The decision to sell your company is a critical one. You’ve invested years or decades painstakingly building your business, and you’ve made countless sacrifices along the way. It’s an emotional decision that shouldn’t be taken lightly. In the words of the American science fiction writer Philip K. Dick, don’t try to solve serious matters in the middle of the night. 

When contemplating such an important decision, there are four critical factors to take into account:

  1. Your goals, including personal, financial, and business 
  2. Internal factors, such as emotions 
  3. External factors, including timing and competition 
  4. Your business’s value and exit options 

You can’t decide to sell your business by following a simple checklist. Instead, the determination should be made deliberately, taking all factors into consideration and balancing emotion and intuition with facts and logic. 

While the framework I outline below is useful, these four factors aren’t all-encompassing, but are meant to be jumping-off points to further explore this important decision. Every entrepreneur’s situation is different, and you may need to consider additional factors I don’t address here. Regardless, start by considering these four factors and see where your journey takes you.

Factor 1: Your Goals

“You are that which you are seeking.”

– Saint Francis of Assisi, Italian Friar

Start the process by writing down your goals – understanding what you want is the first step toward achieving your objectives. Only after you clarify your long-term goals can you examine how selling your business will move you closer to them. 

You must take many factors into consideration when deciding to sell your business, and considering all elements simultaneously can be overwhelming. Starting with your goals simplifies the decision-making process. The risk in selling your business before examining your goals, is that you may make a decision that doesn’t align with your goals. As a result, you may find yourself backing out of the sale or living with regret after you no longer own your business.

Questions to Help You Target Your Long-Term Goals 

To gain a better focus on your goals, ask yourself these questions:

Align your long-term objectives with the sale of your company. If your business is preventing you from achieving your long-term goals, consider selling your business. If selling your business is critical to achieving your goals, spend additional time planning your exit to ensure the sale accomplishes your objectives.

Is your goal to sell your company and become financially independent? If so, have your business valued and develop a strategy for increasing the value of your business, then track your results to ensure you meet these objectives. You should also prepare a personal financial and tax plan to make certain your exit will help you achieve your financial goals and mitigate the tax implications of the sale. When it comes to taxes, remember Albert Einstein’s keen observation: “The hardest thing to understand in the world is the income tax.” Unless you’re smarter than Einstein, consider hiring a tax expert to advise you.

Is your goal to sell your business so you can start another business or pursue an opportunity in another industry? If so, consider your lost opportunity cost and the cost of remaining in your business. 

What are you losing now by not pursuing your next business or opportunity, or a different goal or dream? Ideas are infinite, but time is finite. You have a limited number of ideas you can pursue in your lifetime, so consider what other opportunities owning your business is preventing you from pursuing. 

Again, the decision to sell your business should always begin with a thorough and careful review of your long-term goals. If your goals are unclear, then the decision to sell your business will be based on a weak foundation. As a result, it will be harder for you to commit to the sale without a definite objective, and this uncertainty will minimize your net proceeds from the sale.

Clarify Your Financial and Non-Financial Objectives 

If you must sell your business to achieve your financial goals, consult with a financial planner to ensure you can meet your financial objectives upon a sale, and meet with a CPA to consider the tax implications of the sale.

For most owners, the sale of their business is critical to achieving a personal long-term objective. Many entrepreneurs depend on the sale to help them accomplish their financial target. But it’s important to separate your financial goals from your non-financial goals to establish crystal clear objectives. 

It’s not always necessary to start your planning process with numbers – after all, money is always a means to an end and not an end to itself. Remember as business author David Baughier once said, Once you have enough money, it’s not about the money.Instead, ask yourself what’s behind the money. First, clarify your long-term goals, and then assign numbers to the goals, if possible. 

Ask yourself these key questions to clarify your financial and non-financial goals:

Other Passions You Can Pursue if You Sell Your Business 

“The price of anything is the amount of life you exchange for it.”

– Henry David Thoreau, American Author and Philosopher

When deciding to sell your business, consider the lost opportunity cost. Pursuing opportunities is a mutually exclusive decision if you believe in focus. If you chase two rabbits, they’ll both escape. Chasing more than one objective at a time dilutes your focus and lowers your chance of success. There’s a significant lost opportunity cost to holding onto a business where you’ve lost your passion. What other opportunities are you passionate about that you could be pursuing if you didn’t own your business?

While the decision to sell your business can’t always be reduced to numbers, it can be helpful to look at a sale from multiple angles, including both quantitative and qualitative perspectives.

In addition to lost opportunity costs, you need to consider the current state of your industry. Not all industries are created equal and careful consideration must be given as to when to jump from one ship to another. 

Many entrepreneurs make the mistake of thinking that the grass is always greener on the other side and that other industries offer more potential than the one they’re currently in. If you believe your industry is in decline, consider consulting with other seasoned entrepreneurs, industry experts, or an M&A advisor or investment banker to get their take. Others are likely to have experience in various industries and perspectives that you lack.

If your other goals are primarily non-financial in nature, your decision can be especially difficult, and you must carefully weigh your options. 

What is owning your business precluding you from doing? What is that experience worth to you? 

Only you can decide. Life is short, but you should take your time when making this important decision.

Factor 2: Internal Factors

“If opportunity doesn’t knock, build a door.”

– Milton Berle, American Actor

Here are more questions you should consider:

Entrepreneurship is a struggle. No entrepreneur is happy 100% of the time. But perhaps the French poet, Charles Baudelaire, was right when he said “Everything considered, work is less boring than amusing oneself.” Whether or not you agree with Baudelaire, look at yourself and your business objectively and determine if a change might make you happier. At the same time, though, beware of trading one set of problems for another. 

Why Making a Commitment to Sell Your Business is a Big Deal

Are you truly committed to the process of selling your business, or have you made this decision on a whim?

Move forward with your plans only if you’re fully committed. But be aware that doubts will remain no matter how committed you are. Be deliberate in making your decision, so you can deal with doubts as they arise. Talk with trusted friends who have successfully sold their businesses. Journal. Read. Explore your decision from all angles. 

Selling a business is a process, not an event. The process of preparing a business for sale and successfully exiting takes several years for most entrepreneurs. Shortcutting the procedure can leave money on the table and waste a significant amount of time if you begin the sale only to change your mind later. Only you can answer if you thoughtfully and purposefully made this decision or if an impulse is driving you. If you’re still on the fence, take more time to explore the decision fully before making a final determination.

Take Your Happiness Into Consideration

Would selling your business make you happier? If you’re facing challenges in your company, ask yourself if the root of your problems is a lack of management skills or if your obstacles are caused by external factors beyond your control, such as increased competition in your industry. If your issues are the result of inadequate management skills, trading one business for another is unlikely to solve your problems. 

On the other hand, some industries aren’t known for creating happy entrepreneurs. These include businesses that may have less-than-ideal customers. When was the last time you saw a happy divorce lawyer? If the general environment of your industry is unhappy and you value your well-being, consider making a change.

Would you keep your business if it made you happier? Would you keep your business if you could revamp your schedule and spend 80% of your time on high-value activities you enjoy and less time on all the other minutiae?

If so, restructure your business to focus on what you love to do and take advantage of your strengths. If you’ve lost passion for your industry and have a strong gut feeling you need to make a change, it’s time to develop a definite plan to exit your business.

Address Your Burnout and Boredom Before Deciding to Sell

Look in the mirror and ask yourself these questions:

Burnout is normal in all endeavors, and all entrepreneurs should make time for regular relaxation to de-compress. Professional athletes periodize their training. CEOs take regular time off to recharge. You should do the same to both prevent and treat burnout.

Fatigue is normal if you aren’t taking time off. Just because you’re burned out doesn’t necessarily mean you should sell your business. First, determine the cause of your burnout and then evaluate if selling your business will be a cure, or if other measures are more appropriate for rekindling your passion.

If your burnout is due to problems with your employees, it’s time to either upgrade your management skills or upgrade the team itself. Trading your business for one in another industry won’t help if people-management issues are at the root of your burnout.

If you haven’t taken a vacation in a long time, other methods are available for relieving burnout. Ideas could include stress-management techniques or restructuring your business to minimize activities you aren’t good at or that cause you stress. First, set out to relieve your burnout. If you find you still lack passion for your industry, are bored, and in need of a change, and if you’ve attempted to address your burnout and boredom one too many times without effect, then perhaps it’s time for a change.

Deciding How to Fill the Void After Exiting Your Business 

The question to ask yourself isn’t, “What will I do with my money when I sell my business?” The real question is, “What will I do with my time when I sell my business?”

To be sure, the matter of what to do with the rest of your life is a difficult topic to face. Most business owners are so busy that they don’t have time to confront the deeper issues in their lives. They’re so occupied playing whack-a-mole in their business that they don’t have the bandwidth to face life’s existential questions. 

After selling your business, it might be the first time in decades you’ve had the freedom to decide how you spend your time. Will you fritter away your days buying toys, or do you plan to pursue something more meaningful? How you spend your time should be based on your values. Your values are the foundation on which you make decisions. Having a clear and documented set of values makes the process of deciding how to allocate your time easier. 

After all, as author Michael LeBoeuf once said, “Waste your money and you’re only out of money, but waste your time and you’ve lost part of your life.”

Selling your business will leave you with time. If you don’t have another passion, you’ll be left with a void, leaving your business to fill that empty time. If this void isn’t filled, your being may lack meaning. Sitting around the pool sipping margaritas on a giant, inflatable pink flamingo can become unfulfilling after a while, especially for driven entrepreneurs. Of course, some may never tire of this. Examine your values and goals so you don’t create a void after the sale. Don’t avoid the real question by drowning yourself in material pleasures.

Factor 3: External Factors

“We’ve done better by avoiding dragons than by slaying them.”

– Warren Buffett, American Investor

Once you’ve considered your internal factors, it’s time to take a broader look at the external factors that will affect your decision. Industry conditions and competition will play a large part in how smooth, and ultimately successful, the sale process is for you.

Choosing the Right Time to Sell Your Business

When it comes to selling your business, the cliched expression applies – timing is everything. While timing the sale of your business is difficult, it can be done. The ideal time to sell is when your business and industry are about to peak. Consult with industry veterans to obtain their opinion regarding the current market cycle of your industry. Consider both narrow industry cycles and broader macroeconomic cycles. But remember that, as with most important decisions, the timing will never be perfect. 

Align the timing of your goals with the timing of the sale of your business, industry trends, and market activity, if possible. Otherwise, avoid selling in a severe economic or industry downturn. Your revenue should be stable and preferably growing by the rate of inflation or more when you put your business on the market. If it’s not, have an expert analyze your business to determine if it makes sense to stabilize your company’s revenue before putting it up for sale. 

Consider Competition, Capital, and Cash Flow 

You can bet that Warren Buffett, the Oracle of Omaha, has asked himself these questions more than once regarding specific investments:

If competition is increasing and becoming more fierce by the day, but you lack the passion and capital to compete, exit as quickly as possible if you can. The value of your business will decline proportionally to a decline in your revenue and cash flow. Face the inevitable conclusion and sell while you have something to sell. Unfortunately, I see too many entrepreneurs hang on for too long, only to have nothing valuable left to sell. 

Don’t make this common mistake. 

Factor 4: Value and Options

“Don’t be afraid to give up the good to go for the great.”

– John D. Rockefeller, American Business Magnate

Knowing what questions to ask yourself is half the battle. Consider the following when it comes to the value of your business:

Consider these questions, and many more, as you begin to explore your exit options.

Know What Your Business Is Worth 

Your business is likely one of your most valuable assets and may comprise the majority of your net worth. Intelligent financial planning is difficult without having an accurate idea of the value of your most valuable asset – your business. 

It makes sense to pay a professional to value your business and have an idea of the steps you can take to increase its value. It’s best if you and your business are prepared at all times for the unexpected buyer, and that you regularly take steps to increase the value. The buyers most likely to pay the highest price are those who approach you directly, unsolicited. So be ready for them.

Consider diversifying your risk if your net worth is highly concentrated in your business. There are many options for diversifying your risks, such as a recapitalization or an outright sale. An appraisal of your business is the most prudent place to start and can help you make an intelligent decision.

Knowing what your business is worth also enables you to determine a bottom-line price if a competitor approaches you out of the blue. Without such planning, you may be caught off guard and end up selling your business for far less than what it’s worth.

