Tina: How involved should my CPA be in the process of having my business appraised? Is it necessary to let them know I am appraising my business?
Russell: While the company’s CPA is a knowledgable financial professional, only people with the appropriate training, education and experience in valuing a closely held business should be valuing the company. The CPA can be very helpful to the appraiser in gathering and interpreting the required information.
Tina: Do I need an attorney and an accountant to sell my business? If so, what role should they play?
Russell: Selling a business is both a legal and financial transaction, and the process should involve the appropriate professionals. The accountant can be very helpful during the due dilignece stage, interfacing with the buyer’s professionals in answering questions and facilitating the process. Also, the final purchase price will often be determined after certain adjustments for working capital and other items. The accountant can be instrumental in making sure this process is done properly. The attorney will be critical in making sure the documents signed by the parties say what the parties intend, and protecting her client’s interest.
Selling a business is both a legal and financial transaction, and the process should involve the appropriate professionals.
Tina: How can my attorney and accountant work together to sell my business?
Russell: The tax impact of certain aspects of the transaction may be signficant, and will likely have an impact on how the legal documents are drafted. These two professionals should be working together for the client.
Tina: Can accountants offer the same level of confidentiality in an attorney-client relationship?
Russell: No. Even in circumstances where the accountant is hired direclty by the attorney, confidentiality cannot be assured. Moreover, before disclosing any confidential information, for any reason, the accountant must be sure not be violating any relevant professional standards.
Tina: What's the best way to value a company when an owner is being bought out?
Russell: The shareholders’ agreement, if properly drafted at the outset, should specify many apects of the potential buyout, including the standard of value, the necessary qualifications of the business appraiser, payment terms, etc.
Tina: When does a business need a buy-sell agreement?
Russell: Anytime there is more than one owner, a business should have a buy-sell agreement that clearly spells out the “trigger events” that will require one party to buy out another. The agreement should be written at the beginning of the business relationship, when neither party knows if he will be the buyer or the seller, and it should be reviewed periodically to make sure that changing circumstances haven’t created a need to modify some of the provisions.
Anytime there is more than one owner, a business should have a buy-sell agreement that clearly spells out the “trigger events” that will require one party to buy out another.
Tina: Should I be thinking about selling stock or selling assets?
Russell: There are many financial, tax and legal considerations in determining whether the transaction should be a stock sale or an asset sale. This is another area where the accountant and the attorney can work together in advising the business owner.
Tina: Do I need a CPA to help with due diligence if I am buying a business?
Scott: Absolutely! A CPA is trained to look for the specific characteristics that give value to the business, the intangibles that are transferable to you as the buyer, and the red flags (the warts of the business the seller is likely trying to cover up).
Tina: What role does my CPA play if I buy a business? Should I hire a CPA right away or can I wait until after the closing?
Scott: Your CPA will provide guidance on how to build value in your business and realize the most from your efforts.
Tina: How would a business owner get the most out of working with a CPA?
Scott: Your CPA can help you understand and highlight the value drivers of your business. These are the specific attributes that are transferable to a buyer and are what make your business attractive. Further, a trained CPA can help you prepare the business by pointing out the negative characteristics of your business and how to minimize these in a sale.
A CPA is trained to look for the specific characteristics that give value to the business, the intangibles that are transferable to you as the buyer, and the red flags.
Tina: What role does a CPA provide business owners, besides financial advice?
Scott: The biggest thing I find is clients believe a good CPA is trustworthy and logical. Often, clients have nobody else to turn to when they wish to discuss subjects other than financial, so they turn to their CPA.
Tina: Should an entrepreneur hire a CPA with any type of specialty or can any CPA help with the transaction?
Scott: Business valuation is a specialty that requires years of training to be able to identify what makes a business tick (or not). A CPA not trained in business valuations may often lack the knowledge and expertise to properly value your business, resulting in you selling for too little or buying for too much!
Tina: Is it more expensive to hire a CPA who is specialized? If so, are there parts of buying/selling a business that can be done by a non-specialized CPA, to save on costs?
Scott: Often yes, but the extra cost is minor compared to the benefit received. The most common analogy when thinking about whether to hire a CPA who is specialized is this: “Would you pay a penny for a dollar?” You are contemplating perhaps the largest single transaction of your life. The worst possible thing to do is be concerned about a few bucks up front!
The worst possible thing to do is be concerned about a few bucks up front!
Tina: The buyer is asking to see my tax returns and bank statements before making an offer. Should I release this information?
Scott: Absolutely (redacted for SSN info of course). This is the basic proof for your selling claims. If you are unwilling to show the buyer these, you immediately lose credibility. Be sure they tie out to financial statements. Poor records or no records immediately cost you credibility and value.
Tina: I am buying a business. Is there a tax benefit to structuring the sale as an asset sale?
Scott: If you can sell it as a stock sale, you likely will receive more favorable capital gains treatment.
Tina: Does a buyer normally assume my liabilities if I sell my business?
Scott: Yes- if they purchased the stock they likely would. However, if they only purchase the businesses assets, then they do not assume the sellers liabilities.
Tina: How will I know when it is a good time to sell my business?
Rick: If your primary goal is simply to get the best price, watch two things: market multiples and what’s going on in your industry. Published data on market multiples show history and current levels. The market is strong right now, recovering from the low point following the recession.
Developments in your industry will also influence price. Some industries grow hot and cold and don’t necessarily follow overall market pricing trends. For example, one of the hottest industries right now is raw food processing.
All of this assumes your business is actually positioned to sell. There is a long list of readiness issues such as successor management, customer concentration, internal systems and controls, and facilities condition and capacity, to name a few. How will buyers view your company? If you’re not sure of the answer, it’s probably not time to sell.
Tina: How long should it take to sell my business?
Rick: Six months is about average, but there is a wide range. If all parties are motivated and focused, it can happen in three months. It isn’t uncommon for issues to arise and drag it out to a year.
Timing shouldn’t have anything to do with value, unless something has changed about the future outlook.
