Buying and Selling Private, Closely Held Businesses
By Matt Dickstein
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Buying or selling a business is a complex process. Legal, tax, accounting, valuation and psychology issues are all involved. This seminar and this outline only introduce certain basic matters to you. Do not think that you can rely on this outline (or any other resource material) and go it alone. You need help from a lawyer, an accountant and if necessary, a business broker and an appraiser, all of whom must have experience in mergers and acquisitions.
Finding a Business for Sale / Finding a Buyer for Your Business.
To find a partner, you can use a combination of the following approaches:
Talk to People in the Business. You should talk to people in the industry on a constant basis. This is a particularly good way to find win-win mergers.
Accountants, Attorneys and Bankers. Frequently a business owner will tell his accountant, attorney or banker of his desire to sell the business, long before making any formal attempt at sale. The accountant, attorney or banker can then introduce possible matches.
Advertisements. Check out the business opportunities section of your local newspaper or trade journal.
Brokers. Business brokers and realtors are possible contacts. A good business broker can be invaluable. But keep in mind:
- The broker takes a fee out of the sales price (up to 10%).
- Buyer beware. From buyer’s perspective, the broker’s fee means that (i) seller might increase the sales price to cover the broker’s fee, and (ii) even though buyer may have contacted the broker, the broker will still try to drive up the price.
- Seller beware. Seller must be very careful when agreeing to the broker’s terms for representation. Review the contract carefully concerning the broker’s fee, and pay special attention to sliding scale fees. Watch out for administration and other fees. Be sure that you can fire the broker after 1–3 months.
Early in the process, seller should require that buyer sign a non-disclosure agreement to protect seller’s confidential information.
Most small deals take around 3 months. You will need 1 month for initial negotiations and to get to the letter of intent, 3 weeks for due diligence, then 1 month to close. Sellers usually want to speed up the process, while buyers like to slow it down.
Letter of Intent.
When buyer has identified a target and has agreed to basic terms with seller, the parties may consider entering into a letter of intent. The letter of intent should not be a binding agreement. It should only confirm the basic deal terms, and obligate seller to (i) cooperate with buyer in its due diligence, and (ii) not accept other offers for a stated period of time.
An open, orderly and professional due diligence benefits both sides. A buyer performs due diligence to understand the business that it will buy. Seller prepares for buyer’s due diligence to mitigate (but not to hide) any problems that can reduce the purchase price. It is very important that seller determine the levels and timing of information and access that it will give to buyer.
What Should Buyer Look For? First, buyer must understand what makes the business tick, and concentrate on that (whatever it is). In general, a due diligence review should focus on the following:
- Why? The first question is, why is the business for sale? Seller should have a good answer, e.g. retirement or a shareholder dispute.
- Goodwill and Client Base. Goodwill is seller’s (good) reputation. Buyer should be sure that seller’s goodwill and client base are not tied to personal relationships (which will vanish if seller leaves the company). Do additional due diligence on key clients and suppliers.
- Employee Base. Buyer should make sure that all key employees come along, and that it can terminate unwanted employees.
- Financial and Tax Review. Buyer should insist that seller produce the business’ (i) financial and business records, (ii) income tax and employment tax returns, and (iii) sales tax returns for the past few years. These documents will shed light on whether the business is and can be profitable. Both sides should use accountants. Buyer should consider having Seller sign IRS Form 2848D to authorize IRS to send tax information regarding Seller directly to Buyer. This will protect Buyer from phony tax returns. Buyer also should be wary of employee / independent contractor misclassification, because such misclassification can lead to a hefty tax bill.
- Assets; Leases; Accounts. Buyer should (i) review and inspect all tangible and intangible assets including IP; (ii) review all leases and other contracts (including for third party consent requirements); and (iii) get an aging of accounts receivable.
- Liabilities. Buyer should check for liens, unpaid back taxes, current and potential lawsuits, unpaid bills, unfunded pension liability, unpaid vacation liability, and environmental issues.
- Capitalization. For a stock sale, buyer should make sure that it will receive clean title to a majority (if not 100%) of the company’s stock. Buyer will need to know of all outstanding securities for seller, and the existence of any disputes concerning such securities.
- Government Issues. Buyer should check into any problems that seller may have with the government, e.g. zoning or environmental cleanup.
Most private companies are valued using the discounted cash flow method, with comparable transactions used as a reference point. Seller should hire a professional appraiser early on in the process to put a value on the company. A bare bones appraisal will cost around $5,000.
The purchase price should take taxes into account, because it is your after-tax (not pre-tax) purchase price that counts. This is one of the reasons why the legal structure of a deal is so important. After fixing a purchase price, the next question is how will buyer pay it? Buyer (and seller if it takes a deferred purchase price) must be sure that financing the acquisition will not dangerously reduce buyer’s liquidity.
Form of Purchase Price.
You have 4 choices: cash up-front, a promissory note, stock in the buyer or an earn-out. From the seller’s perspective, cash is king. When a seller accepts a promissory note, stock in buyer or an earn-out, seller essentially becomes an investor in buyer.
Even though you may have settled on a purchase price, negotiations are not over. The structure of the transaction and the purchase agreement directly affect the bottom line risks and after-tax price of the deal.
Structure. Rule of thumb: buyers buy assets and sellers sell stock.
- Stock Sales. Here buyer purchases the stock of seller’s shareholders. Each shareholder makes its own decision whether or not to sell. Buyer assumes all liabilities of the company. Buyer gets a carry-over basis in seller’s assets (usually lower than a stepped-up basis). Seller’s shareholders pay taxes on the appreciation in their shares (with no double-tax). For these reasons, sellers prefer stock sales.
- Asset Sales. Here buyer purchases seller’s assets, and assumes only those liabilities that it agrees to assume. Seller’s company remains liable for its obligations. Seller dividends up to its shareholders the proceeds of the sale. This causes the double tax problem — seller’s company pays taxes on the asset sale, then its shareholders pay taxes on the dividend to them (exception for pass-through entities). Buyer gets a stepped-up basis in seller’s assets (consisting of the purchase price plus assumed liabilities plus transaction expenses). For these reasons, buyers prefer asset sales.
- Mergers. Although there are different forms of mergers, the end result is that buyer will convert the stock owned by seller’s shareholders into the consideration given for the merger. For more on mergers and acquisitions, see Business Mergers
- Tax-Free Reorganizations. The basic concept of a tax-free reorganization is that buyer pays the purchase price by using buyer’s own securities as consideration. The transaction frequently looks like an exchange of stock between buyer and seller. The transaction is tax free, except for any “boot” received by seller’s shareholders.
Representations. Seller will make extensive representations about its affairs. This allows buyer to recover back some of the purchase price if any of the representations is materially misleading, for example, seller did not disclose certain liabilities. Representations are not a substitute for due diligence, but they do provide additional security.
Holdbacks. Buyer should try to holdback a portion of the purchase price, in case seller has made false representations. Holdbacks can be structured as a promissory note, an escrow or an earn-out (which is a purchase price that is paid over time based on the company’s post-closing performance).
Post-Closing Adjustments. Sometimes the parties agree that buyer may adjust the purchase price before or after the closing. Buyer usually makes adjustments based on an accounting and inventory that it performs after it takes over the business, or for the gap period between the signing of the sale agreement and closing.
Buyer should receive non-competition agreements from seller. Otherwise, buyer is at risk that seller will set up a competing shop across the street.
Buyer should receive employment agreements from the key employees of the company that buyer wishes to retain.
Psychology. Ego drives deals. Be sensitive to your own and the other side’s psychology.