Understand Your Exit Options 

Ask yourself these questions that go to the heart of the choices you’ll face:

Most entrepreneurs lack the experience to determine exit options most suitable for their business that will unlock the most value. That’s why you should consider having a third party perform an unbiased assessment of your business.

This assessment should lay out your exit options and steps you should take to prepare your business for sale. The risks and opportunities vary depending on who you sell your business to. Different steps will need to be taken depending on whether you plan to sell your business to a strategic buyer, a competitor, or a financial buyer. You should carefully consider these issues before deciding which exit option to pursue.

There are also creative alternatives to a conventional sale. Again, before proceeding, establish your goals. With clearly defined goals, a professional can easily and efficiently lay out the most practical exit options for your business based on your goals, along with tips for reducing the risk associated with each option. In the words of Warren Buffett – Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.” 

Determine the Direction the Value of Your Business Is Going 

Sell while you’re able to extract any remaining value. If the value of your business is decreasing and you lack the drive to turn it around, consider the lost opportunity cost of holding onto your business. If revenue continues to decline, so will the value of your business. Selling a business with consistently declining revenue is difficult, but it can be done. Selling a business with stable or increasing revenue is far easier.

Take an honest look and ask if you can turn your business around. If you’re burned out and competition is increasing, it’s time to get out. If the decrease in the value of your business is due to a one-time event or an internal factor and you have time to cure the problem, then do so.

How to Know When Your Business Is Ready to Sell 

These aren’t always easy questions to answer, which is all the more reason to ask yourself:

Ideally, you should invest several years preparing your business for sale to maximize its value. The more salable your business, the more your business will be worth. There are two ways to improve salability – eliminate deal-killers and optimize your business’s value drivers. 

Start by fixing any deal-killers. These could include inaccurate financial statements or undocumented intellectual property, or one of a hundred other issues that an investment banker can help you identify. Once you address these issues, calculate the ROI on the remaining potential changes and start with the highest ROI tweaks.

Not every business owner has the time and energy to fully prepare their business for sale. If this describes you, continue to make changes while your business is on the market. If your business isn’t fully prepared, you may still be able to sell it but expect to receive less than full value.

Key Points 

“See things in the present, even if they are in the future.”

– Larry Ellison, American Inventor

Choosing whether to sell your business will be one of the most important decisions of your life. Use the framework outlined here for making this determination: 

  1. Goals: Start by considering your objectives and lost opportunity costs. This is the foundation of your decision. 
  2. Internal Factors: Address the emotional or internal factors of a sale – namely, those relating to happiness. This step takes time to do correctly, so don’t rush it.
  3. External Factors: Once you’ve thoroughly explored your emotional objectives, consider the external factors, such as the timing of selling your business and the state of your industry. 
  4. Value and Options: Finally, you can commit to the process after considering your goals and both the internal and external factors. Only then should you explore the additional facts related to the decision – such as timing, value, exit options, and salability.

By following this framework, you can make sound decisions on your company’s future with the assurance that you have taken the most important factors into consideration.

Learn More

The idea of being happy in business is one which doesn’t get talked about much, but I had an entire conversation about exactly this topic in my M&A Talk podcast episode titled Happiness: How it Relates to M&A and Entrepreneurs with Marco Robert. You can join us for this unusual conversation by going to the Resources section of our website at morganandwestfield.com.

The Audience for this Book

I wrote this book not only for owners and sellers of companies valued from $10 million to $100 million, but for anyone involved in the M&A process, such as buyers, attorneys, accountants, and business appraisers. For the sake of clarity, I address sellers directly throughout the book, but I wrote this book with all of you in mind.

A Note on Exceptions

I’ve based the advice and guidelines in this book on what you can expect to encounter 95% of the time or at the middle of the bell curve. When selling or valuing your business, you shouldn’t count on exceptions – you should target the middle of the bell curve and base your strategy on what works the majority of the time. Doing so will increase your odds of success and significantly lower your risk of not meeting your expectations. Encountering an exception that works to your advantage is always a nice bonus, but you shouldn’t count on it, or you will likely be disappointed. 

There are exceptions to every rule. For example, a company earning $18 billion a year is unlikely to acquire a company that generates only $3 million per year. But I’ve interviewed the head of M&A for an $18 billion company on my podcast, M&A Talk, who did just that. You can listen to the episode titled The Acquisition Process with Brian McCabe at morganandwestfield.com/resources

To make this book readable and keep my advice sensible, I’ve avoided listing every imaginable exception throughout these pages. Instead, the goal of this book is meant to illustrate 95% of the bell curve you’re most likely to encounter. The M&A world is highly idiosyncratic, and there are deviations from every rule in the industry. I have noted when an exception is more likely to occur or when an exception can have disastrous consequences. Otherwise, the aim of this book is what you can expect to happen in the overwhelming majority of the situations you’ll encounter when selling and valuing your company.

When selling your business, you shouldn’t count on exceptions – you should target the middle of the bell curve and base your strategy on what works the majority of the time. 

Let’s get started.

More Resources on Selling a Business

Acquired will help you navigate the complex process of selling your business. If you’d like to learn more about buying, selling, valuing a business, or dozens of other topics related to mergers and acquisitions, please visit the Resources section of the Morgan & Westfield website at morganandwestfield.com/resources. Here’s what’s included:

The Art and Science of Selling a Business Course

Have you ever wished you could get into the head of the party on the other side of the negotiating table? Here’s your chance. Join us in this nine-hour audio course as we take a deep dive into the sales process to discuss the perspective of both the buyer and the seller with Jim Evanger, a serial entrepreneur and operating partner for several middle-market private equity firms. Jim has founded, started, operated, and sold multiple middle-market businesses and assisted in acquiring dozens of companies as both a corporate buyer and private equity partner, giving him deep experience on both sides of the table. 

The Art & Science of Selling a Business contains priceless advice for entrepreneurs of middle-market businesses with revenues up to $100 million. This course wasn’t built on theory – it’s grounded in practical advice that’s been field-tested in the real world. Listen as Jim shares the lessons he’s learned on both sides of the table from over 20 years of experience as both a seller and an acquirer. He’s already made the mistakes, so you don’t have to. You’ll learn how to avoid the most expensive errors business owners commonly make that can harm the value of your business or even derail your sales process entirely.

Additional Books

Other Resources

Here are the acronyms you will encounter as you read this book:

For a full definition, check out the Glossary in the Resources section.

“Perpetual devotion to what a man calls his business is only to be sustained by perpetual neglect of many other things.”

– Robert Louis Stevenson, Scottish Novelist

When I began helping entrepreneurs sell their businesses over 20 years ago, I scoured the market for useful information on the topic. I soon discovered that most of this knowledge didn’t deal with many of the real-world problems I encountered when working with my clients. A big chunk of it was theoretical. Or it was directed at large, publicly traded companies. Many of the books at the time were simply a random collection of observations that were difficult to apply in the real world.

I wrote this book for owners of companies valued from $10 million to $100 million – or companies with earnings before interest, taxes, depreciation, and amortization (EBITDA) of $2 million to $10 million per year. 

Whether you’re seeking general guidance or looking for a useful, concise description of the sale process for companies in this size range, you’ll have difficulty finding truly useful, actionable tips. To be sure, there’s a lot of theoretical intelligence out there that might be helpful to academics. But if you own a private business, much of the information in these books won’t be helpful to you. You’ll find that most M&A books are written by academics, accountants, attorneys, financial planners, or business appraisers who have abstract knowledge about the process but who may not have participated in actually selling a business. 

This book is different. It offers clear, concrete, and practical advice grounded in real-world experience. In it, I’ll walk you, the seller, through the entire sales process and offer guidance based on my decades of helping entrepreneurs in a variety of industries successfully sell their businesses. 

In these chapters, I offer recommendations that even the busiest entrepreneurs can apply in their hectic lives. And while this book speaks directly to sellers, anyone involved in the M&A process – buyers, attorneys, accountants, and business appraisers – will benefit from the observations and advice that follows.

Sincerely, 

Jacob Orosz

The purpose of this book is to educate entrepreneurs on the entire process of planning their exits and selling their business. This book is a team effort, and without the significant contributions from several amazing people, this book would never have come into existence.

I dedicate this book to the entrepreneurs who demonstrate the imagination, focused preparation, hard work, and courage necessary to create and grow the businesses that drive our economic engine. You are a precious resource that should be recognized and rewarded. 

I’m grateful to all of the people who generously gave their time and provided me with information for this book, including small- and medium-sized business owners, lawyers, accountants, investment bankers, partners at private equity groups, industry analysts, and others with specific knowledge of the issues I address. 

I’m also thankful for the many guests I’ve had the pleasure of interviewing on my M&A Talk podcast. Your insights have proven invaluable in rounding out my knowledge of this complex topic. M&A is a complex multidisciplinary topic. No one expert can do it all. Hearing a diversity of viewpoints from a variety of experts has increased my appreciation for the complexity and subtle nuances of this field.

I’m particularly grateful for the help of our team of four editors, Pamela Eastland, Bob Bogda, Graham P. Johnson, and Barbara Wright, who have patiently stood by my side throughout the entire process and who have taken what was initially a mess of ideas and turned it into a cohesive story. Thank you for your attention to detail, persistence, and ability to tie up loose ends to make this a finished product.

A special thank you for the help of my father, Emery Orosz, who has carefully reviewed this book. On a side note, thank you for providing me with the discipline I needed as a child and the patience to allow me to mature and blossom into a successful professional. I love you and could never thank you enough for standing by me every step of the way.

Jacob Orosz

President of Morgan & Westfield
morganandwestfield.com
Host of M&A Talk – The #1 Podcast on Mergers & Acquisitions

Author of – The Art of the Exit, A Beginner’s Guide to Business Valuation, The Exit Strategy Handbook, Closing the Deal, Acquired

The Lean Startup by Eric Ries (Crown Business, 2011) and Running Lean by Ash Maurya (O’Reilly Media, 2012) – These books teach you the “lean” system in business strategy as opposed to the outdated waterfall method of business planning in which each stage of the process has to be completed before moving on to the next stage. Being lean and agile in business can help you quickly accomplish many goals and speed up the process of the steps involved.

Work the System by Sam Carpenter (Greenleaf Book Group Press, Revised 3rd edition, 2019) – This is a book that walks you through, step-by-step, how to document your business and prepare an operations manual for your company. This is a great resource if you have never automated, documented, and delegated processes in your business.

The E-Myth by Michael E. Gerber (Ballinger Publishing, 1988) – This is a classic book that all entrepreneurs should read and many franchisors recommend. The essence of the book is that entrepreneurs spend too much time working in their business and too little time working on their business.

Scaling Up by Verne Harnish (Gazelles, Inc., 2014) – This popular book, a sequel to Mastering the Rockefeller Habits, teaches you the four essential processes any small business needs to install before they begin scaling their business. This book is a collection of skills, tools, and processes but installing these tools is easiest if you have a management team to help you. Implementing all the suggestions contained in this book may take you from 6 to 12 months.

Duct Tape Marketing by John Jantsch (Nelson Business, 2007) – This book will help most small business owners create scalable marketing processes. Yes, you need scalable, repeatable marketing processes in your business. These are practical, easy-to-implement suggestions. Like all the suggestions contained here, though, implementing these processes entails a lot of time and help from your core management team.

Focal Point by Brian Tracy (Amazon, 2001) – This book assists you in establishing a laser-like focus on critical goals in your life. Focus is paramount to entrepreneurs. Most entrepreneurs suffer from an overabundance of ideas rather than a dearth of ideas. In other words, they have a “lack of focus.”

Getting Things Done by David Allen (Penguin Books, 2015) – The GTD system is widely known as the most effective time management system in business. David Allen’s book, in my opinion, is the best book available on time management. David teaches specific techniques you can implement in your life to improve your time management.

Your Brain at Work by David Rock (Harper Collins, 2020) – I always say that energy management is more important than time management. This is the case once you possess rudimentary time management skills, such as daily planning, prioritizing, and delegating. I always run out of energy before I run out of time – you’re likely the same. Your Brain at Work recognizes that energy is a limited resource, and it teaches you how to strategically use this scarce resource. You should treat energy like any other limited resource, such as time or money. Did you know that multitasking can turn a Harvard MBA into the mental equivalent of an eight-year-old? Yet, we all do this all the time. This book offers practical insights on how to earn the highest ROI on your energy investment.