Tina: I am preparing to sell my business within the next year. Can the timing of when I get a valuation affect the "value" of my business?
Rick: Valuation is about the future. Timing shouldn’t have anything to do with value, unless something has changed about the future outlook.
Tina: Does structuring the sale as an asset or stock sale impact the valuation of my company?
Rick: It doesn’t impact the value but does have a big impact on what you wind up with after taxes. Your advisors can help explain this and structure the transaction for best tax advantages. Sellers usually want a stock sale. Buyers want an asset transaction.
Tina: I am preparing to sell my business and I do not need a full appraisal. Can I hire a business appraiser to just offer me some guidance and help?
Rick: Selling what might be your most valuable investment dictates a good business appraisal. This is not the place to save a few thousand dollars. How can you make an informed decision without an independent appraisal? You may know your business better than anyone, but you are probably not in the best position to independently assess the many areas that encompass a valuation.
Tina: I am only going to sell a minority portion of my business. Do I need a valuation?
Rick: Minority positions typically sell at a discount to control positions. These discounts are usually in a range of 10% to 50%. The level is determined by a list of factors and current market data. Qualified business appraisers have access to these factors and how to quantify them.
Tina: How do I know if my company is ready to be sold?
Rick: This becomes a long list of checkoffs. Leading the list are successor management, history of growth and profitability, diversified customer base, niche products and markets, internal controls and systems, and low employee turnover. Your business appraiser will have a complete list of these value enhancers.
Tina: Can I sell my business to a private equity group?
Rick: Sure. We’ve been seeing more of this for a few years now. PE has a ton of money available from investors seeking to diversify. Mid-size and larger businesses are more attractive to PE.
Tina: Can I sell my business to a venture capital group?
Rick: Yes, but they aren’t usually interested in established businesses. Start-ups and early stage businesses are good candidates.
Tina: What is a Working Capital Adjustment?
Rick: Any business needs a certain level of working capital (usually receivables and inventory) to operate. If you agree on a price for your business, the buyer assumes an adequate level of working capital will be there when the deal is closed. If not, the buyer would have to invest more money. To avoid that, a set level of working capital is determined in the deal price. If that level is less at closing, the price is adjusted down dollar-for-dollar.
Any business needs a certain level of working capital (usually receivables and inventory) to operate.
Tina: What is an earnout?
Rick: An earnout is a way to get a deal done when parties can’t agree on a price due to future uncertainties. The earnout provides for additional monies to be paid if certain profit or sales goals are met. This allows the buyer to afford a higher price if things go well and avoid overpaying if it doesn’t. Sellers often don’t like this because future control of the business is out of their hands.
Tina: How do I best structure an earnout to make sure I am paid?
Rick: Base the earnout on easily determined and auditable data. Sales are often used for this since profits can be manipulated. Require monthly financial statements to monitor. Have an independent CPA audit the annual amount. Have your attorney make sure the closing documents provide assurance of payment, such as a deposit.
Tina: What is Equity Value? Is this different than Enterprise Value? Do I need to know this if I am selling my business?
Rick: This is one of the most commonly misunderstood areas of valuation. Enterprise value is the value of the business by itself without regard to how it’s financed (with debt, for example). It’s usually based on the present value of future cash flows or EBITDA times a multiple. Equity value is enterprise value less debt and plus or minus any non-operating assets such as cash or investments.
It’s critical that you understand the difference and how it figures into a sale transaction. Your business appraiser can help with this.
Enterprise value is the value of the business by itself without regard to how it’s financed; Equity value is enterprise value less debt and plus or minus any non-operating assets such as cash or investments.
TIna: Will I need to finance part of the purchase price of the business?
Rick: You may have to. This depends on your personal needs and motivation and also on the buyer’s finances. If you can afford to hold out for a cash buyer, fine. Many buyers of small businesses are really buying themselves a job and don’t have funds for a cash deal. Typical terms are 20% down with the balance over 5 years.
Tina: How can I get a premium value for my business?
Rick: Look at the list of value enhancers discussed above. Work with your appraiser or other advisors to get the business “dressed up for sale.” It also helps to be patient. If you don’t like the first offer, wait.
Tina: Do you have any other tips of advice for anyone buying, selling or appraising a business?
Rick: Start early. One of the biggest mistakes is to decide today that you need a deal done in few months. Plan on it taking a year to fully navigate this tricky landscape. If the business needs dressing up, plan for longer, especially if it needs major work.
Get a good team. Besides a business appraiser, you’ll need an attorney and a CPA experienced in sale transactions. This may not be your current attorney or CPA. Don’t be bashful about finding the right people. The long-time family attorney or CPA may be comfortable but not the right person for this job.
Tina: How involved should my CPA be in the process of buying a business? At what point in the process should I hire a CPA?
Sam: It is essential that a buyer enlist the advice and counsel of their CPA, even before the decision has been made to acquire a business. The CPA can help you explore financing alternatives, identify strategic acquisition candidates, and address tax ramifications. The CPA knows what opportunities and pitfalls to look for that are specific to their client, and along with the rest of the transaction team, can help the client structure the transaction in a way that will both maximize investment return, and help the client manage a multitude of risks.
The acquisition of a business is a major transaction that needs to be considered in your overall tax and financial planning, and it is your CPA that generally knows your specific tax/financial position, and can therefore provide invaluable guidance in this area. The CPA can also perform due diligence and analysis designed to identify potential financial reporting irregularities and risks associated with a target company. The CPA can work with management post-acquisition to ensure that working capital adjustments and other financial covenants are being properly addressed. Finally, the CPA can help the client navigate the many financial, tax and legal considerations involved in an acquisition, which includes determining whether the transaction should be structured as a stock sale or an asset sale.
It is essential that a buyer enlist the advice and counsel of their CPA, even before the decision has been made to acquire a business.
Tina: Can my accountant/CPA value my business?
