SELLING A BUSINESS

Many small business owners eventually decide to sell their companies, though the reasons for such divestments vary widely from individual to individual. Some owners may simply wish to retire, while others are impatient to investigate new challenges—whether in business or some other area—or tired of the frustrations of the business in which they find themselves. Others decide to sell for reasons more closely associated with the health of the business itself; disputes with partners, incapacitation or death of principals, or downturns in the company's financial performance can all spur business owners to ponder putting their business on the block. Whatever their ultimate reason for selling, though, business owners can get the most out of their company by carefully considering a number of factors.

TIMING THE SALE OF A BUSINESS

"External economic forces, together with internal financial performance, will dictate when you should put your company on the market so as to achieve the maximum results," wrote Lawrence W. Tuller in his book Getting Out: A Step-by-Step Guide to Selling a Business or Professional Practice. "If the timing isn't right, it will take much longer to sell the business, and the price you negotiate will inevitably be less than you should get."

The financial performance and history of the company in question is often the most important factor in determining price at the time of sale. A business owner who chooses to sell after posting several years of steady growth will naturally command a higher price than will the business owner who decides to sell only a year or two into that growth trend, even if the environment continues to appear friendly to the business for the foreseeable future.

The business environment in which the company operates is also an important factor in determining the asking price that the market will bear. If the company in question operates in an industry that is suffering through a downturn, the owner should delay selling the business if at all possible. Few companies are able to buck the tide when the industry in which they operate is stuck in a sluggish cycle, and even attractive businesses will not shine as brightly during such periods. For most business owners looking to sell their company, it is usually wise to ride out the trough and put the company up for sale after the industry enters a more robust cycle. Of course, some industries never post a recovery; business owners engaged in under-performing industries need to determine whether the downturns they experience are simply an inevitable part of the business cycle within a basically healthy industry, or whether changes in the marketplace are fundamentally altering the strength of the industry (establishments as varied as roller rinks and hat manufacturers have been relegated to the fringes of the American economy by the ever-changing tastes of U.S. consumers).

The stock market is a third factor that should be analyzed when pondering whether to put a company up for sale. "Stock market averages and trends reflect not only the current health of the national economy, but the projected conditions for the near future," pointed out Tuller. "Major corporate decisions for capital appropriations, expansion or contraction moves, and new product and service introductions are strongly influenced by the perceived well being of the economy. In turn, the magnitude of these corporate decisions affect investor confidence in the stock market…. The price an entrepreneur can get for his company will be heavily influenced by public investor attitudes."

STOCK SALES AND ASSET SALES

Another decision that some business owners need to make early in the selling process is whether to hand over the company through a stock sale or an asset sale. If a business has been incorporated, the owner has the option of making a stock sale or an asset sale. Under the terms of a stock sale, the seller receives an agreed-upon price for his or her shares in the company, and after ownership of those stocks has been transferred, the buyer steps in and operates the still-running business. Typically, such a purchase means that the buyer receives not only all company assets, but all company liabilities as well. This arrangement is often appealing to the seller because of its tax advantages. The sale of stock qualifies as a capital gain, and it enables the seller to avoid double taxation, since sale proceeds flow directly to the seller without passing through the corporation. In addition, a stock sale frees the seller from any future legal action that might be leveled against the company. Lawsuits and claims against the company become the sole responsibility of the new stock owner(s).

Partnerships and sole proprietorships, meanwhile, must change hands via asset sale arrangements, since stocks are not a part of the picture. Under asset sale agreements, the seller hands over business equipment, inventory, trademarks and patents, trade names, "goodwill," and other assets for an agreed-upon price. The seller then uses the money to pay off any debts; the remainder is his or her profit. Changes in ownership accomplished through asset transactions are generally favored by buyers for two reasons. First, the transaction sometimes allows the buyer to claim larger depreciation deductions on his or her taxes. Second, an asset sale provides the buyer with greater protection from unknown or undisclosed liabilities—such as lawsuits or problems with income taxes or payroll withholding taxes—incurred by the previous owner.

PREPARING TO SELL

When preparing to sell a business, owners need to gather a wide variety of information for potential buyers to review. Financial, legal, marketing, and operations information all need to be prepared for examination.

FINANCIAL INFORMATION Most privately held businesses are operated in ways that serve to minimize the seller's tax liability. As John A. Johansen observed in the SBA brochure How to Buy or Sell a Business, however, "the same operating techniques and accounting practices that minimize tax liability also minimize the value of a business. …It is possible to reconstruct financial statements to reflect the actual operating performance of the business, [but] this process may also put the owner in a position of having to pay back income taxes and penalties. Therefore, plans to sell a business should be made years in advance of the actual sale." Such a period of time allows the owner to make the accounting changes that will put his or her business in the best financial light. Certainly, a business venture that can point to several years of optimum fiscal success is apt to receive more inquiries than a business whose accounting practices—while quite sensible in terms of creating a favorable tax environment for the owner—blunt those bottom line financial numbers.

