Sooner or later every business owner arrives at a point in his or her career where he or she indulges in the notion of selling the business and moving on to a different life style or challenge. It may come in the form of day dreams during long commutes or family discussions about retirement from the stresses of day to day operation of a business… but comes that day for almost everyone who runs a business.
A brilliant entrepreneur once told this writer that the challenge of selling or transferring control of a business can be the single greatest challenge a business owner ever confronts. Or, as he put it, “Starting this business with no money or assets was a cinch compared to selling it for what it is worth.”
Forget the fantasy of someone coming along and offering you a lot of money for your business. If such an offer comes along, it is rare and most often stems from a “fishing expedition” from a competitor or someone “bottom feeding” and looking for a bargain. Forget the unsolicited calls from business brokers telling you that a premium price is easily found if you just retain their services. Selling the business for what it is worth is almost always a matter of engaging in the same type of planning, preparation and implementation of programs that allowed the success of a business in the first place…and normally takes years of effort.
Most people concentrate on getting the right price. While that is important, there are actually equally critical issues to be confronted. The two most common dangers deriving from attempts to sell the business stem from the need to keep the business healthy while trying to sell it…and making sure that once sold, the purchase payments do not falter because the business falters.
More often than not, the health of the business during the sale and after it is sold remains a critical part of the seller’s concern despite a desire to let the stress of business operations fade away. The need for continued business success is particularly pressing if any of the consideration paid for the sale is dependent on continued viability of the sold entity via payment on notes due from the business or a percentage of future income. Since often a Promissory Note is given for part of the sale, or a consulting arrangement is part and parcel of the transfer, the health of the company after sale remains a matter that the seller must consider.
And that fact, in turn, often negates much of the value of the sale. As that same entrepreneur told this writer, “If I have to depend on the business to generate my buy out, why bother selling it? I might as well own the whole thing and keep any profits.”
In short, selling the business creates issues and problems every bit as complicated as starting a business and only careful planning and preparation can make it happen to the mutual benefit of buyer and seller.
Certain recurring themes and methods are required for the seller hoping to remove him or herself from a company and this article shall outline the considerations that must be confronted by a potential seller. Obviously, top rate accounting, legal and financial advice is required to be honed for the particular transaction, but this overview may allow an overall approach that the potential seller will find useful.
The Need for Advanced Planning on the Basics:
1. Who Buys?
The most likely person or entity to purchase your business is one who knows it best-your competitors or your employees. The odds of a stranger coming along and desiring to purchase your business is small, though such things do happen. Occasionally, entities from outside your locale in your same business do wish to enter the market and buying your company may seem a good way to get easy entry. But, in reality, those out of locale buyers are simply potential competitors since if they do not buy you they may very well enter your market to compete, so the same issues will confront the seller…how to allow due diligence for a potential competitor who is not bound to buy the business? And since employees can become potential competitors as well, the problem is not solved by restricting potential buyers to employees.
There are solutions to these problems, including Non Disclosure Agreements and careful screening of the information that is provided for due diligence, but the wise seller will spend a good deal of time considering the potential buyers who may exist and how to protect the business from the results of failed negotiations. This is not academic. This writer’s experience is that fully two thirds of inquiries from competitors or large companies looking to expand into a new territory result in a quickly abandoned negotiation after due diligence and a newly vibrant competitor who has entered the field.
Employees are also difficult to sell to. First, most are not entrepreneurs. That is why they are employees. Both they and their families are used to a salary and guaranteed income (at least they think it is guaranteed) and often do not have the drive or willingness to sacrifice to invest in the business. Further, they often feel they have contributed to the value of the company by their own efforts and react negatively to the idea of buying the very value they feel they have created. Most of the time, employees over value their own contribution to the company and efforts to reveal to them their limited value seldom work and can create ill feeling.
Put simply, most employees feel they should get a very sizable discount on the price they must pay for the business due to past contributions to its success and the past relationship to the owner. While such sales are possible and while many employers also feel some type of discount makes sense, the danger of an alteration in the relationship between the employer-employee due to a failed negotiation must be considered. More than one key employee has left the company when it was apparent that said employee could not afford to buy it and that, in turn, can lower the value of the company when presented to other buyers.
If not an employee or competitor, then who? Finding people who wish to enter your business world who are not existing or potential competitors or employees is not easy. Many owners seek to use business brokers and that sometimes works though the commission is quite expensive (ten percent is common) and some engage in a side business which may form the real purpose in the transaction-creating a “prospectus” to show to potential buyers which they charge you to create. It was only a few years ago that one of our clients paid seventy five thousand dollars to create a slick brochure that the business broker put together…but who then found no potential buyers aside from employees!
In reality, the search for a buyer may take years both in terms of grooming potential employee buyers or making contacts in the field so that potential buyers in one’s own field may be checked out and slowly approached to determine if there is real interest. Trade journals and trade association officers are often good sources for leads. But note the implicit lesson here…the seller is not passive but actively explores potential buyers in the field.
