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Structuring A Deal
There are sections below dealing with how to finance or the law involved in selling a business. Here, I want to talk about the human aspects of structuring a deal.
Customers and Employees
Ensuring continuity for customers and employees can be very important to a business owner. When I sold my business the buyer was concerned that major customers would leave and I was concerned that the buyer might lay off employees that had been loyal and contributed to my success for years. In the end I offered to place part of the purchase price in escrow and refund it to her if a major customer was lost in the first year and she obligated herself to pay severance for any employee fired or laid off during the first three years after she acquired the business, based on length of service to the combined entities. I essentially bargained for insurance on my employees’ jobs.
Proposed Balance Sheet at Closing
Many offers are structured with a proposed balance sheet at close. This is to assure the buyer that they are getting what they expect and to allow the seller to continue to operate their business as if no sale was going to take place. This is especially true if the business has a lot of assets that can be quickly converted to cash, for example inventory or accounts receivable that are being included in the sale or if the buyer is assuming liabilities as part of the transaction.
For example, suppose that you own a widget store with accounts payable of $100,000, accounts receivable of $200,000, and inventory of $200,000. You get an offer to buy the store a month from now for $2,000,000. In this offer, the buyer will acquire all of the assets and assume all liabilities.
The buyer is counting on getting $300,000 in net assets at close. However, you decide that you will run inventory down to zero, stop paying bills for a month, and really lean on your customers to collect the accounts receivable. At the end of the month, you have $10,000 in receivables, $10,000 in inventory, and $200,000 in accounts payable. You have managed to pull $460,000 in cash out of the business in one month, leaving a balance sheet with negative $180,000 in net assets. You are a genius, because you've managed to turn a $2,000,000 sale into a $2,460,000 sale — a 23%increase in price. Hold on though, the sale falls through — and in this scenario the buyer and his lawyer both have an incentive to find a reason to make the sale fall through. Your business now has no inventory, upset customers, past due bills that make your vendors angry — in short, the business is not functioning well. You may have irreparably damaged the business,
An offer with a proposed balance sheet at closing makes this scenario unlikely. With an offer structured this way, the buyer says I will buy the business for $2,000,000 assuming that there are accounts payable of $100,000, accounts receivable of $200,000, and inventory of $200,000. If on the day you close your inventory's value is $220,000 the purchase price is increased by $20,000. Conversely, if on the day you close your inventory's value is only $180,000 the purchase price is decreased by $20,000. This means that you can run your business as usual, without worrying that every time you order additional inventory you are giving a gift to the buyer and the buyer does not need to worry that he will buy a business that will be unable to sell to customers because the inventory is depleted.
Non-compete agreements
In almost any deal, they buyer will insist on a non-compete agreement. Nobody wants to buy a business only to find themselves competing with the owner of the business that they just bought. As a seller, you need to closely examine what the non-compete agreement precludes you from doing. Generally, non-compete agreements are narrow, because a court can invalidate a non-compete that is too broad. The old owner must still be able to make a living. For example, a non-compete may say that you will not own or work for a doughnut shop in the state of Idaho.
I have heard lawyers say that a seller should just accept an overly broad non-compete because in the end it will be struck down as invalid. I disagree, because even if you "win",everybody loses if they have to go to court.
Think about your plans after a sale. If you are moving, you can easily ask that the agreement be structured so that it applies only to areas near your old business. You may also want to define the industries in which you cannot work narrowly (doughnut shop is better than retail food establishment, for example).
Often non-compete agreements say that you may not own any part of a competing company. I advise asking for wording that allows you to hold a small stake in publicly traded competitors so that you don't have a problem complying with the agreement when you invest in the stock market.
Merging as Opposed to an Outright Sale
If you are planning on remaining employed by the company after the sale, you may consider a merger instead of a sale. In a merger two companies are combined and the owners of both businesses retain some ownership in the combined entity. You need to be careful if you become a minority shareholder in the new company (see Partial Sale Below). It is important to be as sure as you can that you will get along with your new partner(s) because a merger is very hard to undo.
In a merger, the relative value of both businesses needs to be determined. In this scenario, it is important to look not just at conventional valuation methodologies but to project the performance of the combined entity, since both sides will bring strengths to the table.
A merger makes sense if the combined businesses are worth much more than the sum of the values of the two businesses operating independently and their relative values to the new entity can be agreed upon. For example, recently we were engaged to help mediate between two closely held companies that were hoping to merge. The companies both produced sophisticated asset tracking software for owners of commercial real estate. The software allowed centralized tracking of the age and maintenance history/schedule for everything from alarm systems to lighting and elevators.