How to Hire A-Players by Eric Herrenkohl (Wiley, 2010) – Management starts with hiring the right people. Sourcing and interviewing are skills that can be learned. This book teaches you a step-by-step process for hiring superstars. It takes a lot of practice, and hiring is simpler if you have a management team to assist you in establishing the right systems for attracting the talent you need.

Carrots and Sticks Don’t Work by Paul L. Marciano (McGraw Hill, 2010) – Most small-business owners with fewer than 50 to 100 employees manage their employees using the carrot-and-stick method, which uses rewards and punishment as tools to motivate. Unfortunately, this method produces poor results in any industry in which engagement is important. This book teaches you 5 to 10 management techniques you can use to develop an engaged long-term workforce. 

These are the typical duties of the escrow holder in a transaction: 

Supporting documents are attached to the purchase agreement as schedule or exhibits and include the following:

Important: The list above is in no way complete. It simply represents the typical documents and steps required to close. Only an experienced professional should handle your closing. The list above is provided for illustrative purposes only.

These are typical clauses in a purchase agreement:

Definitions: Any well-written purchase agreement contains definitions of the key terms used throughout the document. 

Purchase Price and Financing: This defines the amount of the purchase price and how it’s paid. The consideration is typically broken down by the following: 

Exclusivity: This area details whether the parties are negotiating exclusively with one another. “No-shop” or “go-shop” clauses may be included in this section.

Inventory: This section contains a description of the inventory included in the sale and identifies who will count the inventory: the buyer, the seller, or an inventory valuation service. It also provides adjustments to the purchase price based on the difference in inventory between signing and closing, as well as a representation regarding the condition and salability of the inventory.

Working Capital: This section describes how working capital will be defined and the procedure for calculating working capital. The purchase price normally includes a set amount of working capital at closing, and then an adjustment is made three to six months after the closing if the working capital was different than the amount that was included in the purchase price.

Contingencies (Conditions): The purchase agreement contains contingencies if it’s signed before closing. Buyer contingencies can relate to obtaining financing, a license, or franchisor approval, and transferring a lease. If the seller is offering financing, the agreement may also be contingent on the seller approving the buyer’s credit and financial position.

Earnest Money Deposit: The agreement outlines who holds the earnest money deposit, whether it is refundable or non-refundable, and the conditions if the deposit is refundable.

Closing Costs and Prorations: This area of the agreement explains who will pay which closing costs. Many closing costs are split equally between the buyer and the seller, with each party paying their own advisors.

Training and Transition Period: This section outlines in detail the length and form of the training agreement in detail. Being highly specific regarding the length of the training agreement, including how many hours and on what terms, is a good practice. Not doing so can lead to post-sale disagreements, and buyers sometimes sue sellers for failure to train them properly.

Representations and Warranties: The seller’s representations are often more thorough than the buyer’s representations. Representations and warranties, called reps and warranties for short, are heavily negotiated in larger transactions and used by many buyers to flush out potential problems. Examples of the seller’s representations include:

Confidentiality: This clause is sometimes included even though a separate confidentiality agreement may have been previously signed.

Default and Remedies: This area includes conditions for canceling the agreement and penalties for defaulting.

Miscellaneous Legal Provisions Common to All Legal Agreements: This section can include attorney fees, mediation, indemnification, severability, governing law, risk of loss, and other provisions that generally apply to all legal agreements.

This is a sample due diligence checklist:

Assets

Financial/Tax

Insurance

Legal

Operations

Staff

Accrual Basis: One of two primary accounting methods which recognizes income and expenses based on when they are “accrued” or when they actually occur. 

Add-Backs: An adjustment made to the income or expenses in a financial statement when calculating the cash flow of a business (i.e., SDE or EBITDA).

Add-On-Acquisition: The purchase or acquisition of a smaller company which is added on to a larger platform company by a corporate buyer to complement the acquirer’s business model.

Allocation of Purchase Price: The allocation of the purchase price of a business, for tax purposes, among various classes of assets which are defined by the Internal Revenue Service, such as inventory, goodwill, land, or buildings.

Asset Deal: One of three ways to structure an acquisition for legal purposes in which the buyer purchases the individual assets of the seller, as opposed to purchasing the seller’s stock or merging with the seller.

Basket: The minimum dollar amount that must be met before a seller becomes liable for the buyer’s losses caused by the seller’s breach of representations and warranties. A basket functions similarly to an insurance deductible in which the seller is not liable for breaches until the threshold amount, or deductible, is exceeded.

Bill of Sale: The document with which ownership of the assets of a business are transferred from seller to buyer – if the sale is structured as an asset sale.

C Corporation: A corporation that has been elected to be taxed as an entity separate from its shareholders in accordance with Subchapter C of the Internal Revenue Code and may therefore be subject to double taxation if the sale is structured as an asset sale.

Cash Basis: One of two primary accounting methods which reports income when received and expenses when paid out.

Cash Flow: The amount of cash generated in a business after all expenses, inflows, and outflows of cash. This term is also loosely used to refer to SDE, EBITDA, or other measures of cash flow. You should always ask for a definition if this term is used.

Confidential Information Memorandum (CIM): A document compiled by a business broker, M&A advisor, or investment banker that describes a company as a potential acquisition target and is used to generate interest in a company from prospective buyers. A typical CIM is 20 to 30 pages long and is only released to pre-screened buyers after they have signed a non-disclosure agreement.

Depreciation: An annual tax deduction that allows for the loss of value of a tangible capital asset, such as a business vehicle or real estate improvement, due to a decline in value over a period of years. Assets can either be expensed (written off in one year), depreciated (written off over a number of years), or amortized (for intangible assets).

Double Taxation: The taxation of income twice on the earnings of a C Corporation. Income is first taxed at the corporate (entity) level and then taxed again at the individual level when dividends are paid to shareholders. Double taxation is a concern when the owner of a C Corporation sells their business and structures the sale as an asset sale. The solution to avoid double taxation is to structure the sale as a stock sale or merger.

Due Diligence: The buyer’s thorough verification and investigation of a business after the seller accepts a letter of intent to determine if both parties wish to proceed with the transaction. Most due diligence periods range from 30 to 90 days, and some may be indefinite as long as the parties continue to negotiate in good faith.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): The most popular measurement of the cash flow of a middle-market company which includes earnings before interest, taxes, depreciation, and amortization.

Earnout: An agreement whereby the buyer pays part of the purchase price to the seller based on the future performance of the company or the fulfillment of some other specified event.

Entity: A separate, legal entity authorized to act separately from its owners, such as a C Corporation, S Corporation, or LLC.

Exclusivity: A provision in a term sheet or letter of intent in which the seller agrees not to solicit offers or negotiate with other potential buyers for a specific period of time.

Fair Market Value (FMV): The most common standard of value used in business appraisals. FMV is the amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.

Generally Accepted Accounting Principles (GAAP): The common set of principles, standards, and procedures established by the Financial Accounting Standards Board (FASB) that companies use to compile their financial statements.

Goodwill: An intangible asset associated with the acquisition of a company normally carried on the acquiring company’s balance sheet. It is the portion of the purchase price allocated to the value in excess of the tangible assets acquired.

Gross Profit: The total revenue minus the cost of goods sold, or the profit a company makes after deducting the direct costs related to manufacturing and selling products and services from the total revenue.

Holdback (a.k.a. Escrow): An amount of the purchase price that is withheld from the seller, usually by a neutral third party (i.e., escrow agent) in a separate account for a period of time after the closing to satisfy any of the seller’s indemnification obligations. The amount is paid to the seller after a specified amount of time following the closing, typically 6 to 18 months, if the buyer makes no indemnification claims.

Indemnification: A provision in the purchase agreement that allows a buyer to seek recourse against the seller for losses suffered due to breaches of representations and warranties.

Intellectual Property (IP): The legally protectable intangible assets of a business which can include patents, copyrights, trade names, domain names, trade secrets, and trademarks or service marks. Intellectual property can be registered (e.g., trademarks, patents) or unregistered (e.g., trade secrets). 

Internal Rate of Return (IRR): The annual rate of growth an investment produces. The most common measure of return used by private equity firms to measure the performance of their investments.

Letter of Intent (LOI): A preliminary agreement that outlines the essential terms of an acquisition and signifies the parties’ commitment to start due diligence and begin working toward a purchase agreement. The letter of intent is replaced by a purchase agreement prior to or at the closing.

Main Street: The segment of the business landscape made up of small “mom-and-pop” businesses such as restaurants, coffee shops, landscaping companies, auto and truck service centers, convenience stores, most franchises, and small businesses that offer services. Main Street businesses are predominantly valued using a multiple of SDE and sold by business brokers.

Merger: One of the three primary methods of structuring a transaction for legal purposes. The combination of two or more companies into one with a single entity by filing a Certificate of Merger with the secretary of state. Transactions can be structured for legal purposes as an asset sale, stock sale, or merger.

Middle Market: The segment of the business landscape consisting of mid-sized businesses, such as manufacturing firms, distribution companies, wholesalers, and large service-based companies. The middle market is further divided into the lower, middle, and upper-middle markets and is primarily served by M&A advisors and investment bankers.

Net Income: The amount of money earned after deducting all expenses, including overhead, employee salaries and benefits, manufacturing costs, inventory costs, distribution costs, and marketing and advertising costs from a company’s gross revenue.

Non-Compete Agreement: A contract that limits the seller or key employees from competing with the business after the closing. Most non-competition agreements range from two to five years. A non-compete agreement is legal in all states in the sale of a business, whereas non-compete agreements in an employment context are illegal in some states.

Non-Disclosure Agreement (NDA): A legal contract between the buyer and seller that outlines confidential material, knowledge, or information that both parties want to share with each other for specific purposes, but with restricted access to or by third parties. The NDA is typically signed very early in the transaction, after the teaser profile is provided but before the buyer is given access to the confidential information memorandum (CIM) or financial statements.

Non-Solicitation Agreement: An agreement signed by employees and management whereby they agree not to solicit customers or other employees of the company regarding job opportunities upon the termination of their employment agreement. Non-solicitation agreements are commonly used as an alternative to non-compete agreements because they are viewed as more enforceable.

Normalize (a.k.a. Adjust, Recast): The process of adjusting, normalizing, or recasting a business’s financial statements to determine the true earnings (i.e., SDE or EBITDA) of a company.

Normalized (Adjusted, Recasted) Financial Statements: Financial statements that have been adjusted to estimate a company’s SDE or EBITDA.

Platform Company: A large company that is the foundation to acquire and add smaller companies to, such as through an add-on or bolt-on acquisitions, or by a financial or strategic buyer to complement the acquirer’s business model.

Private Equity Firm: A company that raises money from institutional investors (i.e., limited partners) and then invests these funds into private companies. A private equity firm normally has multiple funds with each fund having a lifespan of 10 to 12 years. Private equity funds are often structured as a general partnership, or other similar entity, in which the private equity firm is the general partner and the investors are limited partners.

Promissory Note: A document signed by a purchaser of a business that includes a written promise to pay the balance of the purchase price over an extended period of time.

Representations and Warranties: Statements and guarantees by a buyer or seller of a business relating to the assets, liabilities, and contacts of the business that are being acquired, or the business that is making the acquisition. Breaches of representations and warranties are addressed in the indemnification section of the purchase agreement. A percentage (usually 10%) of the purchase price is normally held back (known as a holdback) in an escrow account for 6 to 18 months following the closing to fund any indemnification claims. This amount is later released to the seller if no claims are made during this time period.

Return on Value Drivers: A proprietary model developed by Morgan & Westfield in which implementable strategic actions are prioritized based on which drivers will have the biggest impact on the value of a business in the shortest period of time and which also pose the lowest risks to implement. 

Roll-Up: The purchase or consolidation of smaller companies in an industry by a larger company in the same industry. The strategy is to create economies of scale and “roll-up” all the small companies into one big company to sell in the future with the hope of expanding the multiple (i.e., multiple expansion).

S Corporation: Short for “Subchapter S corporation,” a state-incorporated business that elects to receive special tax treatment. An S Corporation is restricted to 100 shareholders, shareholders must be U.S. citizens/residents, and only one class of stock is permitted to be issued, although it can have both voting and non-voting shares. Most small and mid-sized companies are structured as an LLC or S corporation, whereas most larger companies are structured as a C corporation.

Seller’s Discretionary Earnings (SDE): The most common measure of cash flow used to value a small business; uses pre-tax net income plus the owner’s compensation, interest, depreciation, amortization, and discretionary expenses, as well as adjustments for extraordinary, non-operating revenue or expenses, and non-recurring expenses or revenue.

