When selling a business, there are many do’s and don’ts that, when followed, can significantly increase the likelihood of securing a good deal, and which help the seller to realize their financial and personal goals. We refer to these guidelines as the “Golden Rules”.
1. Make the Company an Attractive Acquisition Target
Before soliciting prospective buyers, the seller should undertake initiatives to make their company an attractive acquisition target. Buyers are wary of “transition risk”, being the risk that major customers and key employees will leave the business shortly after it has been acquired. Therefore, the seller needs to ensure that they have a strong and committed management team in place (beyond the business owner). Ideally, owners should make themselves redundant to the business. Over-reliance on the business owner makes it difficult to sell the business on attractive terms. Consequently, many business owners become “stuckholders”, who are unable to sell their business without their continued long term involvement (and deferred payment terms). Likewise, the company should work to create “customer stickiness” through unique product or service offerings, customer service, long term contracts or other means, so as to increase the buyer’s perception of revenue stability.
2. Timing is Everything
It’s not possible to determine the optimal time to sell a business, but there are various indicators as to whether timing is good or bad. In general, businesses sell for higher values when they have demonstrated growth over the past few years in both revenues and cash flow, and there is reason to expect that growth to continue. Proof is worth more than promises, so a business with a poor track record will often be acquired on a contingent payment basis, which means that the seller still bears much of the risk. Growing businesses also tend to fetch higher valuation multiples and attract more buyer interest, which is fundamental to creating a strong negotiating position.
3. Understand the Components of Value
There are three underlying components to value, being: (i) the cash flow that a business is expected to generate; (ii) the valuation multiple (or rate of return) applied to that cash flow; and (iii) the underlying assets of the business. Cash flows and valuation multiples are inter-related. The product of these two factors determines the “enterprise value” of the business. Deducting outstanding debt from enterprise value results in the equity value (i.e. share value) of the business. But don’t forget about the balance sheet. It’s not just about the price that’s paid for the business, but also the underlying net assets (e.g. working capital and retained earnings) that must be delivered to the buyer in support of that price. The key in this regard is to get a high price for the shares (equity value) on the least amount of underlying net assets, thereby maximizing “intangible value” (or “goodwill”) – which is the essence of shareholder value creation.
4. Understand Each Buyer’s Motivations
In many cases, the seller is anxious to show what a great company they have built, so they focus on providing a lot of information to prospective buyers. But it’s important to recognize that the sale of a business is a two-way street. Every buyer is unique. The seller needs to understand the interests and motivations of each buyer, and how their company will fit into the buyer’s long term strategy. This insight will help the seller in negotiations. It’s also important to look for clues as to buyer synergies, which will influence the price that a buyer is willing to pay. In most cases, the best buyer is what is referred to as a “platform buyer”, being one that looks to leverage the target company’s product and service offerings, customers and employees. Platform buyers tend to focus on revenue growth, and are more willing to pay for synergies, as opposed to buyers that emphasize cost-cutting following the transaction.
5. Stay in Control of the Process
Buyers act out of their own self-interest in order to minimize the price they pay and to get the best deal terms from their perspective. Therefore, many buyers will attempt to derail the sale process in order to avoid being part of an auction. Common tactics include delaying responses to questions from the seller’s intermediary, declaring their position of being unwilling to participate in an auction, and trying to get the inside scoop on other offers. It’s important that the seller maintain control of the sale process in order to effectively negotiate a good deal. This means having some flexibility to accommodate reasonable buyer requests, but ultimately coordinating the receipt of offers from buyers around the same time frame in order for the seller to maximize their negotiating position.
6. Create a Strong Negotiating Position
Selling a business ultimately comes down to negotiations. The seller’s negotiating position is a function of the number and quality of alternatives available to them. You can’t negotiate effectively unless you understand the potential downside of losing a prospective buyer that decides to walk away. The seller’s negotiating position is strengthened when they understand the buyer’s motivations and potential synergies, as noted above. It’s also important for the seller to maintain credibility, which can be compromised when the seller suddenly changes their demands or provides inaccurate information to the buyer. For example, many sellers present prospective buyers with forecasts and projections that are overly optimistic. When this undue optimism is found to be unsupportable during the due diligence period, the seller’s credibility is compromised and their negotiating position is weakened.
7. Deal Structuring is Key
Sellers tend to emphasize the highest price. But the terms of the deal are equally important. The terms of the deal dictate when, how and under what conditions the purchase price is (or is not) paid. In this regard, the seller should recognize that any dollar not received at the closing of the transaction represents a dollar at risk. The seller must be satisfied that the upside potential is worth the risk. It’s also important to recognize that there are three parties to every deal – the buyer, the seller and the government. There are many ways that transactions can be structured so as to legitimately reduce or defer the government’s take. This includes consideration of whether the shares or assets of the business are sold, the structure of contingency payments, and remuneration paid to the seller pursuant to a management contract after closing.
8. Secure a Comprehensive Letter of Intent
The letter of intent (LOI) is a pivotal document in any transaction. While the LOI is non-binding, it establishes the parameters of the deal and sets the stage for negotiating the purchase agreement. Once the seller executes an LOI, it grants the buyer a period of exclusivity to conduct final due diligence and close the deal. During that time, the buyer has the advantage in negotiations, as it becomes difficult for the seller to switch horses. The seller generally has the negotiating advantage up to the execution of the LOI. Therefore, it’s critical for the seller to ensure that the LOI is specific with respect to the purchase price, the terms of payment and other important elements of the deal. Anything not covered in the LOI is subject to negotiation during the exclusivity period, where the buyer has the upper hand. If the seller can’t negotiate a favourable LOI, they will not be able to negotiate a favourable purchase agreement.
9. No Surprises in Due Diligence
Sellers should not underestimate the time and effort that will be required from them, and their management team, during the due diligence phase. Most buyers conduct a detailed due diligence investigation on every aspect of the target company. It’s important that there are no surprises during the due diligence phase that give the buyer the opportunity to renegotiate the price or terms of the deal (which is when the buyer has the upper hand). Any significant issues involving the company (e.g. legal claims, environmental concerns, customer issues, etc.) should be addressed prior to the time that the seller executes the letter of intent.
10. Stay Focused on the Business
The sale of any business is a comprehensive undertaking. The role of the investment banker is to relieve as much of the work as possible so that the seller can stay focused on running their business. Ensuring that the business runs smoothly and reports satisfactory financial results during the sale process and through the closing date is critical. This is because most buyers carefully scrutinize a company’s most recent financial results when establishing their offer price. Furthermore, any deterioration in the financial results or the operations of the business (e.g. lost customers) during the due diligence period can result in renegotiations of the price and terms, and possibly even jeopardize the deal itself.
The sale of a business is fraught with potential pitfalls and challenges. However, if the process is well managed, the seller can maximize shareholder value, both from the perspective of a good price and attractive deal terms. Remembering these Golden Rules can be helpful in that regard.
