With the stronger economy we are seeing an uptick in the sale and purchase of small and medium sized businesses. Banks are lending once again, interest rates remain reasonable, and potential buyers are more optimistic about the future of the economy. In the aftermath of the great recession, sale of business transactions virtually ground to a halt, with banks generally unwilling to lend; without bank financing, potential buyers sat on the sidelines and even motivated sellers were prevented from selling.
When contemplating the sale or purchase of a business there are several critical issues which must be considered:
Price/Valuation. Setting the price of a business is part science and part educated guess. A business can be valued in many ways, but most commonly the value of a business is determined as a function of its earnings and earning potential. Typically, the annual earnings of a successful business will be capitalized using an accepted capitalization rate (interest factor) to arrive at a value for the business. Since this type of valuation is based upon the earnings of the business, a buyer’s accountant reviewing the transaction will typically adjust the earnings (sometimes called normalization) to make certain that all income and expenses are properly recognized in arriving at the final earnings figure.
Financial Due Diligence. In addition to coming up with a proper value for the business, a potential buyer must carefully review the seller’s business records over the past several years to understand the business and profitability trends of the enterprise. Inconsistencies from year to year must be explained by the seller. The buyer must gain an understanding of precisely how the seller makes its money and determine the vulnerability of the business to adverse changes in the future. Relationships with suppliers and customers must be understood. Key employees must be identified and retained. Favorable contracts and leases must be identified and preserved or extended. Comprehensive due diligence is critical to the success of the business acquisition. Sellers should insure that their corporate records are current and that their financial statements and tax returns are complete and accurate. “Audited” financial statements can be especially helpful in getting a business sold – but they are expensive. Most financial statements are prepared on a less rigorous “review” basis.
Financing the Purchase. The three major choices here are self-financing, bank financing and seller financing. Often a transaction will include all three in different proportions. Most banks will not make a loan to a buyer if the buyer is not also investing in the business. If a bank is willing to commit a loan for 80% of the purchase price, the buyer must still come up with the remaining 20%. This can come partly from the buyer’s own funds, and possibly from having the seller take back a note for the balance of the price. Often the seller will want a lien on the business assets to secure seller financing. This can be a sticking point if the bank also takes a lien on the assets to secure its loan. Seller financing often gets subordinated in priority.
Structure. Business acquisitions are usually structured either as a sale of the shares of stock (or LLC ownership interests) of the business, or as a sale of the business assets to the buyer. Buyers almost always prefer to purchase the assets from the business rather than the entity which operates the business. This is because purchasing the assets of the business is usually more favorable from a tax standpoint (allowing depreciation and other deductions) and largely eliminates the possibility of the buyer having liability to the seller’s creditors after the sale. Sellers often want to sell the entity ownership interests to obtain long term capital gain tax treatment. Choice of the sale structure has important economic consequences for buyer and seller, and may affect negotiation of the final purchase price.
Employment Agreements and No Competes. On the one hand, a buyer should consider entering into written employment agreements with the key employees of the business to make certain they continue working after the sale. On the other hand, the buyer should also consider having the seller enter into a “no compete” agreement to prevent the seller from competing with the buyer after the sale. These are customary terms of a stock or asset purchase agreement.
The purchase of a business can be both exciting and stressful. The attorneys and accountants for the buyer and seller play critical roles in ensuring that the business is sold for a fair price and that the parties are protected after the sale. Give us a call if you feel we can help you in this area.
– Kevin Palmer