investment bankers and business brokerage firms, they will speak to the M&A cycle, and where its at, at any point in time.
The basis of the M&A cycle is that over a period of time, buyers are more actively interested in acquiring businesses and business assets than at other times. Factors that feed into the formation of an actual cycle are available capital, the economic landscape, market potential in different industries and so on.
While there is definitely a pattern to overall M&A activity, it also becomes a selling tool for M&A firms, brokers, and consultants, all in the business of making money from buy/sell transactions.
The is also the more traditional approach to simply building your business year over year until you reach retirement age and then, at that point, if there is no internal or family succession, then sell your business interest in the open market.
Personally, I subscribe to a third approach…
Sell your business when someone wants to buy it for a fair or inflated price.
Under this approach, your business is always for sale whether you’ve been operating for 20 months or 20 years. By being open to this possibility, there may be more opportunities to consider over time than you may have thought possible.
The rationale for always being ready to sell is quite simple. It takes a buyer with access to capital to complete a sale and without buyers that have the desire and means to take action, there is no market.
And you never know when you have created something of value for someone else. Take a look at websites like YouTube.com and more recently Mint.com where young entrepreneurs were offered small fortunes to acquire their business models, only a few years after start up. Perhaps you would view these as extreme cases, but the point here is when opportunity comes knocking, what will you do?
When a motivated buyer is interested in what you have it typically doesn’t hurt to at least listen. And the motivation for buying could be all over the map… You own a property with a location of interest, you’ve developed a new technology or have a strong product brand, and so on.
The other side to this coin is what happens if you don’t take advantage of a great offer from an impatient buyer? You could end up better off over time, but that most certainly is not guaranteed … a bird in the hand …
If the buyer is a competitor with money, then the competitor will likely take another approach to gain market share and end up becoming a stronger competitor in the future.
Another scenario to consider is when a small company hits the market right and starts growing like crazy, attracting buyer interest in the process. If a larger company steps forward to buy you out because they have the infrastructure and resources to take advantage of your business offering, will you be able to scale the business yourself if you turn them down?
People can look back in the rear view mirror and say so and so business was foolish to sell out to XYZ company because of the profits generated from XYZ over time. But there is absolutely no guarantee that the buyer would have been able to achieve the same level of success and in fact could have ended up failing badly and cashed out for nothing.
Too often, sellers establish their own time line for exit with the hope that there will be a fair market when the time comes to put the business up for sale. And when you view your exit strategy decades into the future, this becomes a form of long term horizon gambling.
I’m not saying you should sell anytime someone shows an interest in a business you own, I’m merely saying you should consider it.
The best time to sell may be sooner than you think.
When you list your business for sale, the bids and eventual proceeds you can expect to receive will be largely influenced by historical cash flow results. Your focus cash flow in the period prior to sale, can significantly increase the profit you realize.
Buyers will tend to look at a business sale price as a multiple of the expected future net cash flow. The multiple will vary based on industry and also future expected growth. The best way to increase the multiple in your favor is to focus on optimizing the cash flow base that will be multiplied.
The ideal financial picture would show 3 to 5 years of past financial statements that show steady and even exponential growth in both earnings and cash flow. Alternatively, there are three other historical cash flow and earnings trends: 1) declining cash flow, 2) cash flow that trends up and down, 3) steady or near flat cash flow results.
If your business is experiencing declining cash flow or eradicate cashflow, the cash flow base and the multiplier will likely be reduced due to future uncertainty. Steady cash flow results will not likely impact the base, but the multiplier will not be high due to absence of growth potential.
Lets look at a few different scenarios to give you a better idea of how these different cash flow trends impact a business sale.
Scenario #1. Mature business sale where the business has been in flat to slight decline. This is a very typical situation where the business owner(s) have held the business for a long period of time, are no longer investing in growth, and are at or near retirement age. To prepare for sale, there may be a final push to show better results from selling off assets and optimizing accounting statements. But the long term historical trend will show that the cash flow improvement occurred immediately prior to sale and will not likely stop the base and multiplier from being discounted.
Scenario #2. Business showing steady cash flow results where growth has been siphoned off to the owners. Because the actual financial results do not show growth, there will likely be no increase to the multiplier. If a typical multiplier was 3 to 4, a growth based multiplier could be 5 to 10, potentially making a significant difference to the proceeds the business owner can expect to receive. Yes, the financial statements can be recast to build back in the funds taken out by the owners. But recasting can be imperfect based on the convoluted ways owners extract funds from their businesses. Plus, unless the recast is done by a third party with significant review, its not likely to be assigned much value by potential buyers.
The key takeaway here is to start planning your exit strategy and future business sale well in advance. By investing in growth 3 to 5 years prior to listing the business for sale and generating financial statements that drive results to the bottom line, business owners are more likely to garner premium returns in the market. The extra work and effort could generate a huge payday by potentially increasing both the base and the multiplier.
Yes, in most cases, it does takes a bit more than the decision to sell and sticking a for sale sign in the ground to get the most profit or return from selling your business interest when you decide to exit.
