This article is in collaboration with panelists from the May 2022 Houston TEI Presidents’ Forum Focused Breakfast. Below is a summary of the discussion points from all professionals on the ‘M&A: Preparing for Sale‘ panel.
Feel free to reach out to us at vcfo or the other panelists in an effort to get ready for a transaction.
- Moderator – Michael Landers, Partner, ABIP Advisors | mlanders@abipcpa.com
- Panelist – Steve Kesten, Shareholder, BoyarMiller | skesten@boyarmiller.com
- Panelist – John Tyler, Senior Vice President, Merrill Private Wealth Management | john_tyler@ml.com
- Panelist – Dustin Williamson, Houston Managing Director, vcfo | dwilliamson@vcfo.com
- Panelist – Jim Briggs, Director, Statesman Corporate Finance | jbriggs@statesmanbiz.com
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Creating and preserving business is fundamental to the roles of CEO and owner. Demonstrating sustainable value to an outsider (i.e., buyer) is only achieved through careful planning and an unbiased look at the business. In addition to the adage of being unable to escape death and taxes, one can add the following – owners will leave their business. The question becomes, how much control does an owner want over that process?
Personal Transition Planning
Personal transition planning is a process that can be used to not only prepare for an exit, but also to de-risk the business and simplify life. Given the need to view the business as an outsider would, third-party advisors are probably going to be necessary to accomplish this. More on this later.
To prepare for an optimal exit, first evaluate the company as is to support planning for what it needs to be to exit in an orderly fashion. Fundamental to this process is evaluating policies, procedures, and people. Here are a few basic questions to ask: Is the corporate strategy sustainable over the long term? Is there a solid set of internal controls? Are all legal documents and corporate information organized and accessible? Does the company have the right talent to propel the business through thick and thin? Are there incentives to motivate and keep key players in place, even after the transaction closes? Do you use Key Performance Indicators (KPIs) to manage the business and guide course corrections? Are the books and records clean and audit ready? Are the corporate records up to date? Not realistically assessing your weaknesses and shortcomings now, and fixing what needs to be fixed, will result in unexpected costs or discounts in value later.
Secondly, it is critical to understand how prospective buyers will value the business. An experienced investment banker can provide a reasonable estimate of market value, but the true market value can only be determined through a high-quality marketing process that produces multiple offers from qualified buyers. An experienced investment banker is needed to carry out such a process. If a business owner receives an unsolicited offer for his business, an investment banker can fairly quickly determine if the offer is appropriate and help the seller negotiate the letter of intent. Unless it is a simple, small business, the valuation of the business can be complicated. Thinking in terms of multiples of EBITDA, revenue, or what a friend received two years ago is a fatal fallacy. Another major mistake made by some sellers is to think that, because they receive an unsolicited offer that they find acceptable, they don’t need a transaction advisor. One of the worst things to do is walk into a negotiation underestimating value and not understanding the common terms of the deal. Engaging valuation expertise is a good way to pave the path to success.
Third, clearly understand the ultimate exit goal. Selling to family members, employees, strategic buyers, or private equity all have very different strategies. Not only are the strategies different, the typical acquisition methods of each drive different tax outcomes. Planning for the end goal needs to be carefully considered. Optimizing the sale of your company requires planning – it is not serendipitous.
Finally, work closely with personal financial and tax advisors. Most likely, the business is an owner’s largest asset, and presently, it is not liquid! Review how personal wealth goals align with the reality of a contemplated sale transaction. If there is a large gap, this step will help determine how big that gap is and provide runway to consider what proactive steps that can be taken to reach desired goals.
Maximizing Net After Tax Proceeds from a Sale
As outlined above, success in this endeavor is planned, not serendipitous. Once the sale plan has been formulated and executed, at some point the seller will be at a transaction inflection point. Having a strong transaction team is critical to optimizing this. Seasoned transaction members will save the deal – or alternatively, mitigate mistakes in the process. For better or worse, sellers are in essence selling their life’s work – it can and will be emotional. A transaction team will be able to take some of the emotion out of the decision process. Sometimes, this may result in deciding against continuing forward with a transaction. Ideally, the transaction advisory team will consist of at least one, and often all, of the following: investment banker, attorney, CFO, CPA/tax accountant, and financial wealth advisor.
When selling to a third party, the sale process usually follows one of two paths – it can be solicited offers with a coordinated offering that is structured and controlled to generate the highest bidder such as through an investment banker (recommended). Alternatively, and more often than not, the unsolicited process where an owner is approached by potential buyers before they are ready to exit. Both processes result in a Letter of Intent (LOI) that lays out the high-level deal terms that buyer and seller have agreed are acceptable (this is where leverage is at its peak). Depending on your business, both paths may necessitate preparatory or sell-side due diligence. This due diligence will usually accomplish several goals, including potentially shortening the close process, giving a third-party overview of the health of the business, and providing third-party support of the historical financial performance of the business.
