Preparing Your Company for a Successful Sale

The decision to sell a company is complicated and often comes after a long period of contemplation, discussion, and quizzing knowledgeable friends and associates. Then again, sometimes the decision is made quickly. Retirement, new business interests, weariness, and a desire to create liquidity are among the common reasons to seek a sale. Regardless of the reason, when the decision to sell is made, owners should be as prepared as possible. The following are some of the important issues, concepts, and terms owners will encounter.

Valuation is not a simple, static number, but a combination of consideration, timing, structure, and terms. Let’s examine each.

• Consideration: What currency will be used? Or will something else of value be used?
• Timing: When will the money be received? How much is being paid at closing, how much will be held in escrow (and for how long?), and how much will be paid in the future?
• Structure: How much cash will be paid. Will the seller be asked to accept a note payable? Or stock? Will an earnout be required?
• Terms: What promises will the seller make? Will any conditions need to be met before stock, a note, or an earnout is paid?

Compared to prior years, buyers use more structured deals. While transactions that are all or substantially all cash at close are preferred, sellers should expect offers that include a mix of cash, stock, notes, and/or earnouts. Depending on the buyer and the interests of the seller, a transaction with structure might be more lucrative for the seller.

Years ago, that’s how a client (jokingly) referred to the ubiquitously bantered acronym for earnings before interest, taxes, depreciation, and amortization (“EBITDA”). It is not part of the generally accepted account principles in the US, it has its shortcomings, but EBITDA is the main underpinning used to calculate valuation. Owners should familiarize themselves with the term by instructing their CFO to make this calculation as part of their regular reporting.

Having a third-party accounting firm prepare annual audits or reviews will help accurately and objectively convey the earnings of the company. This is especially important for companies that have inventory. When a third party observes inventory levels at the start of the year and the end of the year, a buyer will have greater confidence that the cost of goods sold is accurate, which means net income will be accurate. And if net income is accurate, the calculation for EBITDA will be accurate, too. Reviews or audits are used to calculate the ever-important EBITDA.

This is a relatively new report, and one I highly recommend to any owner thinking of undergoing a sale process. The QoE report highlights adjustments to earnings, quantifies one-time only expenses and other expenses that will cease after a sale is complete. These expenses are commonly called “add backs.” The QoE will be used to calculate adjusted EBITDA, which, for a company with a lot of add backs, is the metric that will be used to calculate valuation. To ensure the opinion is as independent as possible, hire an accounting firm different from the one performing the annual audit/review.

Working capital is an important but often overlooked aspect of the sale process. Transactions are conducted on a “cash free/debt free” basis. Cash and equivalents on the balance sheet belong to the seller, but any funded debt (bank loans, notes, etc.) needs to be repaid by the seller. The rest of the current assets and liabilities are used to create a formula that determines the target amount of working capital the buyer will expect at close. Here’s the typical formula:

(accounts receivable + inventory + prepaid expenses + other current assets) minus (accounts payable + accruals + other current liabilities)

The reason for the target is to prevent a seller from having a perverse incentive to sell off receivables and inventory for pennies on the dollar and to run up payables by not paying bills.

Neither side should gain a benefit at the expense of the other. The target should be fair and reasonable, and the business should be run in the normal course. However, failure to plan accordingly can cost a seller hundreds of thousands of dollars at close. Maybe more, depending on the size of the transaction. In most cases, a 12-month average will be used, but owners should instruct their CFO to calculate working capital for 36 months in order to understand trends and/or seasonality.

Who will run the company after the transaction closes? What is the current bench strength of the company? Is a successor being mentored or will the new owner need to eventually hire new management? Also, what are the owner’s plans? Immediate retirement, a transition period, indefinite employment? The market responds to clarity. The clearer/simpler the message, the better the odds for success.

Instead of focusing on getting as much as possible, what does the seller need to achieve their goals and live life as they wish? Instead of chasing an ill-defined but fabulously large number, knowing the (after tax) number needed to plug a hole in financial planning increases the odds the seller will close a deal they view as a successful outcome. That said…the bigger the valuation the better!

Owners should have their tax advisors determine their preferred tax structure. Should assets or equity be sold? Will accounts receivable be taxed as income instead of capital gains? What guidance can be provided for the buyer in terms of allocating the purchase price? These questions and more should be explored by knowledgeable tax professionals.

Whether the decision is made after extended contemplation or with alacrity, business owners should prepare as much as possible for what they will likely experience in a business sale process. The above details some of the important issues, but not all. Anyone contemplating a business sale should seek the advice of lawyers, accountants, tax experts, and investment bankers.

When you are ready to take the next step, I can help you evaluate your options, navigate the complexities and position your company to achieve a successful and rewarding transaction.