Would-be business sellers also need to prepare financial statements and other documents for potential buyers to review. These include a complete balance sheet (with detailed information on accounts receivable and payable, inventory, real estate, machinery and other equipment, liabilities, marketable securities, and schedules of notes payable and mortgages payable), an income statement, and a valuation report. The latter is an appraisal of the business's market value.

LEGAL INFORMATION The seller should also prepare the necessary information on legal issues pertaining to the company. These range from such basic operating documents as articles of incorporation, bylaws, partnership agreements, supplier agreements, and franchise agreements to data on regulatory requirements (and whether they are being adhered to), current or pending legal actions against the company, zoning requirements, lease terms, and stock status.

MARKETING INFORMATION Intelligent buyers will want detailed marketing information on the company as well, including data on the business's chief market area, its market share, and marketing expenditures (on advertising, consultants, etc.). In addition, product line information will also be expected. Buyers, for instance, will want to know whether any of the company's products are proprietary, or whether there are potentially valuable new goods in the production pipeline. Descriptions of pricing strategies, customer demographics, and competition should also be available for potential buyers to review.

OPERATIONS INFORMATION Finally, business owners looking to sell their company should be prepared to provide detailed information on various aspects of the business's day-to-day operations. The "operations" umbrella encompasses everything from company policies to historical hours of operation to personnel listings, including organizational charts (if applicable), job descriptions, rates of pay, and benefits. Other factors that can potentially impact one or more aspects of the company's operations, such as the presence or absence of an employee union, will also have to be detailed.

Once information on all facets of the business has been gathered, it should be organized into a comprehensive business presentation package. A complete business presentation package, remarked Johansen, should include the following:

History of the business
Description of business operations
Description of physical facilities
Discussion of suppliers (if any) and agreements with those suppliers
Review of current and historical marketing practices
Description of competition
Coverage of personnel and employee issues
Identification of owners
Description of insurance coverage for business
Discussion of pending legal issues or contingent liabilities
Financial statements for the past three to five years

LOCATING PROSPECTIVE BUYERS

Most business owners sell their companies to external buyers—buyers who are not current partners or employees in the organization. There are three primary routes that sellers can take to notify these buyers of the availability of their companies: print advertising, industry sources, and intermediaries.

Many people hoping to sell their businesses make arrangements for advertisements in the Thursday edition of the Wall Street Journal, which produces several regional versions of its paper around the country. The Journal is a particularly popular option for owners of large, privately held businesses. Owners of smaller businesses, meanwhile, often turn to the classified sections of their own local newspapers to advertise the availability of their company for acquisition. When submitting a "business opportunity" advertisement for publication in the newspaper, however, sellers need to take a sensible approach. "There is a delicate balance to be struck in any kind of advertising between the need for confidentiality and giving enough information to attract potential buyers," wrote Michael K. Semanik and John H. Wade in The Complete Guide to Selling a Business. "When your ads describe too much, competitors and others can deduce who you are and find out information you don't want them to know. Give too little information and you won't attract any interest." Advertisements should provide a brief description of the type of business for sale, its primary assets (location, popularity, profitability, etc.), and a way for interested buyers to make contact. Sellers who wish to maintain some degree of anonymity while looking for a buyer may wish to arrange for a post office box rather than include their telephone number.

Industry sources also can be valuable when a business owner decides to sell his or her business. Suppliers, for instance, may know of potential buyers lurking elsewhere in the industry or community. In addition, trade associations and trade journals can be used to get the word out about a company's availability.

A third option that many sellers use is to secure the services of a business broker or merger and acquisition consultant to sell their business. Business brokers, who generally handle the sale of smaller companies (though this is by no means an absolute rule), typically charge the seller a fee of about 10% of the final purchase price. "Business brokers are exactly what the name implies," wrote Tuller, "firms that list businesses for sale, then advertise them for sale to the public. They are very similar to real estate brokers but not licensed…. A business broker will not usually investigate the businesses he lists but will rely entirely on data given to him by you, the Seller. Valuation of the business is usually left completely up to you, and although a reputable broker will make suggestions, he is generally either not qualified or not interested in spending much time analyzing the business to determine marketability." Merger and acquisition consultants, on the other hand, typically specialize in handling larger middle-market companies. "Their coverage of the entrepreneurial market is usually very broad and they generally know, within specialized industries or regions, which larger companies are actively searching for additions to their product lines or industry groupings," said Tuller. Payments to "M&A" consultants are usually less than 10%, but this is in part because of the larger scale of the deals in which they are typically involved. In addition, many consultants ask for a monthly retainer fee. One of the benefits of securing the services of a merger and acquisition consultant is that he or she will typically provide help in preparing presentation packages, valuing businesses, and negotiating with prospective buyers.

A well chosen business broker or merger and acquisition consultant can save the seller of a business a considerable amount of time and effort. However, both groups include hucksters who prey on unwary business owners, so it is important for sellers to conduct the appropriate background research before soliciting services in these areas.