Sam: Not every accountant or CPA is qualified to perform a formal business valuation. Business valuation is a highly specialized discipline that should be performed by an appropriately licensed and credentialed expert. The American Society of Appraisers (ASA), the National Association of Certified Valuation Analysts (NACVA), and the American Institute of Certified Public Accountants (AICPA) offer programs to certify both CPA’s and non-CPA’s in the area of business valuation. There are national, regional and local boutique valuation firms, as well as CPA firms and investment banks that have valuation practices.
Tina: How involved should the accountant be in the exit planning process?
Sam: Once again, it is essential that a business owner enlist the advice and counsel of their CPA early in the planning process. The CPA is best positioned to provide guidance to a seller that best addresses the seller’s financial position and long-term financial plan. Buyers often require one to three years of audited financial statements; by getting the CPA involved in this process sooner rather than later, certain accounting irregularities or errors can be timely identified and addressed, thus ensuring a smoother due diligence process. Further, the CPA can provide invaluable information to the due diligence team, providing information about the business that could result in significant “add-backs” and other adjustments to the company’s financial statements that would result in a larger sales price and more cash in the seller’s pocket. It is essential that the seller’s CPA meets with the seller’s attorneys and other advisors at an early stage to ensure that the seller’s long-term financial plan is not damaged as a result of poor planning and execution.
Buyers often require one to three years of audited financial statements; by getting the CPA involved in this process sooner rather than later, certain accounting irregularities or errors can be timely identified and addressed, ensuring a smoother due diligence process.
Tina: What does "recasting financial statements" refer to, and how are you involved with the process?
Sam: “Recasting financial statements” refers to the process of adjusting the financial statements of a business to reflect the actual financial benefits of business ownership. Most privately-held middle-market businesses are managed to minimize taxable income. Accordingly, adjustments to the financial statements are generally necessary to indicate the actual cash flows generated by the operations of the business. These adjustments also facilitate comparison to industry standard metrics. Examples include adjustments to accounts receivable and inventory in accordance with Generally Accepted Accounting Principles that reflect anticipated collection and salability factors; the removal of certain items that would not remain with a buyer (e.g. certain prepaid and accrued expenses), removing excess cash to be retained by the seller, removing amounts due to/from shareholders, “step-up” adjustments of assets and liabilities to fair value, the removal of any real estate, vehicles or other property that is not part of the purchase transaction, adjustments or additions of intangible assets and/or goodwill if necessary, accrual of transaction-related liabilities (including certain contingent liabilities), adjustment of owner salaries to market rates, adjustment to depreciation and amortization expense consistent with balance sheet adjustments and asset lives, adjustment of rents to market rates, and adjustments to expenses incurred at the owners’ discretion (travel, meals and entertainment, vehicles, club dues, bonuses, etc.), and the removal of other certain non-recurring expenses. The CPA is highly trained with respect to financial reporting and is the most qualified of the team to assist with preparing recast financial statements. The CPA can provide guidance to management on how to prepare financial statements in accordance with Generally Accepted Accounting Principles, and in identifying possible “add-backs” to the recast financial statements. The CPA can also audit and report on a company’s financial statements; most buyers generally require at least one to three years of audited financial statements.
Tina: What is the difference between Net Income, SDCF, EBIT and EBITDA? What do I need to know about these when buying/selling a business?
Sam: Seller’s Discretionary Cash Flow (“SDCF”) is pre-tax earnings of the business before non-cash expenses (for example, depreciation and amortization), one owner’s compensation, interest expense or income, as well as one-time and non-operating related income and expense items. If there are additional owners working in the business, their compensation is adjusted to market rates. Earnings Before Interest and Taxes (“EBIT”) is the pre-tax earnings of a business before interest expense (and interest income if interest income is not a core revenue-generating activity of the business). Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) is the pre-tax earnings of a business before interest expense (and interest income if interest income is not a core revenue-generating activity of the business) and depreciation and amortization. It is important to know how these measurements are calculated when buying or selling a business because SDCF, EBIT and EBITDA are commonly used as the income basis in various multiple-driven valuation methods. In other words, every $1 of additional SDCF, EBIT or EBITDA would mean an additional $7 to the purchase price of a business that is selling at a 7x multiple.
Business valuation is a highly specialized discipline that should be performed by an appropriately licensed and credentialed expert.
Tina: What about personal expenses that I run through my business?
Sam: When buying or selling a business, any personal expenses of the owner that are being run through the business are generally pulled out to remove the impact of these discretionary expenses in the recast financial statements. These are generally referred to as “add-backs.” Pulling these expenses out increases SDCF, EBIT and EBITDA, and consequently the value of the business. Another reason why a seller should consult with their CPA is because these add-backs could have various income tax ramifications to the seller that need to be addressed. A seller who intends to remain with the company as an employee after the sale should understand that these personal expenses in large part will not be paid by the company after the sale unless negotiated into an employment contract.
Tina: What other liquidity or financing options do I have for my mid-market business?
Sam: Many business owners who want to retain the benefits of ownership sell only a portion of the equity of the business. The owner can sell a majority stake and receive a higher multiple as a result of transferring control to the buyer, or sell a minority, non-controlling stake in the business at a discounted multiple. There are many variations to this type of partial sale, and the owner can provide the buyer with various instruments such as warrants, preferences, conversion options, etc., all of which generally increase the sales proceeds but also transfer more rights to the buyer and confer more risk to the owner. Another popular option is a recapitalization transaction whereby the company takes on some form of debt (line of credit, term loan, etc.), distributes all or a portion of the proceeds of the loan to the owner (as permitted under the debt agreement), and then services the debt according to the terms of the debt instrument. This option is popular for owners who have a significant portion of the company’s equity tied up in the business and who want to “take some chips off the table,” but who do not want to divest any equity.
Every $1 of additional SDCF, EBIT or EBITDA would mean an additional $7 to the purchase price of a business that is selling at a 7x multiple.
Tina: What valuation methodologies are used to determine a price for a targeted company? Does financial due diligence have an impact on the valuation?
Sam: There are three methodologies that are used in probably 95% of business valuations:
Each of these methodologies has its benefits and limitations, and are chosen by the valuation expert based on the properties of the business or assets being valued.