Seller Financing: A note or loan payable to the shareholder(s) or owner(s) of a business provided in the sale of a company by the buyer.

Stay (Retention) Bonus: A bonus given to employees, usually by the seller, to ensure they stay on board after the business is sold. A typical bonus ranges from 5% to 20% of annual base salary and is released in multiple stages (i.e., ⅓ at closing, ⅓ at 6 months, ⅓ at 12 months after the closing).

Stock Sale: One of the three primary methods of structuring a transaction for legal purposes whereby the buyer purchases the stock, or entity (a stock sale), of the seller, as opposed to purchasing the assets of the seller (an asset sale). Transactions can legally be structured as an asset sale, stock sale, or merger.

Strategic Buyer: A buyer or company that may provide similar or complementary products or services to the target and is often a competitor, supplier, or customer of the target, or one that brings other synergies to the transaction.

Successor’s Liability: Liability that passes from the seller of a business to the buyer of a business by operation of law without an express contractual agreement for the buyer to assume the liabilities of the seller. Successor’s liability is most common in the areas of tax and environmental liabilities and can be imposed by governmental institutions. Successor’s liability is mitigated through extensive due diligence, representations and warranties, and escrowing a portion of the purchase price to fund indemnification claims.

Teaser Profile: A short summary of a business that doesn’t normally reveal the company’s identity. This is provided to prospective buyers before the buyer signs a non-disclosure agreement.

Term Sheet: A document that outlines the key terms of the purchase or sale of a business.

Uniform Commercial Code (UCC): A standardized set of laws and regulations for transacting business with the aim to make business activities consistent across all states, and that has been adopted to some extent in all 50 states. 

Working Capital: The amount by which current assets exceed current liabilities in a business. Working capital is calculated as the value of accounts receivable, inventory, and prepaid expenses, less the value of accounts payable, short-term debt, and accrued expenses. Working capital is normally included in the purchase price of mid-sized businesses.

Thanks again for reading The Art of the Exit and for putting your trust in me. I have written this book to help you navigate the complex process of selling your business.

More information on the complex process of selling your business can be found in the Resources section of the Morgan & Westfield website at www.morganandwestfield.com/resources/. Here’s what’s included:

“It’s not the mountain we conquer but ourselves.”

– Sir Edmund Percival Hillary, New Zealand Mountaineer and Explorer

“A good traveler has no fixed plans and is not intent on arriving.”

– Lao Tzu, Chinese Philosopher

Thanks for reading The Art of the Exit: The Complete Guide to Selling a Business. Whether you plowed through the entire book or zeroed in on specific chapters, whether you’re ready to sell now or are considering doing so, I trust you found a realistic and helpful depiction of what you can expect to happen during the process.

Most business owners will hire a business broker, M&A advisor, or investment banker to sell their company – as well they should. But your knowledge of how to prepare for the sale before you even join forces with an intermediary will help you ask the right questions, choose the right advisor, and maximize the value you can receive for your business. By taking advantage of the knowledge gleaned during my more than two decades of buying and selling businesses, you’re already a step ahead of the game.

Let’s review a few of the high points, starting with some of the preliminary considerations and factors to know and be ready for: 

Next up: Buyers. Knowing the type of buyer likely to be interested in your business will save you time and money getting your message across.

If your company earns less than $500,000, for example, it will likely sell to an individual. If that’s the case, you should take the appropriate measures to maximize the net income on your financial statements, as this will significantly improve the buyer’s ability to obtain a Small Business Administration loan. If you’re selling a business with EBITDA greater than $2 million, you’ll likely be dealing with an institutional investor, as they have the cash and more access to financing. Businesses with EBITDA from $500,000 to $2 million may sell to either an individual or an institutional investor. In any case, your intermediary will be able to apply the right targeted approach to attract the buyers most suitable for your business.

Confidentiality is a legitimate concern when dealing with buyers. Key sales documents should be prepared and released to buyers in stages. Your intermediary will have a template NDA, but you should have your attorney prepare a custom NDA if you will be selling your business to a direct competitor and have specific concerns that a standard NDA doesn’t address. Your broker will also handle the screening of buyers and prepare a confidential information memorandum (CIM).

Now, for another fun part of the process: Meeting the buyer.

When an offer is forthcoming, get your attorney involved in the negotiations unless the buyer is an individual who is comfortable using your broker’s template. Rely heavily on the advice of your intermediary and attorney while negotiating the deal structure.

What’s next? Due diligence. Here are some keys:

All of which leads to the closing. The key here is to maintain your emotional objectivity. Your attorney should be deeply involved in negotiating the purchase agreement. But be on guard – a deal can still die at any minute for literally hundreds of reasons.

For most owners, the closing is an anticlimactic event – a simple formality. But it represents years of painstaking dedication and hard work. Congratulations! There won’t be a defining moment when you realize you reached the finish line, but one day you will wake up and realize the finish line is well behind you.

Thank you for turning to Morgan & Westfield for your M&A information needs. You made the right choice. 

Sincerely,

Jacob Orosz

President of Morgan & Westfield (www.morganandwestfield.com)

Host of M&A Talk – The #1 Podcast on Mergers & Acquisitions

“The time to stop talking is when the other person nods his head affirmatively but says nothing.”

– Henry Samuel Haskins, American Stockbroker

The scene is like a living, breathing postcard from paradise. Clear skies, white sand beaches, warm ocean breezes. And, look! There’s you – tanned and rested, a John Grisham legal thriller in one hand, and a piña colada in the other.

In one sense, it took a lifetime to get here. You spent decades building your company and a grueling 12 months to get it sold. But you did it, and now you’re reaping the rewards. You’ve heard about former lifelong business owners who found it impossible to relax after successfully exiting the fray. But that’s not you. There are going to be plenty more postcards like this one. Life is good.

Then the phone rings and life is about to get a little less good. It seems there was a problem with your financial statements. The buyer of your business discovered that the numbers aren’t compliant with generally accepted accounting principles (GAAP) and as a result, EBITDA was overstated. Not a big deal, you think … your deal closed six months ago, and it’s the buyer’s problem now. The buyer is demanding a reduction in the $6 million purchase price. But, hey, the deal is already closed!

You call your attorney in a fit of fury. Your attorney asks if you remember signing a representation or warranty stating that your financials were prepared in accordance with GAAP. Your response: “What’s a representation or warranty?”

Welcome to the final stage of the transaction – the closing – where, in extreme instances, a misrepresentation – inadvertent or otherwise – about the company you’re selling, or have already sold, could put the kibosh on the deal or a major drain on your bank account – the account where you keep the proceeds from the sale. Let the headaches and lawsuits commence.

As you’ll read below, the closing is a critical part of the process and not just a formality. 

The purchase agreement is a hotly negotiated component of the closing process. 

In the chapter that follows, I’ll touch on everything you need to know about closing the deal and what you can do to ensure a smooth and uneventful process. After all, I wouldn’t want to spoil your day at the beach.

“Facts explain nothing. On the contrary, it’s facts that require explanation.”

– Marilynne Robinson, American Novelist

After you accept an offer or letter of intent (LOI) on your business, the buyer will begin due diligence. Due diligence is the process of gathering and analyzing information to help the parties determine whether to proceed with the transaction. Due diligence is conducted in three primary areas:

Due diligence normally lasts 30 to 60 days but can be extended if both parties agree. In most circumstances, the buyer can walk away from the transaction if they are unsatisfied for any reason during due diligence.

So, what should you do? Start by conjuring up your best Boy Scout. Start by being prepared. 

Conducting pre-sale due diligence on your business will uncover any potential problems and give you a chance to resolve them before a buyer discovers them. I’ll show you how to do that in this section, in which I also answer the following questions:

“A handful of patience is worth more than a bushel of brains.”

– Dutch Proverb

When you receive a letter of intent (LOI), it’s critical to pin down the buyer on all the key terms of the transaction. If you don’t, there’s a good chance that the unwritten terms won’t be favorable for you when they’re finalized in the purchase agreement. It’s also critical that the purchase price be negotiated collectively with the other components of the deal structure. Let’s take a look at the different elements of the offer and considerations to bear in mind during negotiations.

“No man does anything from a single motive.”

– Samuel Taylor Coleridge, English Poet

What happens after the buyer receives the confidential information memorandum (CIM) on your business?

Here’s a summary of the typical sequence of steps in screening and meeting with a buyer:

  1. The buyer is pre-screened and signs a non-disclosure agreement (NDA).
  2. The buyer receives the CIM.
  3. The buyer has a few questions about your business that you answer on the phone.
  4. You and the buyer meet in person.
  5. Additional phone calls or meetings are conducted until the buyer makes an offer or decides not to pursue the purchase.

When meeting with a potential buyer, remember the Golden Rule: treat others how you want to be treated, specifically:

Let’s proceed …

“Marketing is a contest for people’s attention.”

– Seth Godin, American Author and Executive

The next step after identifying likely groups of buyers will be marketing your business for sale to reach specific buyers. You will want to respond to a buyer who is interested in your business and send them information about your company. But how do you do this without jeopardizing confidentiality? In this section, I offer several tips for identifying buyers and how to ensure you maintain confidentiality during the process of screening and sending them information about your company.

“The golden rule for every businessman is this: Put yourself in your customer’s place.”

– Orison Swett Marden, American Author

One of the first lessons in Marketing 101 is this: Know your audience. Who are they? Where are they? What buttons can be pushed? What incentives need to be dangled? If you’re not armed with this basic information and more, it’s going to be a tough sell no matter what you’re offering, be it widgets or entire businesses.

This is especially true when it comes to marketing your company. By educating yourself about the different types of buyers in the marketplace, you can identify which is most likely to purchase your business, and then design a strategy to target that group of buyers. This is essential to developing a marketing strategy to sell your company. 

In the section that follows, I explore in detail the four different types of buyers and the goals, considerations, and risks associated with each. If you want to maximize the value of your business with your particular target audience, keep reading.

“If you think advice is expensive, try ignorance.”

– Unknown

Remember the original Dream Team? The occasion was the 1992 summer Olympics in Barcelona. It was the first time active professional players from the National Basketball Association were allowed to ply their trade on the American Olympic team. And what a team it was! The likes of Michael Jordan, Magic Johnson, and Larry Bird defeated their opponents by an average of 44 points before taking home the gold medal. Their collective notoriety, “…was like Elvis and the Beatles put together,” said head coach Chuck Daly at the time. Despite their disparate playing styles and personalities, the superstars gelled. They played like a team, a dream team.

One of the first tasks in the process of selling your company is building your own dream team. Let’s call it the deal team. You won’t necessarily need Michael Jordan or the Beatles, but it would behoove you to pick proven role players who can effectively contribute to the task at hand.

Here’s your starting lineup, Coach. The game plan follows. This is a summary of who your lineup should consist of, based on their level of involvement in the transaction. A more detailed discussion follows. 

M&A Advisor (Investment Banker)

To borrow yet another sports analogy, think of your M&A advisor as your quarterback. They will play a key role throughout the transaction from the opening kickoff until the final gun sounds. Your investment banker will initially assist in helping you package your company for sale, which will include valuing your company, identifying any issues that need to be addressed before you put your business on the market, and preparing key sales documents. 

Once the preparation is complete, they will put your business on the market, contact buyers, and manage your negotiations. They will also work closely with your M&A attorney in negotiating the letter of intent (LOI) and purchase agreement. Your M&A advisor will negotiate with the buyer regarding the high-level elements of the transaction and how the various components work together to form the overall deal structure, while your M&A attorney will negotiate the finer details of the agreements.

M&A Attorney

Your attorney will play the second-most critical role in the transaction and will negotiate the key agreements – primarily the non-disclosure agreement (NDA), the LOI, and the purchase agreement. In some cases, your M&A attorney may assist you in identifying legal issues that need to be resolved before you put your business on the market, and you can then delegate these matters to your commercial attorney to resolve. In most cases, your M&A attorney becomes involved during the stages of negotiating the LOI and plays a crucial role in the transaction until the closing transpires. It’s critical that you hire an attorney that has significant experience buying and selling businesses. The biggest mistake business owners make is hiring an attorney that has limited M&A experience, which in many cases can cost you the sale due to their inexperience.

It’s critical that you hire an attorney that has significant experience buying and selling businesses.