Here are a few points to consider that can individually and collectively increase your probability of higher returns and a faster sales process once you put your business interest on the market.
#1. Develop a business exit mindset. As you grow and develop your business, remember to do so keeping the end in mind. Part of being in business is to develop asset value that someone will want to pay you for someday. Too often, when business owners are ready to sell, their business is not in what I would call an optimal sell-able position whereby buyers are not rushing to place high value offers to purchase.
#2. Related to the first point, continually focus on building assets, especially as you get closer to your projected time of exit. If you are in a service business, building a bigger and more responsive customer list will create more value. If you are in a more asset intensive industry, keeping your assets up to date, and investing in a physical location will also create more asset value and buyer interest.
#3. Build proof of performance. The preparation of financial statements and tax strategies can strategically save you money, but can also reduce the historical performance of the business. Sometimes your accountant can be too cleaver where you may save some taxes in the short run, but loose out on your sales price in the long run. Remember that while business valuations are done in a number of ways, the primary method will always be some multiple of generated net cash flow. So the closer you get to business exit, the more cash flow you want to be able to book in the financials, which could end up costing you some taxes short term, but also gaining you even more long term sales proceeds.
#4. Make yourself Dispensable. Too often, business owners do not transition the management and control of the business to others or create systems that do not require their direct involvement. One of the key things that can scare off buyers is the fear that the business may not be able to profitably continue without the presence of the owner.
#5. Develop a financing friendly scenario. In most cases, optimal profits from selling a business and quick business sales, have everything to do with the buyer being able to finance a portion of the business purchase price. Third party business financing is more likely when lenders can clearly see the historical performance of the business, a solid transition plan, and business assets that have significant market value. The other business financing aspect of getting an optimal sale price is for the business owner to supply part of the financing. While this limits the cash proceeds in the short term, it can also make or break the potential for higher total returns.
Vendor financing can also significantly speed up the sales process as third party lenders are more interested in participating in deals where the vendor is also prepared to contribute. Why? There are a couple of reasons. First, the amount of third party financing required will likely be less so less risk to the lender. Second, the vendor financing will create risk for the vendor and should motivate the vendor to support the transition of ownership and disclose all risks and issues that may impact the business in the future. This will also reduce the risk of a third party lender. Third, lenders are not typically interested in financing goodwill, so when goodwill is built into the sale price, vendors are many times expected to finance all or part of the goodwill valuation, creating a more comfortable position for third party lenders to provide business financing
If you’re like most business owners, you or may not have thought about your eventual business exit strategy. Lets look at why this is a very common issue with business owners and why it should be given more time and attention. The underlying goals of any for profit business is to generate cash flow, build assets, and create a profitable exit plan from the business some time into the future. While the these goals are clear, the exit related goals do not get a great of attention until the owner is getting near retirement age or after some event causes the owner to need to exit. The result tends to be a suboptimal ending in terms of money actually realized from selling their business interests. Here are the main reasons (from my observations and discussions with business owners) for a lack of business exit planning and the resulting disappointing financial returns. 1. Business owners do not see a connection between what they’re concentrating on in the business today and their eventual exit. This is a highly flawed way of thinking as the present and future are closely linked in a number of ways. The actions of today, will impact the potential of any future exit. If the goal is to build optimal wealth, then all activities need to be ultimately geared towards increasing the value of the business enterprise, which effectively is to increase the value of the business exit. If the present actions are eroding the potential future exit value, then they should be corrected in order to maximize overall wealth of the owners. 2. Business owners assume that the process of exiting from their business will be quite straight forward and easy to navigate when the time comes. Again, in most cases this can be a radically incorrect assumption that can have a disastrous impact on the business owner’s retirement fund. The reality is that business exits can be hard to manage and in many cased they take way longer than expected to complete and the profit realized is far less than expected. 3. Business owners don’t want to deal with the end of their business ownership, so its easier to just ignore the whole ‘process and wait until they’re forced to deal with it. This holds true for many individuals that started a business from scratch and operated it for a considerable length of time. 4. Another misguided point of view many owners have regarding their eventual business exit is that there will actually be a buyer ready to buy at the exact time the owner wants to sell for the price the owner wants to sell for. This type of thinking can lead to very disappointing results. In reality, a business owner should always be ready to exit and always be directing their business to achieve an optimal future exit, regardless of when it actually takes place. If a buyer is looking for your type of business right now and is prepared to pay a premium for a business in an optimized and sale-able position, then a business that is always ready to exit stands to profit handsomely. While this particular circumstance may never occur, it also prepares the business for immediate exit if other circumstances present themselves, either personally or professionally. The most common unplanned circumstance I can think of here is the sudden passing of the owner or a death in the owner’s family where the owner does not want to continue with his or her business commitments on a day to day basis. If the owner is always ready to exit, then this or any other unforeseen circumstance will reduce the potential of a massive discount in sales proceeds caused by a sudden unplanned business exit. If you want to get the most cash out of your business exit, then start building one into your planning, because you never know what the future holds.