Many business owners who want to retain the benefits of ownership sell only a portion of the equity of the business.
Tina: Do you have any other tips or advice for anyone buying, selling or appraising a business?
Sam: Be proactive; plan ahead and start thinking about your goals and strategy early. One of the biggest mistakes is to decide today that you need to consummate a deal tomorrow. Assemble your team of advisors at least a year in advance of a planned transaction, preferably two years. This will allow time for your team to properly prepare the business for sale (or identify an appropriate business to acquire) in order to maximize value and minimize risk. A properly executed transaction will include at a minimum a business valuation expert and an attorney and CPA experienced in buy/sell transactions. They may not be your current attorney or CPA, so be sure to have conversations with your current advisors about their experience well in advance. There are many legal, financial and tax considerations in determining the structure of a sale transaction, including whether the transaction should be a stock sale or an asset sale. It is important that everyone on the team communicate and be on the same page as it will always result in a smoother transaction and fewer complications and disagreements post-sale. An investment banker or business broker can also provide valuable guidance to both the buyer and the seller, particularly as the businesses and transactions become larger and more complicated.
Tina: How involved should my CPA be in the process of selling my business?
Matt: The seller’s CPA should be involved in every step of the potential transaction. Initially, your CPA can review the potential buyer’s financials to make sure that they are qualified, or that they are a legitimate buyer. Once a buyer is qualified, your CPA can facilitate the information gathering process, all aspects of the due-diligence phase, negotiation, and the deal structure to minimize the tax consequences of the transaction. All this is necessary in order to allow the business owner to continue normal business operations without disturbing growth or company moral.
Tina: I am buying a business; when do I need to consult with an accountant or a CPA?
Matt: In my opinion, you should contact your CPA before purchasing a business. I have been in many situations where a client comes in with a potential business opportunity, and as we look at the pros and cons of the business, we determine that the risk or return does not justify spending more time looking at the business. Involving a CPA that is experienced in mergers and acquisitions can save you time, money and frustration. CPAs normally have a long list of clients, and it just might work out that your CPA has a client who is looking to sell his or her business. Even if that is not the case, a skilled CPA with Merger and Acquisition experience can help guide a buyer to the best business. Once a potential business has been identified, if your CPA is experienced in Transaction Advisory Services, he or she can break down the financial information to measure the quality of earnings (Q of E). Measuring the Q of E will help a buyer determine if the risk of the purchase is worth the reward of buying.
Post-closing items can arise from poor communication, a lack of adequate bookkeeping, or any other item out of the blue.
Tina: Will there be a conflict of interest if both the seller and acquirer appoint the same firm of accountants for due diligence advice?
Matt: No, CPAs must maintain a high level of independence. If the appointed firm believes they are not independent, then they should say so immediately. Typically, many firms have more than one CPA. The buyer and the seller can have a CPA in the firm represent a buyer, and a different CPA represent the seller. Each CPA should then represent their client with the highest level of transparency and independence. I have seen on many occasions two CPAs within the same firm represent the buyer and the seller. In most cases, the transaction ends with both the buyer and seller walking away with the satisfaction that they achieved their goals. Communication in every deal is extremely important. Having one firm conducting the due-diligence process can greatly improve communication.
Tina: What will a buyer review during due diligence, and how should I prepare for the process?
Matt: Any potential buyer will want to verify what they see on the financial statements, as well as verify the potential items that are not on the financial statements. Typically, the pre due-diligence or due-diligence is being done because the buyer is interested in the seller’s business. Now the buyer has to come to a degree of satisfaction with the financials. The buyer will review source documents (bank statements, invoices, payable vouchers, lease agreements, contracts, etc.) and anything else to arrive at a high level of satisfaction in the quality of earnings.
Extending the due-diligence period as a result of findings or questions that arise during due-diligence is normal.
A seller can prepare by:
Tina: How should the areas of potential overlap between legal and financial due-diligence be minimized?
Matt: A smart business owner has a team of professionals, and it is very important that the business owner’s legal and accounting advisors communicate and have a good understanding of the services they will be providing, as well as the areas of due diligence that they will be performing. Both the buyer and the seller should remain hands off when it comes to due diligence, or in other words, they should allow the CPAs and attorneys to do their work. The buyer and seller should be kept informed of the progress at all times. Regular communication between the buyer, seller, and the professional team will expose any overlap between legal and financial due-diligence. Lastly, a competent legal advisor is not going to step into the financial aspect of due-diligence, just like a competent CPA would not opine on legal issues.
Performing a test run on what a buyer would look at is always better than being thrown into the lion’s den.
Tina: How many years of financial information does a buyer typically want to review?
Matt: In the ordinary course of business, a buyer will want to review no less than five years’ worth of financial information. Normally, five years will show a trend or pattern in business revenue and expenses. In some situations it is advisable to review more than five years; for example, if a business has experienced a natural disaster or some other transition that affected the business, or any other circumstance that influenced the business’s operations. Again, this is a great example of the need for a CPA to be involved in every step of the transaction process.
Tina: What type of information do I need to disclose to a buyer, and when should I offer this information?
Matt: If you ask ten different M&A professionals, then you will get ten different answers. In my opinion, being honest with the buyer is the best route. An honest seller will build trust with a buyer by addressing the big issues upfront. By no means am I saying that a seller should perform due-diligence for the buyer, but if a seller knows something is in the financials that is a one-time occurrence, or there is a lawsuit pending, then I suggest that the seller disclose such information. If it is important to the buyer, and the information is disclosed further along in the due-diligence process and the buyer decides to back out, then the seller could have saved time had the issue been brought up sooner. This is another very important reason why one should take a team approach to selling or buying a business. Consulting your professional advisors about disclosure will pay off in the long run.
If the transaction is a stock sale, then the buyer is inheriting the tax situation of the company.
Tina: What are some things to watch out for during due diligence?