The danger is that word will get out that one wants to sell and immediately competitors, customers and employees become nervous and it can adversely affect the business. Thus, it is vital to make sure the message is that one still enjoys the business, has no immediate plan to retire, but if the price was right a transition plan taking some years might be worked out. (In reality, that message is usually quite accurate for most sellers we have represented.) It is absolutely vital that no third parties can use your search for buyers to undermine the value of the business you are trying to sell or that customers or employees fear you leaving and look for alternatives for themselves. And…the message that it is a transition plan is probably true. The odds are good it will take many years before you can fully withdraw from the business.
Which is not necessarily bad. Most owners we know do not necessarily want full retirement but a better balance of life style with more time off. Given the realities of sale of a business, that may very well have to be the goal in any event.
2. How Is the Business Purchased?
As stated at the beginning of this article, if most of your consideration is dependent on the future success of the company, why bother to sell? You might as well stay on board and get all the money…and with the risk essentially the same, that only makes sense.
Too often buyers come in with a generous price which turns out to be dependent on anticipated profits of the company. If that is the case, the seller loses the power to control operations but only gets paid if those operations are successful-the worst of all worlds.
Thus, the sale should provide for payment that is not entirely dependent on future success. Most buyers argue rightfully that they wish to purchase a successful business and if it is not successful, they did not buy what they wished. They argue that if due diligence shows a successful business, they should be able to rely on the continued success and if you do have faith in your own business, why not agree to a payment plan predicated on future success? Indeed, they can even suggest a special bonus price if the business does better than expected. Often this is coupled with some type of continued employment relationship or consulting relationship.
Those arguments have plausibility but miss the most essential fact of sale-you are selling precisely to avoid having to depend on the vagaries of the future success of the business. You are selling both risk and reward in return for a guaranteed price. They get the upside by buying your business…and you should get freedom from the downside. If they will not eliminate your risk, you have little to gain from the sale. And much to lose since if they do not run the business correctly, you can lose the valuable asset you have created.
In reality, most sales end up a mix of cash buy out and a part of the consideration paid via a note over time or a consulting arrangement. If that is the case, it is essential to get reasonable terms on the Promissory Note and, if possible, a guaranty of the Note or adequate hard security. Your task is to eliminate the risk of the business as much as possible.
Related to this issue is the question of tax planning. Adequate experienced tax advice is essential for the transaction since various decisions can have substantial impact on the value of the sale to you. For a typical example, if you sell your interest, capital gains will apply to the income from the sale of stock or ownership interest. But if part of the consideration is payment to you as a consultant, with the parties understanding that your hours will be minimal, it is taxed as regular income to you at a much higher rate…and fully deductable to the buyer. The difference in tax on a million dollar sale could exceed one hundred thousand dollars in extra taxes.
It is important to note that many of the fringe benefits that owners enjoy are also likely to be lost due to the sale and many owners neglect to factor that into their economic planning in determining the benefit of sale. Thus automobile allowance, business and entertainment expenses, reimbursement for a home office, etc. are often ended and the cost for those same items increases significantly. Balancing the tax aspect of the sale is as vital as determining the price.
The two typical ways the business is sold is sale of the assets (with the buyer not assuming the liabilities of the entity) or purchase of the entity, itself. Most buyers want an asset purchase and depending on the tax status of the seller, that may be the preferred method. Note that the existence and elimination of liabilities of the business is a central issue for both buyer and seller. See our article on Bulk Sales.
Just remember that in determining the mix of methods of sale between asset sale, entity sale, consulting or employment arrangements, covenants not to compete (taxed at regular income rates) and continuation of some fringe benefits, tax rates and ultimate sums to be received must be considered.
3. Right to Compete.
In California, restrictions on competition are usually invalid unless coupled with the purchase of a business. Even then, the restrictions must be “reasonable” in scope and timing. It is fairly typical for a non compete to form part of a purchase package since the buyer has little interest in buying a business in which the owner can turn around and compete with the very business sold. Thus, restrictions from entering the same field in the prior territory for three or five years is a common term.
Of course if the buyer breaches the agreement by failing to pay on any of the consideration, the seller is again free to compete in most instances.
Too often this office has seen sellers who wish to again begin the same business a few years after the sale, or become disenchanted with the “poor job” the buyers are doing in entering the market and running the business,. Many business owners have established their own identity and value by what they did for a living and after a few years not working, find they miss the challenge a great deal.
In most consulting arrangements set up by buyers, the seller may give advice but it need not be taken and more often than not, the seller is entirely ignored after a few months or years. Sometimes that pleases the seller who is delighted to spend the time on the golf course. However, it can be quite frustrating to the successful business person who sees poor decisions hurting the business he or she created. For sellers who hunger for reentry into the market, such restrictions on competition can be difficult to endure and the seller would be wise to consider the long term ramifications of such covenants not to compete.