One company, that we will call Established Co. had been in business for more than ten years and had a stable established client base. Their code was legacy code, character based, not even truly Windows software, although it now ran on Windows. They were making few new sales, but made a great deal of profit on maintenance contracts. They were having a great deal of difficulty trying to rewrite their software.
The other company, which we will call Upstart Co. had written really fabulous new software that allowed the use of a web interface. Moving the application to the web not only allowed easy access for the landlord's employees, but allowed tenants to enter and check the status of work orders.
Upstart Co., however, was having trouble making sales. Part of the problem was a lack of sales expertise. Another issue that they faced was that converting from other systems was difficult so the best potential customers, those that saw the benefits of a computerized asset tracking system, were reluctant to switch to a new system.
Established Co. argued that since there were no earnings from Upstart Co, a fair way to value upstart was to total their development cost and value the company based on those costs (a buy vs. build calculation). This would have given a value of approximately $1,000,000 for upstart Co. Since Established had a long history of earnings, they felt that the fairest way to value themselves would be to use a multiple of 4.5 times EBITDA, making their value approximately $9,000,000.
Upstart Co. didn't feel that a 10% share of the combined company was fair, although they had a hard time articulating why. One point that they raised was that the software had taken them three years to develop and they said that the lead-time was worthwhile. Established Co. countered that they believed that by basing new web-based software on their existing product's code base they could decrease development time to between six and nine months. Upstart believed that existing customers would quickly switch to their software and that the new software, when coupled with an established player's name and sales force would create a great deal of growth. Upstart viewed itself as the future and as such felt they should own the majority of the new entity.
Both companies wanted the merger to go ahead, because together the two companies were worth substantially more than they were worth separately. However, neither set of owners wanted a deal that was unfair to them. They came to us and asked us to help them make it work.
We reviewed product literature, the software itself, and financial statements from both companies. Then, we spoke to management of Established Co. and pointed out a few basic problems with their methods of trying to value Upstart Co. First, we pointed out that in a buy vs. build calculation you can not just assume that the cost of development that Upstart incurred would be the same costs that Established Co would incur. In large software projects there are significant chances of significant cost over-runs and more serious failures. Upstart Co. brought in a software project on-time, under budget, and (in the opinion of everyone involved) elegantly designed and executed. There could be no guarantee that Established would be able to do the same. I pointed out that while the cost of the winning lotto ticket in my pocket was $1, the value was far greater.
Another issue with the buy vs. build methodology was that both parties recognized that the value of the combined companies was higher than the value of the two companies separately. Since much of the increase in value came from the growth that would come from the new software, it seemed fair that the owners of upstart be allowed to share in that growth.
After warning against creating incentives for one party that might motivate them to do things that were not in the best interest of the merged company, we suggested that measures, such as the rate at which existing customers adopted the new software — which Upstart and Established had wildly different projections for, could be incorporated into the deal. Both companies, however, preferred to keep the deal simple.
We did two valuations, the one for Established used as its primary methodology, the excess earnings method of valuation. The valuation for Upstart included a Buy vs. Build methodology that took into account the risk of outright failure, the savings in lead time, and the almost certainty that the results of a development effort by Established would produce less elegant software. We also calculated the value of Upstart based on discounted future cash flows, both with and without the merger.
Finally, we explained to the owners of upstart that a company with no proven ability to produce profits is generally worth little to most buyers and that in order to capture some of the value of the combined entity that it would be in their best interest to be flexible on price.
Once given the valuations and a new framework in which to look at the deal, Established and Upstart were able to negotiate a merger.
Post Sale Planning
Consider what you will do after the sale closes. Have your accountant help you calculate how much money will be available to invest after you pay taxes on the income from the sale. Plan how the proceeds from the transaction will be invested.
In the event that you plan to retire after the sale, make sure that the deal will give you enough money to support you in retirement. There are many retirement calculators available on the web. Often, these retirement calculators will disagree with each other about how much money you need to have saved for a comfortable retirement. Some are criticized for overestimating the amount that you will need, which is in the best interest of the financial institutions that sponsor them. I believe that it is better to overestimate what you'll need to have saved than to eat cat food in your final years. Another criticism of retirement calculators is that they use average returns for each asset class in your portfolio. This means that if you tell the calculator that you have a riskier portfolio it will require a smaller nest egg than if you invest in a safer asset mix. This leads to a temptation to plan to invest in a portfolio that is riskier than the asset allocation that you will truly be comfortable with.
If you are planning to take another job after the transaction closes, will the sale enable you to be comfortable if it takes longer to find a new job than you anticipate. Remember, that finding executive jobs is often something that takes far longer and is more difficult than finding a low level job. Make sure that you understand any non-compete agreement that is part of the sale, so that you can be sure that will not restrict your future employment prospects in unacceptable ways.
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