Matt: Review the financials for revenue trends, be wary of a seller that increases revenue and accounts receivable in an effort to inflate the sales price. Contrary to my opinion, some buyers purchase a business based on a multiple of sales. Inflating sales leads to an inflated purchase price. Watch out for intercompany or related transactions. If you are buying a division or subsidiary of a company, focus on the transactions between the related parties. Many items can be manipulated if there are related entities. Be careful of obsolete assets, and ask yourself whether you are buying old or out dated inventory. It is important to have industry knowledge, or to have access to industry knowledge. This information is key when knowing the “tricks of the trade.” Finally, watch out for transactions involving key personnel. If you are buying a business, ask yourself whether the seller’s current customers, and or clients, will continue to do business with the company after the seller is gone.
Tina: What steps are taken in financial due diligence in order to assist in identifying hidden liabilities and potential exposures?
Matt: Although there is no way to discover potential exposures with 100% certainty, the buyer should do everything possible to bring these issues to light. Contacting the seller’s attorney or legal team and requesting a legal representation letter should confirm any potential legal issue known at the time. Another way is to review the company’s bank statements for any recurring payments to any banks or institutions. If liabilities are being paid by company funds, tracking the money is the best way to research what is not on the books that should be.
Tina: What is the function of Tax Due Diligence in mergers and acquisitions?
Matt: There are at least two aspects to this question; 1) if this is a stock sale, what tax attributes will a buyer be purchasing and 2) how can the deal be structured to minimize tax on the sale, or to maximize tax benefits on the purchase. If the transaction is a stock sale, then the buyer is inheriting the tax situation of the company. In this case we want to consider whether there are taxable accumulated earnings, whether there are loss carry forwards, etc. The buyer and seller can make a large difference to the net of a transaction based on the tax structure of the transaction. Engaging a CPA experienced in mergers and acquisitions can help a buyer and seller navigate through the waters of a transaction.
The WCA is a temporary fund that is intended to guide the buyer and seller through the transition period that results from the sale.
Tina: Should I have my financial statements audited if I am thinking about selling my business?
Matt: My opinion on this is yes, the financial statements should be audited before selling the business. Keep in mind the cost benefit of an audit; if the seller is a small outfit, paying the cost of an audit does not automatically increase the purchase price. While a financial statement audit doesn’t eliminate the bumps during due-diligence, it can drastically reduce issues that arise in the due-diligence stage. If cost is a factor, I would suggest having the financial books audited every few years at a minimum.
Tina: Are there ways to protect a transaction from post-closing challenges?
Matt: Post-closing items can arise from poor communication, a lack of adequate bookkeeping, or any other item out of the blue. In my opinion, having a team of professionals can help the seller cover many bases when it comes to post-closing issues. CPAs will look at the financial aspect, while attorneys will look at the legal aspect of post-closing items.
The financial information for a strategic buyer should be presented in the same manner as any other buyer with the addition of an adjustment for synergies.
Tina: How long should I expect due diligence to take?
Matt: Due-diligence can take anywhere from one day to six months depending on the size of the transaction and the size of the team performing the due-diligence. Most contracts will allow for 90-120 days from the signing of the Letter of Intent to the performance of due-diligence. Each transaction is unique and will bring new challenges. Extending the due-diligence period as a result of findings or questions that arise during due-diligence is normal.
Tina: What are Working Capital Adjustments?
Matt: A buyer expects to purchase a business in an ongoing manner. A Working Capital Adjustment (WCA) is a certain amount of money that is temporarily held back so that the buyer can operate the business with the appropriate cash that is needed. The buyer will need cash for inventory purchases, payables, etc. The seller will want credit for the business earnings up to the date of the sale. The WCA is a temporary fund that is intended to guide the buyer and seller through the transition period that results from the sale.
Having a professional team will pay for itself. Make sure you contact CPAs and Attorneys that are experienced in transaction advisory services for the best results.
Tina: How should financial information be presented to a strategic acquirer?
Matt: A strategic acquirer is buying for that reason: strategy. This can be a competitor, a company currently not in the local marketplace, or a large company establishing a division. The financial information for a strategic buyer should be presented in the same manner as any other buyer with the addition of an adjustment for synergies. Synergies are expenses that can be eliminated by adding two or more companies together. For example, if a buyer acquires the competition, is there a need to have two physical locations in the same town? If the office space of the buyer can handle the new employees, inventory, etc., then there is no need to occupy two locations. In presenting the financial information to a strategic buyer, the M&A professional would add back the rental expense of the seller to arrive at a new quality of earnings. Other examples of synergies are advertising, professional fees, salaries & wages, office expense/supplies, payroll taxes, and utilities just to name a few.
Having a professional team will pay for itself.
Tina: Do you have any other tips or advice for anyone buying, selling or appraising a business?
Matt: Buying a business should not be taken lightly. Many times M&A professionals aren’t notified until after the purchase because the buyer wanted to save some money. The truth is, the fees for such services are usually justified through a reduction in purchase price and tax savings or synergies, which are created by the purchase. Having a professional team will pay for itself. Make sure you contact CPAs and Attorneys that are experienced in transaction advisory services for the best results.
Tina: What are the top mistakes that sellers make when setting a price for their business?
Elliott: I am more in the business of determining the price of a seller’s company using industry and professional standards than I am a broker advising a seller on the appropriate price to set. Professional standards require that I apply the appropriate measure and premises of value based on the situation at hand.
However, business owners I have encountered normally think the business is worth more than it is. This is likely the result of a long-term endearing relationship with the business and a sense of pride because of it. Although this attachment is not unexpected, it does not consider things such as discounts for lack of marketability or adjustments for liquidity deficiencies.
Tina: What is enterprise value? Is this different than equity value? Do I need to know this if I am selling my business?
Elliott: The short answer is it depends.
Enterprise value, also known as market value of invested capital, is:
Fair Market Value of Equity + Long-term Interest Bearing Debt – Cash and Equivalents.
Equity value, on the other hand, is: fair market value of a company’s equity.
In the case of small businesses, book value is more likely to be the same as equity value. For larger companies, particularly publicly traded ones, book value will not be the same because there is an actively traded market for that company’s shares. Fair market value of equity value will be the total market capitalization (number of shares multiplied by the price of the stock), which fluctuates all the time.