Accountant

Your accountant will assist you in preparing your company for sale from a financial perspective and make sure that your financials are clean and consistent once your business is on the market. Your accountant may also be involved in financial due diligence, examining the financial and tax implications of the purchase agreement. Your accountant will typically play a lesser-involved role than your M&A attorney, although the extent to which this is the case varies based on the transaction. If you’re selling a smaller business with a simpler set of legal agreements and less-involved negotiations, it’s possible your accountant will play a more involved role than your attorney, especially if issues are discovered during financial due diligence.

“The value of a financial asset is directly related to the ability to finance it.”

– Jacob Orosz, President of Morgan & Westfield

In this chapter, I examine each source of financing in detail, including the advantages and disadvantages of each, and how different forms of financing can be combined into some common transaction structures. We also address the following questions:

So, let’s dive into financing … 

“Money flows in the direction of value.”

Uche Ugo, International Brand Consultant

Valuing a business is an inherently difficult undertaking, but it’s a critical step in planning the sale of your company. Valuing a business is challenging due to the following factors:

In this chapter, I explore why valuing a business is inherently difficult, and why the ranges of potential values for a business are much wider than for other assets. After reading this chapter, you will have a greater understanding of the challenges you may face when valuing your business, and learn what factors can affect the potential range of values for your company.

The essence of valuing a business is predicting its future cash flows and then placing a price tag on those cash flows based on their present value.

“Before anything else, preparation is the key to success.”

Alexander Graham Bell, American Inventor

Congratulations on the decision to sell your business. As with any complex multi-step process, you should begin with preparation. To be sure, some businesses get sold with minimal groundwork – or none at all. But that’s the exception, not the rule. If you have the time, patience, and dedication to get your business ready and you don’t need to sell right now, jump right into this chapter. If you have already begun the sale process, you can skip this chapter and come back to it when you have the time to make quick fixes while your business is on the market. If you have the choice, I highly recommend that you fully prepare for the sale to maximize the value of your business and increase the chances of a successful sale. 

“An entrepreneur is someone who will work 24 hours a day for themselves to avoid working one hour a day for someone else.”

– Chris Guillebeau, American Author and Entrepreneur

Selling your business will be one of the most stressful events in your life, period. Make no mistake about it – selling a business is not an easy task. Nor can you hire an expert and expect them to handle the entire process for you without an immense amount of effort on your part. Not only is the process stressful, it is also tremendously complex and filled with potential landmines and other setbacks.

When I began helping entrepreneurs sell their businesses over 20 years ago, I scoured the market for useful information on the topic. Once I started my career, I discovered that most of this knowledge did not deal with many of the real-world problems I encountered when helping my clients sell their businesses. Rather, it was theoretical knowledge or was directed at large, publicly traded companies. Many of the books available on the topic were a random collection of insights that were difficult to apply in the real world.

I wrote this book for owners of companies valued from $500,000 to $10 million – or companies with earnings before interest, taxes, depreciation, and amortization (EBITDA) of $200,000 to $3 million per year. This size range tends to be a no-man’s land for most business owners. That’s because most business brokers may not be equipped to deal with a million-dollar transaction, while the majority of M&A firms are accustomed to handling much larger transactions. Another challenge for businesses in this size range is that the potential buyer can be either an individual or a corporate buyer, such as a competitor, private equity firm, or other company. The issue here is that the marketing strategies, negotiating tactics, and processes can be significantly different for these two groups of buyers. 

Whether you are searching online for general guidance or browsing books for a useful, concise description of the sale process for companies in this size range, you will have difficulty finding valuable, actionable information. To be sure, there is a lot of theoretical intelligence out there that is specifically helpful for academics. However, if you own a small business with less than $10 million to $30 million in annual revenue, most of the advice in these books will not be useful to you. Additionally, most books on the topic are written by academics, accountants, attorneys, financial planners, or business appraisers who have theoretical knowledge but may not necessarily have real-world experience selling businesses. 

This book offers a solution. If you are looking for clear, concrete, and practical advice grounded in real-world experience, you’ve come to the right place. These pages walk you through the entire sales process and offer advice based on my decades of experience helping entrepreneurs successfully sell their businesses. 

How This Book Can Help You 

Selling a large, established $500 million company requires an entirely different process than selling a small to mid-sized business. This book is written for owners of both Main Street and lower middle-market businesses valued at $500,000 to $10 million, or approximately $1 million to $30 million in annual revenue or $200,000 to $3 million in EBITDA – these are the small companies in America that keep our economic engine running. They are the service companies, manufacturing businesses, professional service firms, technology companies, construction businesses, wholesale or distribution businesses, manufacturers, small professional practices, medical practices, and other small businesses with fewer than 500 employees. 

Through my years of experience devoted exclusively to helping people buy and sell businesses, I realized that most business owners do not want answers to technical questions such as how to allocate the purchase price between the various assets. Rather, they want straightforward answers to basic questions such as:

In this book, I offer practical advice that even the busiest entrepreneurs can apply in their hectic lives. I also want to note that I wrote this book not only for sellers, but for anyone involved in the M&A process, such as buyers, attorneys, accountants, and business appraisers. For the sake of clarity, however, I address sellers directly throughout the book, but I wrote this book with all of you in mind.

As the incomparable Mark Twain once said “Twenty years from now, you will be more disappointed by the things that you didn’t do than by the ones you did do, so throw off the bowlines, sail away from safe harbor, catch the trade winds in your sails. Explore, dream, discover.” 

Sincerely,

Jacob Orosz

On the closing date, the seller and buyer may physically meet around a table, where the buyer delivers the final payment, and the seller signs and delivers the closing documents. Alternatively, they may sign the documents electronically or via FedEx. At Morgan & Westfield, most of our closings are virtual closings where documents are sent electronically or via next-day delivery.

Is your head spinning yet? If so, that’s good.

Days Before Closing

You and the buyer should do the following several days before the closing:

Bring-Down

A “bring-down” condition requires the parties to reaffirm the reps and warranties at the closing. Normally, both the buyer and seller are required to deliver a bring-down certificate to one another at closing. A bring-down is necessary only if there is a delay between signing the purchase agreement and closing. In other words, the reps and warranties must not only be true as of the date the purchase agreement is signed, but they must remain true in all material aspects from the time the purchase agreement was signed through the closing. 

If there has been a material change in the reps and warranties, the buyer may terminate the transaction if the purchase agreement contains a condition that the reps and warranties are true as of the closing date. The purpose of the bring-down condition is to shift the risk of operating the business prior to closing to the seller. The buyer seeks assurance that the company they are agreeing to purchase will be materially the “same” company at closing. 

Materiality can be evaluated either on an individual or a collective basis. In most cases, the reps and warranties must be materially true on an aggregate basis before the closing can occur. For example, several immaterial inaccuracies may constitute materiality on an aggregate basis. 

“Each of the representations and warranties of the Seller contained in this Agreement shall be true and correct in all respects (without giving effect to any limitation as to “materiality” or any derivative thereof qualification set forth therein) as of the date hereof and as of the Closing Date as though made on the Closing Date, except for any failures to be so true and correct that, individually or in the aggregate, have not had or would not have a material adverse effect.”

Is your head spinning yet? If so, that’s good. This should serve as a wake-up call to rely on the guidance, experience, expertise, judgment, and objectivity of an experienced M&A attorney in such negotiations. While you should understand the high-level mechanics of the transaction, this is a perfect example of issues you should leave to your attorneys to sort out. If your head is about to explode now – while you are presumably in a calm, cool state of mind – imagine trying to make sense of this in the whirlwind of one of the largest, most emotionally draining transactions of your life. And that is why you should hire the best advisors you can afford.

The parties may conduct the closing virtually or meet around a table on the closing date.

Closing

Once the closing conditions have been satisfied, the closing can occur. In most cases, the closing is uneventful … an anticlimactic formality … an ordinary occasion … a forgettable event … a routine affair … a humdrum transaction. The more uneventful, anticlimactic, ordinary, forgettable, routine, humdrum, the better. For that’s precisely how the closing should be. All problems should have been worked out well in advance of the closing and the closing process should be as uneventful as possible. 

The parties may conduct the closing virtually or meet around a table on the closing date. Most closings today occur virtually. In this situation, the closing documents are often mailed to the parties via courier for signatures, and then sent back to the escrow agent for release on the closing date, or the documents are signed electronically. A virtual closing is uneventful for most, and this is becoming more common with advancements in technology.

Items To Immediately Address After Closing

You and the buyer should address the following after the closing:

Escrow serves several important functions in the sale of a business. The primary purpose is the same as that for buying or selling a house, which is to provide a neutral third party to handle all monies and paperwork until all conditions of the escrow are observed. That being said, an escrow for a business transaction has different sets of laws to follow and generally involves many other parties, unlike escrow for buying a home. 

When selling a business, escrow is often required if a third party, such as a bank, is involved. I also recommend using an escrow agent to assist with the closing of smaller transactions if each party is not represented by an attorney. 

During any closing, multiple adjustments and prorations must often be made to account for timing differences between when bills are paid and when a change of possession occurs. Among others, these can include lease payments, utilities, property taxes, and accounts receivable. Escrow can assist in making these closing adjustments and prorations.

Typical Duties of the Escrow Holder

The typical duties of the escrow holder in a transaction include:

Considerations Around Escrow

Because the escrow officer is a neutral third party, they do not negotiate or try to settle any disputes between the parties in the transaction. This includes providing legal advice and resolving disagreements, which are the responsibilities of the attorney or business broker in the transaction. The escrow officer also doesn’t send notice of the completion of the sale to the landlord or to the utility and insurance companies.

It is important to note that your broker can’t act as the escrow agent because they can’t provide a fiduciary relationship to both parties. It would represent a compromise of the broker’s ethics if they simultaneously function as the escrow agent.

It is also important to note that not all escrow agents have the same functions. For example, a holding escrow is when an escrow agent limits their services to the holding of funds. In this case, the agent may hold the buyer’s earnest money deposit and may not perform any other services.

It’s not an absolute requirement that you use an escrow company. Certain states, such as California, require that you comply with specific laws, such as bulk sales laws, and typically only escrow agents offer this service. 

You should, however, strongly consider the use of an escrow agent. Why? It’s always a good idea to have an objective third party hold the funds, make sure there are no additional encumbrances against the business, and ensure you and the buyer are in agreement on the closing prior to releasing funds.

The primary purpose of escrow for a business transaction is the same as that for buying or selling a house, which is to provide a neutral third party to handle the money and paperwork.

Bulk Sale

A “bulk sale” refers to the sale and transfer of nearly all of a business’s inventory to a single buyer where the transaction is not part of ordinary business. Bulk sales laws are meant to protect creditors by giving them notice when one occurs. This notice is to stop business owners from buying inventory on credit then liquidating the inventory to a single buyer and skipping town with the cash. 

Bulk sales statutes require advance notice, often released 14 to 30 days before the sale, typically through publication in a newspaper. Creditors are then given the opportunity to submit claims to the escrow holder. Most states, however, have repealed the bulk sales laws because in reality, they have done little to protect creditors. Additionally, bulk sales laws only apply to certain types and sizes of businesses.

Is the escrow process the same in every state?

No. The closing process is generally easier in states that have repealed bulk sale statutes than those that have not. Additionally, business sales on the West Coast tend to be handled by escrow agents, whereas those on the East Coast tend to be handled by attorneys.

Representations and warranties (reps and warranties) are statements of facts regarding a company’s business, assets, liabilities, and operations. As discussed in greater detail in the previous chapter and elsewhere in this book, reps and warranties can relate to the past, present, or future and are included as one of several critical clauses in a purchase agreement. 

A representation is a statement of fact. If a representation is untrue, it is “inaccurate.”

For example, a seller may represent that the assets of the business are in good repair, that all inventory is salable, that there are no hazardous substances used in the business, that the business has operated in compliance with all laws, or that the seller has the legal capacity to sign the purchase agreement. 

A warranty is an assurance. If a warranty is untrue, it is “breached.”

For example, a seller may warrant that they will operate the business in a regular and normal manner and will comply with all laws until closing, or that they will pay all payroll taxes that will come due from past operations up to the time of closing. 

In practice, however, no distinction is made between representations and warranties. They are collectively referred to as “reps and warranties” and are said to be breached if they are untrue.

The reps and warranties that are signed in the purchase agreement survive the closing when you sell your business.

Issues Addressed by Reps and Warranties

Here is a list of sample topics reps and warranties may address: 

Why Reps and Warranties Are Important

Many sellers think that they can run off into the sunset after closing, free of all future obligations related to the sale of their business once the check clears. Not true. 

