For many business owners, the sale of their company is the largest, most complex transaction of their career. Due to its magnitude and impact on a business owner’s (the seller’s) future, it also is one of the most stressful. A seller will often find solace and security in an experienced, determined acquisition advisor who can provide guidance during this process. It can be especially helpful for selling owners, if the advisory firm is headed by an advisor who understands the intensity and depth of emotions that an owner is facing.
There is very little information available on middle market transactions (defined as deals valued between $2 million and $250 million) to enable a potential selling owner to know what is involved in the sale process. Correspondingly, prospective sellers are often under numerous misconceptions that can be harmful. During many years in acquisitions and input from thousands of owners/entrepreneurs, I have determined that there are six common pitfalls, based on erroneous beliefs, for middle market owners.
The Misconceptions & Pitfalls
Valuation is a numbers-crunching process.
Nothing could be further from the truth. A properly conducted valuation involves the complete investigation of a company’s business foundation. It includes defining the company’s future opportunities and major risks along with its projected impact. The following factors must be evaluated during this process:
a. The strength of the company’s marketing program, including the diversity and control of its customer base.
b. For manufacturing companies, the ability to produce a high quality, low cost product, and the caliber and productivity of its research and development function.
c. For distribution or service businesses, the demographics of its trading area, the quality of its product and/or service line, the attractiveness of its locations and the ability to run its operation in a cost-effective manner.
d. The quality of the management team and the presence of a reasonably paid, well-motivated work force.
These factors become a prime determinant of the multiple to apply to the company’s expected future earnings.
Planning and timing the sale of a company increases the transaction price.
Prudence dictates that the seller plans and times the sale to maximize the transaction price. As part of the planning process, all factors defined in previous points are evaluated, and suggestions are made to strengthen the business foundation. The solidifying of the business foundation will increase the transaction price. In addition, the planning of the sale will enable a company to be prepared to go to market at the appropriate time to generate the maximum price. It also enables an owner to be capable of responding intelligently to the unsolicited interest of a prospective acquirer.
The deal is fundamentally completed when a preliminary price is established at the letter of intent (LOI).
In fact, the execution of an LOI is merely the start of the negotiating process. Unless a seller has a sophisticated, experienced advisory firm that has a strong personality and the ability to control the deal, it is not unusual for an acquirer to demand a price reduction between the LOI and the closing. It is in the seller’s best interest to see to it that an acquirer knows these demands will never be productive.
The negotiation of the definitive purchase agreement (DPA) is a difficult, confrontational and time-consuming process. The DPA includes all the critical representations, warranties and indemnifications that are of potentially equal financial importance to the deal price itself. If they are not negotiated to provide the seller maximum protection, it can give the acquirer a post-closing opportunity to recover a considerable portion of a seller’s deal proceeds.
Owners should only sell near the end of their careers.
Definitely not. Most owners don’t understand many of the benefits that can arise from a sale. Usually owners of closely held corporations have a vast majority of their personal wealth concentrated in the business. In and of itself, this is poor financial planning, but it is a typical by-product of owning a closely held corporation. By selling all or part of the company, owners can reduce their concentration of wealth in the business. In addition, it puts their estate in more liquid condition.
Younger owners, too, must evaluate their financial condition and whether they want to enjoy the finer points of life while still in prime health. After their covenant-not-to-compete expires, which could occur after a five-year period, they can get back in business if they so choose. However, they will commit only a small portion of their sale proceeds to the new business endeavor. This will assure that they have lifetime financial security. They will likely be refreshed and might even be eager to pursue a new business endeavor. From a personal standpoint, this is a very attractive alternative for a number of owners.
Where owners merely want to reduce their concentration of wealth in the business but still want to run the company, a recapitalization with a private equity firm might be the answer. In this type of situation, a selling owner can get approximately 90% of the deal value while still retaining a 30% interest in the recapitalized company. As most private equity firms strongly prefer management to stay, the selling owner should be able to continue to run the business in, basically, an unfettered manner. The only thing likely to change is that the owner will now report to a board of directors. The owner will still determine the company’s strategic course.
For a business owner who wants to pursue this alternative, it is essential that they find the right private equity firm. Only a few private equity firms are price-aggressive and pay a price comparable to a strategic acquirer. As a seller, verify whether these firms have companies in their portfolio that are a strategic fit with the business. This should enable the private equity to pay a price comparable to a strategic acquirer. An experienced advisory firm will know if a recapitalization makes sense for the owner and which private equity firms historically pay a strong price.
A seller has to accept notes as part of the transaction proceeds.
Unsophisticated sellers and advisory firms that are not overly concerned about maximizing their client’s interests believe that acquirers will always want a seller to take back a significant portion of the purchase price in notes. They rationalize that an acquirer needs this as protection against legitimate hidden problems that might be uncovered after the business is sold and because growth-oriented companies must use all available leverage to fund future expansion. This, however, is nonsense. When an individual sells their company, they have the right to receive their proceeds in cash except for the equity portion retained in a recapitalization.
A selling owner should employ special legal counsel to handle the transaction.
This depends on the sophistication of the seller’s present law firm. If it is a large firm that has specialists in the critical areas of environmental law, human resources, intellectual property, corporate finance and certain other areas, it might be appropriate to retain the current counsel for the transaction. However, if the seller presently utilizes a smaller law firm of generalist attorneys, the seller may want to employ new counsel that has specialists in the numerous functional areas.
If the seller employs a sophisticated advisory firm that will direct the deal negotiations, it is often advisable to allow the advisory firm to bring in a large, experienced law firm with whom it is familiar. This will ensure a blending of compatible negotiating styles with people who are familiar with each other’s negotiating style and skills. And this will be a significant asset to the seller during negotiations.
Owners who understand and avoid these pitfalls should be able to sell their company at an aggressive premium price with only limited, if any, exposure to post-closing issues.
Back to the May issue.