Mathematically these two will be different if there is even one dollar of interest-bearing debt or cash. One does not really have a choice between one or the other when setting a price because not only are these numerically different but they’re also conceptually different.
You can think of enterprise value as the price one would have to pay in order to take over the business today, assuming its debt and all. Equity value is the price you would pay to the owners of the business for their interest in the company. So if you paid the owner enterprise value then you would be paying for the debt twice because you would still be liable to the debtors for the balance owed in long-term debt.
In the business valuation arena we typically do the opposite with debt than that which is calculated in enterprise value. We subtract long-term interest bearing debt when applying the market approach. It is fair to say from a business appraisal standpoint I would side more with equity value as a fair price for the business than enterprise value.
I think business owners need to know this when listing the company because regardless of which method you use (or your broker recommends) the owner will know how to tweak the business to increase the list price and get the maximum value.
Tina: What is book value and does it impact the value of my business?
Elliott: Book value is the value of your assets on paper, net of depreciation. If that does not mean anything to you then do not worry because book value does not really matter for valuation purposes. For small business owners it only matters for tax purposes.
However, some seasoned valuators I have worked with feel strongly that a business cannot be worth less than book value. Those valuators argue if it is, “the business should just close its doors, cash out and sell its assets, and do something more profitable with the money.”
I disagree with this, but only on a personal-needs basis because businesses do more than just carry a high valuation. They provide purpose and security for the owners and those who work for them. However, if I am looking at businesses as an investor and I find one not even worth book value then I get concerned. As an investor I am looking to see which business will be the most likely to provide me a return on my investment. If the business has negative cash flow and is not worth the assets on its books then it’s unlikely I will get my money back, much less a return.
The importance of book value will vary depending on the person analyzing it.
“The saying, ‘beauty is in the eye of the beholder’ is true because the type of person needing a value for your business will dictate the method used to value it.”
Tina: Is there one definitive value for my business, regardless of the purpose of the valuation?
Elliott: You may think there is only one type of person who wants to know the value of your business, but in reality there are more situations which would require a business appraisal. The saying, “beauty is in the eye of the beholder” is true because the type of person needing a value for your business will dictate the method used to value it. No value can be definitive.
For instance, if you are trying to place a value on your business simply to sell it, then you can use rules of thumb or just about any other method. If you are valuing the business for estate or tax purposes then you must use fair market value as set forth in revenue ruling 59-60 in the IRC. If you’re valuing the business because you have filed Chapter 11 Bankruptcy, then you might use liquidation value or fair value, which is different than fair market value. Which value would you use during divorce proceedings if the family business was a divisible asset? What about the value to use in the appraisal of your small business stock plan, such as an Employee Stock Ownership Plan (ESOP)? Do not forget about sentimental value – the value you secretly think the business is worth - or at least would like to receive.
Value is only definitive when your situation becomes definitive.
Tina: I own a deli and have been in business for 20 years. We are no longer profitable. I am ready to retire, and I am thinking about exiting my business. What are my options?
Elliott: If your business is no longer profitable then it is likely the pool of buyers will be limited. So I would recommend two actions.
Tina: What are damage cases? As a buyer/seller, what do I need to know about this?
Elliott: Damages cases, also called lost profits cases, are lawsuits filed by parties who say they suffered an economic loss of some kind because of an action by another party. This would be important from at least three perspectives.
“A good plan of any kind should always consider the final stages of that plan when charting the initial stages.”
Tina: When should I develop an exit strategy?
Elliott: You should develop an exit strategy when you buy or start a business. A good plan of any kind should always consider the final stages of that plan when charting the initial stages. The businesses I have seen without an exit plan have either lingered in limbo without buyers, or have been litigated. The strategy does not have to be complex or definite for that matter. Getting one down on paper and modifying it as you go is better than nothing at all.
Tina: I am selling my business; will I be responsible for financing the sale?
Elliott: You do not have to be responsible for financing. However, it is very common to see this type of financing arrangement in small business sales because the average buyer does not have the assets to acquire the business or have assets to serve as collateral for a loan.
This is also a matter of personal preference. Some sellers will require buyers to have a loan from a third party. Other sellers who want to get out more quickly will facilitate the transition to another owner by offering to take a portion of revenues or the buyer’s salary as payment. This is seen a lot in professional practices.
From my point of view, seller-financing is more risky for the seller and carries zero risk for the buyer. If the practice fails or the buyer is unable to make payments for whatever reason, there are no real repercussions. The buyer has the downside of no longer becoming the owner, but the hit to the seller is more devastating. The seller has wasted time/years and company money on a sale that is no longer going to happen.
Tina: What is the rationale behind adding back interest and depreciation when recasting earnings?
Elliott: It is a way to get free cash flow, which is the stream of value or benefit stream often used to value a business. Free cash flow is money that a company has to spend as it pleases. Interest is technically a choice by the company to utilize debt to expand or fund capital projects. Depreciation is only a book entry, meaning it is not an outflow of cash. Even though depreciation shows up on the books as an expense and it reduces net income, a company really has the amount of depreciation in cash or equivalents. By adding back both of these items you get to a more true view of profitability. I also add back amortization, as it is not a cash entry either. Some analysts also add back taxes, but my view on the issue is taxes are unavoidable and should not be added back to the value stream.
Other adjustments I make to get to the benefit stream include capital expenditures, repayments of debt, and significant one-time expenses, or revenue for that matter.
“My advice to buyers and sellers is to make sure you understand the terms of the stockholder’s agreement and any repurchasing clauses.”
Tina: Do you have any interesting stories about an appraisal you have done? Maybe something that can help a business owner avoid common pitfalls?