The reps and warranties that are signed in the purchase agreement survive the closing when you sell your business. In most purchase agreements, you must indemnify the buyer, and a breach of a representation would be subject to indemnification. 

In other words, if a statement you make later proves to be untrue, the buyer may offset a portion of the purchase price, also called a setoff, withhold funds from escrow, or sue you to make themselves whole again. For example, if you claim your financial statements were prepared in accordance with GAAP and the buyer later proves this to be untrue, the buyer can seek damages from you, even after the closing. 

You will remain liable for a significant period of time after the closing if any of the reps or warranties are breached or found to be inaccurate. For this reason, a significant amount of time is spent negotiating the reps and warranties. 

The Purpose of Reps and Warranties

Reps and warranties serve three main purposes, so let’s look at each of them. 

Purpose 1: Reps and warranties flush out material facts.

The representations serve as a method for disclosing material facts. Without reps and warranties, buyers would need to verify every statement you make as the seller. This would make for an inefficient process, and the cost of completing an acquisition would skyrocket. As a result, purchase prices would decline to offset the increased risk, and higher professional fees would result in performing more thorough due diligence.

How do buyers use reps and warranties to flush out the facts? It’s simple: The buyer includes a set of comprehensive representations and warranties, then uses your response as a device for ferreting out areas of concern. 

For example, the buyer may ask you to represent that your financial statements were prepared in accordance with GAAP. If you know this to be untrue, you will refuse to sign such a representation, and your attorney will either strike or heavily modify the clause. Your response will signal to the buyer that they need to perform more thorough financial due diligence. This may lengthen the due diligence period for selling your mid-size business and possibly result in a purchase price reduction if the buyer finds out there are significant deviations from GAAP.

Purpose 2: Reps and warranties function as closing conditions.

For example, you may warrant that the business will operate in the normal course of events until the closing. If you decide to liquidate any assets, terminate any contracts, revise your product warranty, or make other material changes to the business outside the ordinary course of events, the buyer may have the right to terminate the transaction before the closing.

Purpose 3: Reps and warranties are used to allocate risk.

For example, if you warrant that all equipment is in good repair, you will bear more risk than if you simply warrant that “all equipment is operational to the seller’s knowledge.” The phrase “all equipment is in good repair” is more restrictive than “all equipment is operational to the seller’s knowledge.” The language used to draft the reps and warranties plays a critical role in risk allocation.

Limitations to Reps and Warranties

There are four limitations that you need to keep in mind with reps and warranties. 

Limitation 1: Knowledge Qualifiers

One of the simplest ways to limit the scope of a representation or warranty is through a knowledge qualifier. A knowledge qualifier limits your exposure based on your “knowledge” of a representation.

For example, if a seller states that the business’s financial statements have been prepared in accordance with generally accepted accounting principles, or GAAP, and the buyer later determines that the financial statements haven’t complied with GAAP, the seller may not be held liable. But, the degree to which the seller is held liable depends on the parties’ exact definition of “knowledge.”

Sample knowledge qualifiers include:

These statements may precede the reps and warranties section in a purchase agreement. For example, “To the best of Seller’s knowledge, the Seller represents and warrants that … .” 

The precise definition of knowledge, as defined in the agreement, will have significant implications for both parties. In the absence of any knowledge qualifier, you could be 100% responsible for any representation and warranties in the purchase agreement, whether or not you knew it was true. 

Limiting the definition of knowledge can dramatically alter the dynamics and put the onus on the buyer to prove that you knew the representation was false at the time it was made. It can also significantly limit the buyer’s indemnification rights by shifting unknown risks to the buyer. 

The buyer will attempt to expand the definition of knowledge to include “constructive” knowledge, which includes information that should have been known after reasonable or due inquiry, or that should be known based on your role in the business. For example, a CEO will be presumed to have a different level of knowledge than that of a CTO or CMO.

Regardless, the parties should remember that uncertainty will always be present, regardless of the parties’ desires. Reps and warranties are not solely a test of integrity but are primarily a legal mechanism for allocating risk. 

Finally, the agreement should specify to whose knowledge the reps and warranties are subject. Are the reps and warranties based solely on the seller’s knowledge, or is the knowledge of officers or other employees also included in the definition? 

If third parties are to be included in the definition, you must be willing to bear the risk of depending on the knowledge of those third parties. In some circumstances, officers or key employees are asked to sign a certificate in which they individually certify knowledge of reps and warranties that are applicable to their roles. For example, a CFO may be required to sign a certificate relating to any financial representations.

Most buyers prefer to operate the business for at least a full year or business cycle to identify any potential breaches.

Limitation 2: Survival

Reps and warranties are almost always limited in time. Without a survival provision, it isn’t clear if they survive at all, or they may be subject to the statute of limitations relative to the specific breach, such as environmental, taxes, etc. Once the time period elapses, you may no longer be held liable to the buyer for a breach, except in certain circumstances such as a purposeful or willful breach or fraud. 

Most buyers prefer to operate the business for at least a full year or business cycle to identify any potential breaches. As a result, the average life of representations ranges from 18 to 24 months. For example: “The reps and warranties of the Seller shall survive for a period of 18 months beyond the Closing.”

Survival periods may also differ, depending on the type and nature of the representation including: 

Limitation 3: Baskets or Minimums

Reps and warranties are almost always subject to a basket, or a minimum threshold that must be met before you become liable. This operates similarly to an insurance deductible. 

The indemnification section of the purchase agreement defines what happens in the event of a dispute. Within the indemnification section is a clause addressing the basket, sometimes called “Limitations on Amount.” You are not liable for claims until the basket, or deductible, is exceeded. The basket sets the minimum loss the buyer must bear before the seller can be held liable.

Example: Most M&A transactions include a basket of 0.75% of the purchase price. In a $10 million transaction, a 0.75% basket would be $75,000. The seller wouldn’t be liable to the buyer until the cumulative amount of the claims exceeds $75,000.

The basket has several purposes, including that it:

Some agreements require the parties to split losses up to the deductible amount. For example, if there were a $100,000 deductible and a $101,000 loss, the buyer would be required to pay $50,000 and the seller $51,000. 

This provision requires the buyer to absorb a significant portion of any losses, and therefore motivates the buyer to be thorough in their due diligence to mitigate potential losses. This also motivates the seller to help reduce smaller losses on behalf of the buyer. This lessens, to some extent, the motivation of a buyer to “tip” the tipping basket, so they are reimbursed for the “deductible.”

The average basket size is 0.75% of the total purchase price. Obviously, buyers will argue for the lowest basket possible while sellers will seek a higher basket amount. 

Certain reps and warranties are often not subject to the basket, such as those relating to employees, environmental, organizational, title to assets, or tax issues.

The basket may also be voided if the seller commits a willful breach, or it may be limited based on the seller’s knowledge as it’s defined in the agreement. However, most sellers contest this language since determining “willful” is subjective and opens them up to costly disputes.

Limitation 4: Caps or Maximums

A cap is the maximum amount of liability a seller can incur to the buyer. Caps average 10% to 20% of the purchase price of the business for most transactions. Once the cap is exceeded, you are no longer liable to the buyer for damages, with minor exceptions such as fraud.

Caps can be higher, or even unlimited, for the following reps and warranties:

Guidelines for Baskets, Caps, and Survival Periods

Here is a chart of general guidelines for baskets, caps, and survival periods:

General Indemnity Provision Guidelines for Baskets, Caps, and Survival Periods
BasketCap(% of Purchase Price)Survival Period
Title to AssetsNone100%Unlimited
TaxesNone100%Unlimited
OrganizationNone100%Unlimited
Employees, ERISA0.75% to 1.0%20%24 to 36 Months
IP0.75% to 1.0%20%24 to 36 Months
Environmental0.75% to 1.0%10% to 100%24 to 36 Months
All Other0.75% to 1.0%10% to 20%18 to 24 Months

Tips for Negotiating Reps and Warranties

How best to work out an agreement on reps and warranties? Let us count the ways …

Tips for Limiting Your Exposure

Here are tips and strategies for limiting your exposure in relation to the reps and warranties.

Sample Representations 

You may be asked to make representations that are broad or specific, such as the samples below:

Key Points

It was American baseball legend Yogi Berra who coined the phrase, “It ain’t over till it’s over.” To which I would add, “But even then, it may not be over.” That’s certainly the case with reps and warranties, as illustrated by the interrupted-vacation example in the introduction above.

In most M&A transactions, 10% to 20% of the purchase price is withheld by a third party in an escrow account to fulfill any post-closing indemnification obligations.

A purchase agreement transfers the ownership of a business and its assets. It replaces any previous agreements, such as a letter of intent or offer to purchase. 

The purchase agreement is sometimes signed before the closing occurs. However, a change of possession of the business doesn’t occur until the closing. Closing occurs when the bill of sale is signed and delivered to the buyer in the case of an asset sale or when the stock certificates are signed in the case of a stock sale. 

If the purchase agreement is signed prior to closing, contingencies may remain, such as approval by key third parties, including the lender, lessor, franchisor, or licensor. The sale is canceled if these contingencies aren’t satisfied before the closing or before the expiration of the purchase agreement.

Because it’s customary for the buyer to prepare the purchase agreement, the buyer’s first draft sets the tone of the negotiations.

The transaction can take two general forms:

The buyer’s attorney normally begins drafting the purchase agreement once the due diligence process begins. Because it’s customary for the buyer to prepare the purchase agreement, the buyer’s first draft sets the tone of the negotiations. If the first draft is heavily weighted in the buyer’s favor, you can expect negotiations to be contentious and lengthy. On the other hand, a “fair” first draft is more likely to speed up the process and facilitate smoother negotiations.

The buyer’s first draft of the purchase agreement also functions as a disclosure tool. If the buyer is unsure regarding any aspects of the business, a representation covering that area will force you, as the seller, to disclose any exceptions to the representation. The purchase agreement can also be thought of as a tool for allocating risk between you and the buyer. 

Negotiating Positions

Here is a more detailed overview of the process of negotiating the purchase agreement:

The scope of the negotiations is different from transaction to transaction. For example, a stock sale may contain a different scope of provisions than an asset sale. Likewise, a buyer who is intimately familiar with an industry and is, therefore, more confident in their ability to conduct due diligence may demand a lesser scope than a buyer who isn’t familiar with the industry. No two negotiations are alike.

The scope of negotiations is dependent on the:

As the seller, you can therefore minimize the potential scope of reps and warranties by:

If you operate a basic retail or service business, the reps and warranties likely won’t be broad in scope. But, if it’s a risky or complicated business, you can expect the buyer to demand much more stringent reps and warranties. For example, if your business handles hazardous materials, the buyer will request stringent representations addressing potential environmental concerns and possible workers’ compensation claims from workers handling hazardous materials. 

Purchase Agreement Outline

The structure of the purchase agreement will vary primarily depending on whether the form of the transaction is an asset or a stock sale. Most purchase agreements for lower middle-market transactions range in length from 20 to 50 pages, including the schedules and exhibits. 

Here are the key elements of a purchase agreement:

The purchase agreement may also contain the following exhibits:

Covenants

Covenants are promises to do – or not to do – something and are seldom a contentious issue in purchase agreements. Covenants in a purchase agreement define the obligations of the parties between signing and closing, and sometimes also after the closing. 

Sample language: “Until closing, Seller will operate the business in the normal manner and will use its best efforts to maintain the goodwill of suppliers, customers, the landlord, and others having business relationships with Seller.”

As noted above, covenants can either be affirmative (a promise to do something) or negative (a promise not to do something). The most significant covenant requires the seller to operate the business as usual prior to closing. This requires the seller to not make any material changes to the business prior to closing without the buyer’s approval. Such changes could include purchasing new equipment, hiring new staff, or changing compensation arrangements with employees.

Pre-closing covenants are necessary only if the purchase agreement is signed prior to the closing. In this situation, the pre-closing covenants define how the business will be operated during the period of time between signing the purchase agreement and the closing. If signing and closing occur simultaneously, pre-closing covenants are usually unnecessary. However, the parties may include post-closing covenants, especially if you as the seller are carrying a note. Pre-closing covenants often require the parties to use their best efforts to obtain required consents or to cause the transaction to close, require the seller to provide information to the buyer during due diligence, or may preclude the seller from negotiating with other parties, which is an example of a negative covenant.