Another option sometimes available to business owners is to sell their company to "internal" buyers—employees, business partners, or family members. Selling to employees through employee stock ownership plans (ESOPs) or other arrangements are particularly attractive for business owners because they accrue significant tax advantages through such sales. Employees interested in assuming ownership of the company via a management buyout (MBO) could range from a single key employee, such as a general manager who already has a good grasp on many aspects of the enterprise, to a group of employees (or even all of the company's employees). "This is fertile territory," claimed Tuller. "Most employees yearn to have their own business. All employees are concerned about someone else buying the company and either being fired, or not being able to work for the new boss." Employee convictions that they could improve on the owner's performance often play a part as well. Finally, noted Tuller, "when it comes time to finance the sale, bankers will bend over backwards to assist a [management buyout], although they might not be interested at all in an outside buyer." MBOs that rely on external financing, however, typically require that one or members of the purchasing group have management training in all aspects of the business; if such expertise is lacking, the seller will need to implement a training schedule for one or more employees to fulfill this requirement.

Business partners, meanwhile, are often ideal business buyers when an owner is ready to get out. Indeed, many business owners—especially in professional practices—bring in partners for this express purpose. The advantages of selling to a partner are numerous: the need to search for a buyer—or to use an intermediary—is obviated; terms of payment are often easier to arrange; and the business transition is eased because of the familiarity that already exists between the partner and the enterprise's suppliers, clients, and customers. Small business owners looking to hand over the reins of a company to a partner, however, need to adequately prepare for such a step. Locating a suitable partner, structuring a partnership buyout, and financing a partnership buyout are all important and complex issues that require care and attention.

Finally, business owners also groom people within their organization to take over the business upon their retirement (or death or disability). Family-owned businesses often hand over the reins from generation to generation in this fashion. In many cases this transfer of ownership is made as a gift or included as part of the owner's estate.

MAKING THE SALE

Once the seller has found a buyer for his or her company, the next step is to arrange the structure of the transaction. In addition to determining whether to make a stock or asset sale (in the case of corporations), the seller and the buyer need to reach agreement on other terms of the sale as well.

EARN-OUTS An earn out is an agreement wherein the seller takes a portion of the selling price each year for a fixed period of time out of the earnings of the company under its new ownership. These agreements are sometimes employed when a seller cannot get his or her full asking price because of buyer concerns about some aspect of the business. "Most earn out plans are contingent on the level of profits a company earns," wrote Tuller. "No profits, no payments." As a result, some sellers insist on minimum payment amounts. In addition, since the seller's total compensation under this arrangement depends on the company's performance during the specified earn-out period, sellers often require that they be involved in management decisions during this period. Earn-outs can be calculated as a percentage of gross profit, net profit, sales, or some other mutually agreed-upon figure. Sellers, however, need to make sure that the measurement used is fair and easily verifiable. As Semanik and Wade noted, "profit is a very difficult word to define. A shrewd purchaser could allocate costs in such a way that profit expectations are repeatedly dashed."

INSTALLMENT SALES Under this common arrangement, the seller of the business receives some cash, but the majority of the purchase price is received over a period of years. The down payment for small businesses may range from as little as 10 percent to as much as 40 percent or more, with the rest paid out—with interest—over a period of 3-15 years.

LEVERAGED BUYOUT A leveraged buyout or LBO is the purchase of a company through a loan secured by using the assets of the business as collateral. This option, however, places a greater debt burden on the company than do other types of financing.

STOCK EXCHANGES In instances where a large, publicly held company is the purchaser, business owners sometimes ask to be compensated with stock in the purchasing corporation. In such cases, the seller is usually required to hold on to the stock for a certain period of time—usually two years—before he or she has the option to resell it.

Buyers sometimes insist on a noncompetition clause as well. "The noncompete agreement is a fair clause in any sales contract," wrote Semanik and Wade, "because it prevents a seller from opening across the street (or town) and winning back the customers." This covenant not to compete with the buyer, which can be incorporated into the purchase and sale agreement or created as a separate document, usually stipulates a market area and/or a period of time (three to five years is common) in which the seller may not open a business that would compete with the enterprise that he or she previously sold.

CLOSING THE DEAL

Once a deal has been struck between the seller and the buyer of the business, various conditions of sale often have to be addressed before the deal is closed. These include verification of financial statements, transfer of licenses, obtaining financing, and other conditions. Most contracts call for these conditions of sale to be addressed by a specified date; if one or more of these conditions is not taken care of by that time, the agreement is no longer valid.

Provided that these conditions have been attended to, however, the parties can move on to the closing. Closings are generally done either via an escrow settlement or via an attorney performs settlement. In an escrow settlement, the money to be deposited, the bill of sale, and other relevant documents are placed with a neutral third party known as an escrow agent until all conditions of sale have been met. The escrow agent then distributes the held documents and funds in accordance with the terms of the contract.

In an attorney performs settlement, meanwhile, an attorney—acting on behalf of both buyer or seller, or for the buyer—draws up a contract and acts as an escrow agent until all stipulated conditions of sale have been met. Whereas escrow settlements do not require the buyer and the seller to get together to sign the final documents, attorney-performed settlements do include this step.

Several documents are required to complete the transaction between business seller and business buyer. The purchase and sale agreement is the most important of these, but other documents often used in closings include the escrow agreement; bill of sale; promissory note; security agreement; settlement sheet; financing statement; and employment agreement.