Elliott: I have worked on dissenting shareholder cases, where I had to support or disprove the asserted value of a stock. Often, the shareholder thinks the value was too low and will claim that based on any number of reasons. My role is to come in and provide an independent appraisal that will then be used to issue a decision in court or settle outside of court. My advice to buyers and sellers is to make sure you understand the terms of the stockholder’s agreement and any repurchasing clauses. For instance, if the stock value is computed using a fixed number of factors and is not obligated by law to have an appraisal using fair market value such as ESOPs, then you will not be entitled to an independent appraisal because you agreed to the terms of the valuation.
Tina: How have you seen the business valuation process change over the years? Are things changing for the better or worse?
Elliott: There are at least two trends in business valuation I have noticed in the last couple of years.
“The take-away here is not only to know the expectations of the other party, but also document them."
Tina: Do you have any other tips or advice for anyone buying, selling or appraising a business?
Elliott: If the buy-in is going to occur over a period of years, then the best advice I can give to both the seller and the buyer of a business is to make sure you know the other person. Know his or her work expectations after the selling process commences. Know his or her work ethic. Know what his or her strong suits are, and know weaknesses too.
I was once an advisor to the sale of a health care professional practice that involved three parties. One individual, a medical doctor, was selling minority stakes to two other individuals using seller financing. One of the buyers was also a medical doctor within the practice and the other handled more of the administrative heavy lifting but was partially involved in the professional aspect when fill-ins were needed.
About six months after the initial purchase of stock, the seller and the doctor were completely at odds with one another. There was an apparent disconnect in expectations of the other party. The buying doctor assumed that buying in to the practice equated to new privileges and freedom to delegate. He began working fewer hours. He asked subordinates to perform tasks for which only he was qualified. He took on no new responsibilities, but he gained a substantial raise. The seller on the other hand expected a long needed reduction in work hours and responsibilities. He was looking forward to transitioning his focus on other aspects in life.
As you can probably guess, it did not end well. The two parties ended up settling outside of court, with the buyer receiving the fair market value of the few shares he owned unfortunately. The take-away here is not only to know the expectations of the other party, but also document them. It may seem petty to some to contractualize job tasks, but it could save you a lawsuit.
Brian: Companies are sometimes acquired for a premium price over-and-above the fair market value of the business on a stand-alone basis. These premiums typically reflect anticipated synergies and cash flow enhancements that a strategic buyer (oftentimes a competitor, customer, or vender) believes it could achieve. Examples of synergies include reduced materials costs, elimination of redundant overhead, or enhanced revenue through an expanded product line. These factors may result in a business that is worth $10 million on a standalone basis being acquired for $12 or $13 million, for example. These synergies are often buyer-specific, so it is difficult to predict what premium may be achievable without knowing the specific buyer.
Tina: Can I get paid for the "potential" of my Company?
Brian: Yes. Valuation is an inherently forward-looking exercise. While the company’s historical performance is an important indicator of future potential, a buyer is not buying your company’s historical cash flows; rather, all of a buyer’s return will be generated from future cash flows. As such, the value of any company is largely a function of the buyer’s and seller’s assessments of the present value of the company’s future cash flows. A common challenge is that buyers and sellers oftentimes cannot agree on a company’s potential, which is why transaction prices are often structured based on current or actual performance rather than future performance. Also, when there is considerable disagreement about the future of a business, an “earn-out” (i.e., additional purchase price that is only paid if certain future performance objectives are achieved) can often be structured to bridge the gap between the buyer and seller’s expectations.
While the company’s historical performance is an important indicator of future potential, a buyer is not buying your company’s historical cash flows; rather, all of a buyer’s return will be generated from future cash flows.
Tina: When should I start developing an exit strategy for my business?
Brian: It is never too soon to being developing an exit strategy. Generally speaking, the more time you plan, the better result you will achieve. A good rule of thumb would to begin developing and planning for an exit strategy no less than 3 to 5 years prior to your desired exit. This will allow you ample time to prepare your business for sale and maximize the value of your company.
Tina: What are my different exit options?
Brian: While there are hundreds of variations of various exit options, they can generally be condensed into 4 categories: (a) sale of the business to a strategic buyer, (b) sale of the business to a financial buyer (such as an investor or a private equity firm), (c) sale of the business to employees or key management, or (d) in the case of a family-owned business, sales, gifts, or transfers of the business to the next generation of family. Each option has pros and cons, and selecting the best option is almost always determined based on the goals and objectives of the current business owners.
Tina: Are there any unique exit options that are often overlooked?
Brian: Selling a business to your employees through an Employee Stock Ownership Plan (“ESOPs”) is an often-overlooked option that can provide tremendous advantages to the selling shareholder, the company, and its employees. ESOPs are permitted to pay up to fair market value, so the business owner will receive a fair price. The business owner will receive favorable capital gains tax treatment because the transaction is a stock sale rather than an asset sale, and there may be an opportunity to defer the capital gains tax if certain requirements are met. The company and employees benefit from numerous significant tax advantages, such as repaying the transaction debt with pre-tax dollars and possibly even becoming an income tax-free entity in the case of a 100% ESOP-owned S-corporation. Another very important advantage of ESOPs is their flexibility; business owners can choose to sell a portion of their ownership to an ESOP and create a gradual ownership transition plan that is often not feasible with other exit planning options. Plus, many business owners would rather sell their business to their employees who have helped build the business rather than a competitor.
Tina: How can I learn more about ESOPs?
Brian: ESOPs offer many advantages, but are highly specialized. It is important to discuss the pros and cons of ESOPs with advisors who are heavily involved with ESOPs, as most CPAs, attorneys, and financial planners only have a cursury understanding of ESOPs, which often leads them to dismiss an ESOP as “too complicated”. Ask your current advisors if they are aware of any ESOP experts in your city. Also, you can search the ESOP Association’s website for a list of experts. Most major cities only have a small handful of ESOP experts, so it is not uncommon to look outside your geography to find this specialized expertise.
Tina: Should I be thinking about selling stock or selling assets?