Post-closing covenants often require the buyer to offer employment to a certain number of the seller’s employees and provide certain benefits to those employees, or may require the seller to assist in collecting any outstanding accounts receivable. The only covenants that survive the closing are post-closing covenants.

Conditions don’t survive the closing. Reps and warranties, on the other hand, do survive the closing.

Conditions

Conditions are requirements that must be met before the parties are obligated to close on the transaction, and are included in a purchase agreement if it’s signed before the closing. Conditions are also commonly called “contingencies.” Once the conditions are met, the closing can occur. The “conditions” section is also sometimes called “termination.” The conditions section typically lists a series of conditions that must be satisfied before the closing can occur.

Conditions don’t survive the closing. Reps and warranties, on the other hand, do survive the closing. This is an important distinction for the parties as the reps and warranties section of the purchase agreement continues to be an important element of the purchase agreement for a couple of years after the closing, or whatever the survival period is, which is typically 18 to 24 months. On the other hand, most other sections of the purchase agreement have no further implications once the closing has occurred. 

A breach of a condition relieves the parties from the obligation to close and is unlikely to provide you or the buyer with the option to initiate a lawsuit, whereas a breach of a representation or warranty provides the parties multiple remedies, as outlined in the indemnification section of the agreement. The sole remedy for a breach of a condition in most cases is simply the right to walk away from the transaction, also called a “termination right.” While termination fees are common in M&A transactions involving publicly traded firms, they are rare for privately held middle-market transactions. The rules and processes are significantly different for private and public firms. 

One important condition to closing is for the reps and warranties to be materially accurate. Thus, each representation functions as a condition to closing. 

While unknowns are common in M&A transactions, the parties must continue marching toward the finish line despite the existence of such gray areas. Successfully completing a middle-market M&A transaction requires a good deal of faith on both sides and not every potentiality can be neatly buttoned up in the agreements. In fact, the attempt to document every eventuality will only slow the transaction and lower the likelihood of a closing. Time kills deals. Either you waste time bickering over minutiae, or you speedily proceed toward the closing, balancing the need for clear documentation and good faith. An experienced advisor can provide guidance on when to proceed based on faith, and when faith is best put into writing. 

Most sellers prefer that buyers have a right to terminate the transaction only if material inaccuracies exist in the reps and warranties. Buyers prefer broader rights – even for immaterial inaccuracies in the reps and warranties, for example. The closing is also conditioned on the covenants. If the seller doesn’t operate the business in the ordinary course, the buyer may have a walk-away right. 

Here are sample conditions to the parties’ obligation to close:

The documents specified in the purchase agreement must be delivered to the parties, such as the promissory note, non-competition agreement, etc.

Here’s the bottom line: let your attorney do what they do best while you focus on what you do best – running your business. Keep your hands on the steering wheel while your attorney tinkers with the technicalities. 

Time kills deals.

Parties to the Purchase Agreement

Whoever signs the agreement is a party to the agreement. If you sign the agreement in the capacity of an officer of the corporation, then in most cases, you can’t be held personally liable for breaches of the agreement. 

The selling entity ceases to exist in most cases after the closing. That’s why most buyers either require that the majority shareholders of the selling entity sign the purchase agreement as individuals, and not as officers of the corporation, or that a portion of the purchase price be set aside in an escrow account to fund indemnification obligations. Alternatively, the shareholders can sign a joinder agreement, which binds them to the purchase agreement. 

What if something happens between signing and closing?

The simple, or affordable answer is, “Refer to the purchase agreement.” The complicated, or expensive answer, and the one most favored by attorneys is, “It depends.” 

If the purchase agreement has been signed, and most aren’t signed before the closing, the purchase agreement will govern the buyer’s obligation to close, particularly the “conditions precedent to closing.” Most purchase agreements include a “material adverse change” clause, also called a MAC clause for short, which outlines the conditions under which the buyer may terminate the agreement. The purpose of a MAC clause is to shift risk to the seller for significant downturns or other calamitous events that may impact the business between signing and closing. In a nutshell, the buyer will not be obligated to close if any covenants have been breached, the conditions for closing have not been met, or the reps and warranties are untrue as of the closing.

You should inform the buyer as soon as possible if an event has occurred that makes a representation untrue. Examples include the loss of a major customer or the filing of a lawsuit. Some purchase agreements obligate the buyer to immediately notify the seller if they discover a breach and require the buyer to either terminate the agreement or waive the breach and proceed with the closing. Without such an obligation, the buyer could withhold this information and unload it on you at the last minute as a negotiating tactic. 

The following is such an example:

The Seller shall promptly notify the Buyer in writing of any change in facts and circumstances that could render any of the representations and warranties made herein by the Seller materially inaccurate or misleading.

Another example of sample termination language:

This Agreement may be terminated at any time prior to the Closing: by the Seller, if the Buyer (i) fails to perform in any material respect any of its agreements contained herein required to be performed by it on or prior to the Closing Date, (ii) materially breaches any of its representations, warranties, or covenants contained herein, which failure or breach is not cured within 30 days after the Seller has notified the Buyer of its intent to terminate this agreement.

Here is a summary of essential actions you and the buyer should take before the closing:

Following are tips to help ensure a successful closing:

Prepare Emotionally for the Closing

You’ve heard of buyer’s remorse and maybe even experienced it. Buyer’s remorse is a feeling of regret after making a purchase. It only stands to reason that seller’s remorse is a thing, too.

Some business owners become stressed before the closing as the personal implications of the sale of their business start to sink in. They often delay the sale or even back out entirely. This may be due to anxiety at the thought of major life changes after devoting so much time to their business.

After being business owners for years, many owners are initially relieved to retire. They may have dreams of traveling, spending time with grandchildren, fishing, reading, learning a new hobby, and every other kind of cliché retirement activity you can imagine. And, in theory, this is a great plan. You have worked hard all your life; now it’s time to slow down and relax.

A year or less into retirement, most entrepreneurs end up looking for something else to do with their time. Many sellers even return with a desire to play a role in their former business. This is an ideal opportunity for the buyer. A savvy buyer will sit down with you and ask what areas of the business you most enjoy working on, then align your interests with the activities that provide the most value to your former business.

Often, your emotional needs are just as important as your financial needs. Keep this in mind during the transaction and discuss strategies with the buyer to ensure your needs are met.

While I can’t write prescriptions for Valium, I can offer sound and drug-free advice on how to deal with the anxieties associated with the selling of a business …

Often, your emotional needs are just as important as your financial needs. Keep this in mind during the transaction.

Find a New Passion

As I discuss the details of finalizing the sale, I have had several clients ask, “Now, what?” Then, when the sale is completed, and they are officially “retired,” they go off to do all the glorious things they imagined. The hitch is that most will not spend the rest of their lives traveling or playing with the grandkids.

Most entrepreneurs are go-getters. They need something to do with their time, be it a hobby, a new job, a role in a charitable organization, or something that will give them a purpose. Once their business is sold, some entrepreneurs find that what they once thought would be their dream of retirement turns out to be the very thing they resent. A year or so into retirement, many of our clients even come back and ask to play a role in their old business.

Another issue is that some entrepreneurs become so stressed during the closing – when they realize they’ll have nothing to do once the business sells – that they often delay the sale or back out entirely. This is because of the anxiety they get at the thought of doing “nothing” after a lifetime of work.

Luckily, there are ways to calm your nerves when selling your business. You need to realize that what happens after you sell your business needs to be planned just as much as the sale itself. You wouldn’t sell your house without knowing where you’d be moving next. The same principle applies here: Why would you sell your business without having a detailed plan about what you will do next? Answering “I will be retired” isn’t enough. You need to direct your energy toward a new passion.

If you’re preparing to sell your business and aren’t sure what you will do next, or you plan to just retire, I challenge you to spend some time answering this question: “What do I want to accomplish over the next 5, 10, or 15 years?”

The more detailed your plan for after the business sells, the better. Writing down your short-term goals, such as traveling or visiting family, as well as your long-term goals, such as learning a new language or starting a not-for-profit undertaking, will help you feel less overwhelmed as you get closer to selling your business. You can even gather information now about the different things you’d like to accomplish once your business is sold. You’ll find that a little preparation now will save you stress and anxiety about your future as you navigate through the complex process of selling your business.

Align Your Interests With the Buyer’s 

Your interests may provide enormous ongoing value to the business, such as recruiting, sales, marketing, or establishing key alliances. These are often difficult positions to recruit for. But, you may be talented at one or more of these roles and willing to continue to perform these for the buyer, especially if your other needs are met. 

Sellers are sometimes willing to continue to work in these positions if the role is structured to align with their lifestyle. Most retirees desire flexibility, and if a buyer can offer this to you, you may develop a win-win situation. Structuring an arrangement like this can also help the buyer retain key customers or employees. Key partners will feel more comfortable if they observe your ongoing participation in the business.

Key Points

Next up: The purchase agreement.

The buyer has done their due diligence, and you’ve done yours. The terms of the transaction have been broadly agreed to – including the price. 

Next up: The closing. You’ve gotten this far – what could go wrong? 

Hold my beer… 

There’s no such thing as a perfect closing. But we can come close. Here is a recap of the process from signing the letter of intent (LOI) to the closing:

  1. Letter of Intent: The buyer and seller sign the offer or LOI. 
  2. Due Diligence: Due diligence begins when the offer or LOI is accepted. Due diligence typically lasts 30 to 60 days. 
  3. Purchase Agreement: The parties’ attorneys draft the purchase agreement. Negotiating the terms of the purchase agreement often takes several weeks or longer. 
  4. Conclude Due Diligence: Once the buyer is satisfied, they sign off on the completion of due diligence. Additional contingencies remain prior to the closing.
  5. Closing: The closing is conducted via a roundtable or virtually. The purchase agreement is either signed before or at the closing.
The closing. You’ve gotten this far – what could go wrong? Hold my beer… There’s no such thing as a perfect closing. But we can come close. 

Does the type of entity impact the structure of the sale for a business? 

Yes, the type of entity you have impacts the structure of the transaction and needs to be considered well in advance of starting the sales process. 

One of the primary considerations when determining how to structure the sale of your business is taxes. When selling your business, federal and state taxes can dramatically impact how much of the proceeds end up in your pocket. 

The type and amount of taxes that must be paid are directly impacted by whether your company is a sole proprietorship, partnership, or corporation.

The section that follows provides general information about the main differences among the various types of entities as they pertain to business sales. You should always consult with a qualified attorney or tax professional when considering a business-sale structure, but a review of the concepts discussed here will give you a head start. 

The type and amount of taxes that must be paid are directly impacted by whether your company is a sole proprietorship, partnership, or corporation.

Sole Proprietorships 

If your business is structured as a sole proprietorship, the sale can only be structured as an asset sale. Selling a sole proprietorship is treated as the sale of a collection of assets that are owned by an individual, which is you. 

The tax you pay will be based on capital gains tax rates for some assets and ordinary income tax rates for other assets. This will be determined by how you allocate the sale price.

Single and Multi-Member LLCs

Single-member LLCs are pass-through entities – there is no tax on the LLC itself. Sales of these entities can be structured as a sale of assets or as a stock sale, although it is technically a sale of the membership interests in an LLC.

Regardless, the sale is generally treated and taxed as an asset sale, and the tax rates depend on how the purchase price is allocated. LLCs may also be subject to higher self-employment taxes than S Corporations, so I recommend consulting with your CPA prior to the sale.

If you have elected for your LLC to be taxed as a C Corporation, different rules apply.

Partnerships

If your business is structured as a partnership, the sale can only be structured as an asset sale. A partnership is a pass-through entity, which means that only the members pay taxes – the entity does not pay taxes. 

Taxes are paid at both capital gains rates and ordinary income tax rates, depending on how the purchase price is allocated.

S Corporation

If you own an S Corporation, the sale can be structured as an asset sale or a stock sale. 

If your business is structured as an S Corporation, there is no double taxation at the federal level, which is the primary advantage of an S Corporation over a C Corporation. State income taxes may also vary from state to state. For example, some states (hello, California) only have income tax rates and don’t have capital gains tax rates.

If your S Corporation was recently converted from a C Corporation, the sale might be structured as if you were still operating as a C Corporation. The IRS has created a 10-year look-back period for this situation. If this might apply to you, I recommend consulting a CPA and engaging in advanced tax planning before the sale or attempting to structure your sale as a stock sale.

C Corporation

Your business is a C Corporation unless you or your shareholders have filed Form 2553 with the IRS electing to be taxed as an S Corporation. 