Deal structuring will drive how much the seller will take home at the end of the day. One of the first dynamics that often gets confusing is whether the sale will be an asset sale versus a stock transaction. If it is a stock deal, then it will be very important to pay attention to Section 1202 Stock Exclusions for small business owners. In the event of the asset deal, many middle market deals are structured this way, there are numerous other tax considerations such as inside and outside basis, depreciation recapture, and which assets stay with the company and which are sold to the buyer. Once the assets have been identified, the next friction point will be the “purchase price allocation.” This is what assigns the consideration paid by the buyer to the assets sold by the buyer – and, potentially, the amount of depreciation that you recapture. These choices can dramatically affect what you have left over after the deal is done and the government has taken its “fair share.”
Proper planning, seamless execution, and identifying the right deal team in the early stages will help optimize the tax burden. Also, never forget that there is tremendous leverage in the LOI stage of the transaction. Much can be negotiated during this stage, including to be tax equalized in an asset sale versus a stock purchase. After the LOI is signed, the major terms of the deal are set. It is much more difficult to change the terms later. There are many facets to the structure and terms of an LOI – your transaction team should be firing on all cylinders throughout the process.
Once the LOI is signed, the confirmatory or buy-side due diligence process will begin. This is where the company CFO and investment banker will shine. They will be handling the information requests and analysis for the potential buyer. The buyer’s team will review and determine that what the buyer’s management team thinks it is buying is actually what they are buying. Be very prepared to support the due diligence process. Due diligence is where most deals fall apart with a lot of wasted time and money on both sides of the transaction.
Once the buyer has signed off on the due diligence, the transaction will immediately move to the documentation stage. This is where the attorney(s) draft the purchase agreement and various other documents that will be used to close the deal. Having level-headed, seasoned legal counsel is critical. There will be a lot of tense moments, including the “earnout” that is typical of most middle market deals (more on this later). Sometimes the process is smooth, but oftentimes it is full of stops and starts as each side huddles up with their advisors to iron out the finer points of the agreements. Once these are agreed to and signed, it may feel like the deal is done; however, it is only halfway there. The hardest part is yet to come!
Managing Expectations Regarding Post-Closing
Post-closing activities could involve several items. It is important to be prepared for these in case they surface. First, and most common, the buyer will want to ensure a sufficient amount of working capital remains in the business, and there may be a minimum working capital amount that will need to be left in the business to sustain operations post-close. This agreed-upon minimum working capital will typically require a settlement to ensure that excess cash be returned to the seller or somehow remedied post-close through escrow or other methods. Secondly, periodically, the buyer will want a seller to have some skin in the game post-close. There are many parameters that the deal team will consider. These provisions may take the form of reinvesting some of the proceeds from the transaction in the newco that was formed to purchase the company’s assets. This can tie up capital for an extended period.
Alternatively, or sometimes additionally, there is typically an earnout involved in the transaction. This is meant to ensure the seller stays engaged long enough for a smooth transfer of the business to the buyer and that the business’ financial results post-sale meet the buyer’s expectations. The earnout amount usually represents anywhere between 10% and 25% of the purchase price. It can span one to two years. The earnout will be maximized if the business performance meets or exceeds the level specified in the purchase agreement. This is likely a period where a seller is an employee of the buyer or has some type of consulting agreement with the buyer.
Once the earnout period ends, the earnout is calculated by both sides and agreed to between the parties. The typical path is for the seller to make a final exit and ride off into the sunset. At this point, the deal team will have faded into the distance and the financial wealth advisor has now become a critical relationship.
Conclusion – Call to Action
You will leave your business someday and when you do, it is highly recommended that you plan for and control that process. Not soliciting the help of an advisory team is the simplified equivalent of putting a for sale sign in your front yard that reads “For Sale by Owner” after living in it for 30 years with no maintenance. You may be able to sell it – however, the suitors are going to be looking, one at a time, for a vulture type deal to score. Some will be eyeing it for the land only value. No prudent business owner should willingly and knowingly take that route. Proper planning, the right deal team, and the right economic timing will help you maximize your investment’s value and your ability to smoothly exit the business.
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The time is now. If you’ve even remotely been considering trying to sell your company 3 – 5 years out, you need to start talking to advisors and start forming your team now. Don’t hold off. The talking is typically free but you’ll pay later. The cost of inaction can be very, very expensive.
Here are a few related blog posts you may find helpful:
- Key Elements of a Merger & Acquisition Integration Plan
- Five HR Pitfalls to Avoid After a Merger or Acquisition
- Revenue Recognition and M&A Transactions