Brian: The decision of whether to sell stock or assets can be an important one for both the selling shareholder and the acquiring company. From a seller’s perspective, there is almost always a preference to sell stock, primarily because of favorable capital gains tax treatment. However, an acquiror almost always will prefer to acquire assets, both for liability reasons as well as for tax reasons, as the buyer would prefer to be able to “step-up” the basis of acquired assets and benefit from higher levels of future depreciation tax write-offs. This is often a heavily negotiated issue in a transaction, and it is imperative to involve your tax advisor in this discussion.
Tina: What if my partners have different succession goals?
Brian: This can be a difficult situation. Oftentimes when shareholders have different ideas about the timing of their exit from the business, it will be necessary to buy out the shareholders who wish to exit. All businesses with multiple shareholders should have a buy-sell agreement that dictates the process by which a shareholder may be bought out. The goal is typically to avoid conflict, ensure that the departing shareholder is treated fairly, and ensure the remaining shareholders can continue to operate the business. Determining a fair purchase price is often the most difficult part, and the best practice is for comapnies to obtain valuations of their business on a regular basis (i.e., perhaps annually or semi-annually) to establish a fair market value that all shareholders understand before a triggering event.
Tina: Should I try to time the sale of my company?
Brian: While many shareholders want to sell their business at its peak value, this is not the optimal time to sell. The optimal time to sell is when a business is on the upswing, and the outlook remains positive. Since value is forward-looking and an educated buyer will be in-tune with the competitive marketplace, it is important that your company’s business outlook is strong when you are attempting to sell a business. Waiting too long and trying to sell a company when growth or profitability are beginning to plateau or decline will typically result in a lower purchase price.
Determining a fair purchase price is often the most difficult part, and the best practice is for comapnies to obtain valuations of their business on a regular basis to establish a fair market value that all shareholders understand before a triggering event.
Tina: How can I get my business ready to sell?
Brian: There are a number of action items when preparing your business for sale, and most of them involve “cleaning up” any issues that a potential acquirer might discover in their due diligence. It is always advantageous to find and correct issues before a potential buyer finds them, as these problems often result in a buyer delaying a transaction, reducing their offer price, or even withdrawing from the negotiations. To uncover these hidden issues, the best advice is to have a reputable CPA firm (i.e., one that a potential acquiror will have heard of) perform a review or audit of your financial statements for the past couple of years. Also, this CPA firm and a good law firm should perform “pre-deal due diligence”, which is intended to replicate the due diligence that a buyer will perform. This process often uncovers accounting, tax, and legal issues that should be corrrected before putting your business up for sale. This can be an in-depth and expensive process, but business owners should view this an an investment that will make their business more marketable and potentially fetch a higher price.
Tina: Do I need to have my business appraised before I sell it?
Brian: While there is no requirement to have your business valued before you sell it, it is often advisable to do so. The key benefits that a valuation from a high-quality valuation firm can provide include: (a) provide an understanding of how a buyer will look at your business, (b) provide an objective bassis for reviewing offers, (c) understand industry dynamics, such as what “multiples” are typically paid by buyers in your industry, and (d) understand whether the value of your company is sufficient to meet your needs, which can affect your decision of whether or when to sell your business.
Tina: Can my financial planner or CPA value my business?
Brian: Business valuation is grown to become a highly specialized niche within the finance field. While historically professionals such as business brokers, financial planners, or CPAs offered valuation services in addition to their core services, the industry has evolved and valuation expertise is now largely concentrated among professionals who have dedicated their entire career to valuation services. There are national, regional, and local boutique practices that offer valuation valuation services. Also, many larger CPA firms and investment banks have dedicated valuation practices. As such, it is not advisable to have your CPA or financial planner value your business, unless these firms have active and reputable divisions that focus exclusively on business valuation.
Tina: How do I select the right valuation firm to appraise my business?
Brian: As mentioned above, business valuation is highly specialized, so it is critical to select a valuation firm that has a high degree of valuation experience. Oftentimes, your CPA, attorney, or financial planner will be able to recommend a valuation firm to you, as they may have had other clients who needed a valuation in the past, so that is a good place to start. Also, you might ask other business owners you know for recommendations. It will be important to interview potential valuation firms before hiring them, and cost should not be the key factor, as better valuation firms are often more expensive. Good interview questions to ask include (a) what percentage of your time is dedicated to business valuation (100% is the only correct answer), (b) how many valuations have you completed during your career (you are looking for hundreds or more), (c) how many valuation professionals are on your team, (d) can you provide references of clients in a similar industry that you have valued, and (e) can you provide references from other attorneys, CPAs, or advisors who you have worked with in the past. Conducting a thorough search and interview process will typically result in you discovering who the most qualified valuation practices are.
... business valuation is highly specialized, so it is critical to select a valuation firm that has a high degree of valuation experience.
Tina: Should I hire an intermediary such as an investment banker or business broker to help sell my business?
Brian: Many business owners make the mistake of thinking they can sell their business without the help of an investment banker or business broker. While these intermediaries often command a high fee (oftentimes 2 to 5% of a transaction price), good investment bankers are worth the investment and will pay for themselves by (a) correctly positioning the company for sale and presenting the company’s advantages in a comprehensive offering memorandum, (b) conducting an in-depth search process to identify as many likely buyers as possible, (c) helping create an “auction process” whereby buyers are competitively bidding for your business, (d) running a professional and smooth managed sale process, and (e) ultimately achieving a higher sales price than could typically be achieved by business owners on their own. Various studies have shown that on average, businesses that are sold through investment bankers will fetch higher prices, with an average difference around 20%.
Tina: Do you have any other tips or advice for anyone buying, selling or appraising a business?
Brian: The most important piece of advice is to prepare. A big part of that is to surround yourself with experienced advisors who can help you and your company prepare to sell. Buying, selling, or valuing your business may be a once-in-a-lifetime event, so selecting appropriate advisors (even if they are more expensive), is almost always a great investment. When buying or selling a business, you will want an attorney and CPA with plenty of experience with business transactions. It is also advisable to use an intermediary, such as an investment banker or a business broker, to help you position the company for sale, search for buyers, and negotiate the best deal. Lastly, if you wish to have your business appraised prior to a sale, be sure to select the best valuation firm you can find.