Related to that is the simple fact that buyers usually do not carry on the ethos and methods of the sellers, regardless of promises or intentions when the deal is being negotiated. This is particularly true when a large entity buys a small entity. Almost universally, the new methods annoy the old owners who invariably do not understand why the buyers do not continue the very methods that made the business the valuable asset they wished to purchase in the first place. Most sellers can hardly wait to end their relationship of consulting or part time work with the new entity and then find themselves restricted in beginning a new company. The terms of such non competes must be carefully reviewed and considered before the business is sold. You may not care now…you may care very much in four years.
4. Security for the Sale; Third Party Liabilities.
Most sellers understand that adequate security should be offered for any Note or future consideration to be paid to the sellers from the buyers. Guaranties, Promissory Notes, and security in the assets or stock sold via UCC 1s are the typical methods to achieve some form of security. Do not forget that consulting agreements that provide future consideration are usually unsecured thus at risk if the company falters after the sale.
Equally vital for the seller is to make sure that liabilities to third parties are avoided, including taxing authorities. A check list for notice to all such third parties must be created and the seller removed from all lines of credit, tax records, etc. The agreement of sale should include some requirement for continued liability and professional malfeance insurance for the future and adequate indemnity provisions which include payment of attorneys fees incurred in the defense.
Again, the key element to keep in mind is that the purpose of the sale is to sell the risk of owning the business. If one trades the risk of the new business going bankrupt for the risk of owning the old business, one has wasted the asset and its benefits. Risk can come from failure to pay on the note…but it can also derive from third party liability including tax liability. The taxing authorities can be ruthless in seeking recovery from past owners if the correct notice and release is not obtained from them.
If the business is sold before various projects are completed, it is vital for the seller to ensure the successful completion of the project and the release from liability for future failure to perform. More than one of our clients held off selling the business until a particularly difficult project was completed, realizing that the potential liability was just too great to risk with the new owners.
5. The Employees and Old Time Contacts.
Business ultimately is based on relationships and that includes relationships with vendors, customers and clients as well as employees and contractors. Most business owners wish to ensure that those relationships, often based on long friendships, are protected and it is common for the seller to insist upon some type of package or employment agreement being created for key employees and attention being given to particular customer needs.
Some buyers are willing to abide by such commitments, at least initially, stating that the reason they are buying the business is precisely to obtain those employees and customers. Our office has seen thousands of such deals, however, and in the overwhelming majority such intentions are seldom adhered to after a year or two. That is not surprising. Personalities and goals differ, and what worked for the old owner does not always work for the new owner. The change in treatment of employees and customers may be particularly galling for an seller who is forced to remain on premises as consultant or part time employee and this writer recalls one seller who offered to pay a “buy out” on his employment contract to avoid seeing sizable layoffs of old friends who were employees.
If you truly want to protect your employees, include that as enforceable rights in the agreement of sale. Do not expect most buyers to agree to that provision.
The Usual Problems:
The issues inherent in the above list are, of course, critical matters to confront, but there are general themes to keep in mind when confronting the need to move on.
- Keeping the Cash Flow Coming: It’s simple-if you don’t control the company, you can’t control its cash flow, and if your buy out is predicated in whole or part on the success of the business, this is a deep area of concern.
- Keep the Liabilities Away: Again, it’s simple. You have to avoid becoming entangled in liabilities deriving from the past and ongoing operations of the business. Your own warranties as to the condition of the business, your indemnity for past claims, and the need to avoid third parties claiming you are still connected thus liable become areas to be concentrated upon.
- Keep Freedom of Action: Both in terms of starting a new life free from the demands of the old and in starting a new business life should you decide to do so, you need to maximize your rights in this area. Right now sitting on the beach may seem all you want to do once you sell the business. Do not count on that lasting more than a year or two and you want freedom of action, at least in part, after that time.
- Balance the Need to Keep the Business Intact with the Need for Freedom From the Business: You built the business, you own the business, you have a sense of pride in it. You have to keep it alive long enough to assure your economic future. You also sold it so you do not have to live with it forever. That balance is the critical issue you will have to face in the next several years. Do not be surprised if you are treated differently if you remain as employee or consultant. Do not be surprised if you find the transition difficult. Do not be surprised if you find you miss certain aspects of the business. But…if you have done it right, you can start a new business if you so desire, but need not start a new one for economic security.
Above all, remember what Richard Bode wrote in First You Have to Row a Little Boat as to state of mind both in starting a business…and starting a new life:
For the truth is that I already know as much about my fate as I need to
know. The day will come when I will die. So, the only matter of consequence
before me is what will I do with my allotted time. I can remain on shore,
paralyzed by fear, or I can raise my sails and dip and soar in the breeze.