If the sale is structured as an asset sale, the C Corporation will sell its assets. You will then face two levels of taxation, also known as double taxation – once at the corporate level when the corporation sells its assets and again at the individual level when the corporation distributes the proceeds to its shareholders in the form of a dividend.

There are two primary methods of avoiding double taxation:

If your business is structured as a C Corporation, I recommend consulting with a CPA experienced in structuring the sale of companies well in advance of the sale. 

You have many options available to you, such as structuring some of the sale as a bonus or salary, or negotiating the sale as a stock sale. But some of these options must be implemented well in advance of selling your business.

Key Points

Learn More

If you’d like to learn more about the importance of due diligence and how it can impact your final price, check out the M&A Talk episode titled Preparing Your Company for Due Diligence with Anthony Nitsos in the Resources section of our website at morganandwestfield.com.

“It isn’t the mountain ahead that wears you out – it’s the grain of sand in your shoe.”

– Robert Service, British-Canadian Poet

Conclusion

Due diligence is the graveyard of deals. Less trustworthy buyers may be looking to chip away at the offer price with each and every finding, while sellers struggle to operate their business during the sale. In many cases, a little bit of preparation will stretch a long way. Taking the time to understand a buyer’s motives during due diligence and actually solving issues within your business before the buyer finds them will save you time, money, and trouble. A grasp of the intricacies of the other mechanics of the transaction will allow you to understand a buyer’s qualms and soothe them before they can spin out of control. 

Sometimes it seems amazing that deals get done at all, what with so many aspects of a transaction to be worked out and agreed to by both parties.

Here’s one issue that often flies under the radar until late in the process – allocation of the purchase price.

Allocating the purchase price, or total sale price, of a business among the various assets of the business, or asset “classes,” is necessary for tax purposes when a business is sold. This is the case regardless of whether the sale is structured as a stock sale or an asset sale. Negotiations regarding the allocation of the purchase price should happen as early as possible in the transaction. In most transactions, this happens during due diligence while the parties are preparing the purchase agreement and working their way toward a closing.

Frequently, the allocation of the purchase price can become another area of negotiation after the price, terms, and conditions of the sale have been agreed upon. In most cases, what is good for the seller is bad for the buyer, and vice versa, which can lead to contentious negotiations. 

You and the buyer will each have a unique perspective when it comes to the allocation of purchase price. 

In the end, it’s crucial that both you and the buyer compromise and meet somewhere in the middle to satisfy your respective goals. An agreement is required because both allocations must match and be entered on IRS Form 8594, which you must file at the end of the year after a sale.

Unfortunately, many transactions have come to a halt because a buyer and seller can’t agree on the allocation of the purchase price. This is more likely to happen when the negotiations have been overwhelming and strenuous. The allocation of purchase price sometimes becomes the final straw, causing a buyer and seller to abandon the transaction. Don’t get blindsided by this issue that is often an afterthought until the end of many negotiated transactions.

Why the Allocation of Purchase Price Is Necessary

Before the closing can take place, you and the buyer must agree on how the purchase price is allocated. This is known as the allocation of purchase price. 

Both you and the buyer are required by law to file Form 8594 with the IRS. This document requires that both parties allocate the purchase price among the various assets of the business being purchased so you can calculate the taxes due upon the sale, and the buyer can calculate their new basis in the assets.

This form must be filed with each of your tax returns at the end of the year, and most tax advisors agree that the allocations should match on both the buyer’s and the seller’s designated forms. While there is no legal requirement that the buyer’s and seller’s allocations match, most tax advisors agree that a match will decrease the chances of an audit.

The Purpose of IRS Form 8594

IRS Form 8594 breaks down the assets of the business being purchased or sold into seven classes or categories. Each type of asset is treated differently for tax purposes. It’s essential that you carefully consider how you will classify each individual asset, as it can have significant tax and financial implications for both you and the buyer.

Specific allocations are referenced on the IRS form and are broken down as follows:

The seller usually seeks to maximize amounts allocated to assets that will result in capital gains tax while minimizing amounts allocated to assets that will result in ordinary income taxes.

Stock vs. Asset Sales

Where stock sales are concerned, the majority of the purchase price is normally allocated to the value of the stock, with the remainder being allocated to the value of any non-competition agreements, consulting agreements, or any other assets that are personally owned by the seller and not the entity.

In a stock sale, the buyer doesn’t receive a step-up in basis and inherits your existing basis in the assets. Most buyers prefer not to structure the transaction as a stock sale because they lose the tax benefit of being able to write up the assets and begin depreciating them at an inflated value. Most assets are fully depreciated, so the buyer has little depreciation to reduce the income taxes that may be due in the business.

For sellers, a stock sale is advantageous because you pay capital gains tax on shares held for more than one year, as opposed to ordinary income taxes due on gains from selling tangible assets. 

This is one of the reasons that asset sales dominate smaller business sales – because the buyer can deduct, or depreciate, the cost of the assets they acquire in the near term, which reduces the buyer’s income taxes. On the other hand, with stock sales, there are no immediate tax benefits to buyers.

Common Allocations 

Here is a list of common allocations for each asset class:

Class I: Cash and Bank Deposits

Class II: Securities: Including actively traded personal property and certificates of deposit

Class III: Accounts Receivables

Class IV: Stock in Trade or Inventory

Class V: Other Tangible Property: Including furniture, fixtures, vehicles, etc.

Class VI: Intangibles: Such as a covenant not to compete

Class VII: Goodwill of a Going Concern

Once the parties agree to the allocation, the allocation is usually attached as a schedule to the purchase agreement and signed at closing. The parties then file IRS Form 8594 at year-end, ensuring that IRS Form 8594 matches the allocation provided in the definitive purchase agreement.

Additional Tips for Allocating the Price

Avoid placing a value on the hard assets of the business in the early stages of the transaction, such as in the confidential information memorandum (CIM) or during due diligence. 

For example, a buyer may innocently ask, “What is the value of the hard assets, such as your equipment?” If you inflate the value, the buyer may later use this against you and argue that the value you provided should also be used for determining the allocation of the purchase price. 

And don’t be ashamed about giving the buyer a low or realistic value of your hard assets – remember, you’re selling an income stream, not hard assets.

You and the buyer will each have a unique perspective regarding the allocation of the purchase price. Each allocation category will have a different effect for both you and the buyer. 

It’s critical to give the allocations careful consideration because these differences can have significant tax and financial repercussions for you. Be sure to weigh the advantages and disadvantages of each allocation because it ultimately affects your bottom line.

Location, location, location. 

That’s a mantra that’s commonly heard when the discussion turns to home values. It’s also an important consideration when it comes to businesses. Don’t blow up your sale by giving short shrift to matters involving this key logistic. 

The lease is an integral part of the sale process. And it’s typically during the tail end of due diligence that the parties contact the landlord to begin the process of transferring the lease. The transfer of the lease is critical if the location of your business is important. The more important the location of your business, the more attention you should give to this matter.

That’s why it pays – literally and figuratively – to handle the assignment or transfer of your lease properly. In this section, I show you how to do just that, from when to contact your landlord to what to expect with your security deposit in conjunction with a sale of your business – and a lot of stuff in between that you may not have yet considered. 

When To Contact the Landlord

The earlier you contact the landlord, the better. Landlords respect business owners who are upfront and give them advance notice that they’re selling. I see many sellers spring the news on the landlord three days before closing, only to have the landlord refuse the transfer of the lease. Contacting the landlord upfront reduces this concern and will also ensure buyers that the landlord is cooperative.

Approach the landlord early in the process and let them know of your intentions to sell your business. Ask what’s important to the landlord in terms of a new tenant, such as operational experience, credit score, or financial strength. When you find a buyer, position the buyer to meet the landlord’s needs. Help the buyer prepare a resume, financial statement, clean up their credit, and otherwise package themselves for the landlord.

The transfer of the lease is critical if the location of your business is important.

Assignment vs. Sublease

With an assignment, the lease is transferred to the buyer, and you remain on the lease as a guarantor. This can be good or bad, depending on your perspective. It’s good if you’re financing a portion of the sale price because this can enable you to take the business back if the buyer defaults, although it depends on how the assignment is worded. It can be bad because you will likely be held liable if the buyer defaults on the lease.

The landlord’s viewpoint is that you initially signed your lease for a specific term, probably two to five years. If you sell the business, they’ll keep your name on the lease, then add the buyer’s name to the lease and typically keep you on as a “guarantor.” 

Why does the landlord do this? Why not? Why would the landlord voluntarily agree to increase their risk without receiving anything in return? The landlord has nothing to lose, so they nearly always request that you remain as a guarantor.

In a sublease, there are actually two leases. 

Most leases address this issue and don’t allow it, so read your lease carefully. Look for a clause titled “Assignment and Subletting.” 

The main reason a sublease might be used would be when you’re financing a portion of the sale price. Because you still have a lease with the landlord, you still have full privileges to access the property, which gives you more control until you’re paid in full. 

Fees and Deposits

There is usually a nominal fee to transfer the lease, perhaps $1,000 to $5,000, which varies by landlord. The fee is reasonable, as assigning the lease involves some legal work on the landlord’s part, and they don’t benefit from it monetarily, other than the reduced risk of keeping you on as a guarantor.

The landlord will typically keep your security deposit, and the buyer will reimburse you for the deposit at closing. This prevents the landlord from returning your deposit and collecting a deposit from the buyer, which is two transactions. 

Problems Negotiating With the Landlord

The landlord does not necessarily have to approve the transfer of the lease to the buyer. Be sure to read your lease, as it should address this issue. The law in most states addresses assignments. Most state laws say that the landlord can’t “unreasonably withhold the assignment of the lease.” What does “unreasonably” mean? That’s the magic question. I’ve had my fair share of deals die due to landlords who outright refused to transfer or assign a lease for no demonstrably valid cause.

If a landlord wants to, they can put up a fight to keep you from transferring your lease for a variety of reasons. It certainly pays to make sure you and the landlord are on the same page before you invest a lot of time and effort in selling your business. It doesn’t pay to litigate this question. It’s best to reach an agreement and move forward with both of you on the same page.

In some leases, the lease reads that the landlord receives half of the sale proceeds when the business sells. Am I kidding? No. This is rare, but I’ve seen it happen. The clause should read that the landlord should receive half of the “leasehold value” or half of the proceeds that are attributable to the value of the lease. But the landlords I saw wanted half of the sale price of the business. The owner fought the case in court and eventually gave up after spending $30,000 in attorney fees.

Read your lease, or at least have an experienced advisor read it to make sure there aren’t any major issues.

Here is a sample due diligence checklist:

Operations

Insurance

Assets

Financial/Tax

Staff

Legal

To download an editable spreadsheet version of this checklist, visit the Downloads section under the Resources menu at morganandwestfield.com.

Other Specialists 

Depending on the nature of your business and industry, other specialists may be employed during due diligence. In some cases, retaining experts in advance can mitigate risk for the buyer, and the buyer may, in turn, reduce the scope of the reps and warranties in the purchase agreement.

Due diligence can be grueling. Be prepared to commit a substantial amount of time and energy to the process. 

Tips for Conducting Due Diligence

Be Emotionally Prepared: Due diligence can be grueling. You must be prepared to commit a substantial amount of time and energy to the process. The objective of some buyers is to wear you down, discover problems during due diligence, and then attempt to renegotiate the terms of the deal. Anticipate this possibility by preparing for due diligence so issues are uncovered and resolved before a buyer discovers them. You should also attempt to remain emotionally unattached to the process so you can negotiate from a detached, objective perspective.

Determine Buyer Type: The type of buyer you negotiate with can determine how thorough they will be during the sales process. Individuals are generally less thorough than companies in conducting due diligence. But some individuals can be especially thorough if they are detail-oriented, are quite risk-averse, or have a CPA or attorney advising them behind the scenes. Most companies are thorough, especially if they have completed multiple acquisitions in the past.

Keep Your Options Open: Keep your business on the market, even after you’ve received an offer, unless you have agreed to an exclusivity period with the buyer.

Don’t Lose Focus: You must be prepared to spend significant time and energy during the due diligence process. By the time you reach the due diligence stage, you may feel as if you’re almost done, but this is a critical stage where the sale can be made or lost. If you lose focus, your deal can die – there is still a lot of work to be done before the sale is complete. It’s vital that you stay engaged and actively involved in due diligence in order to reach your ultimate goal of a smooth closing.

Involve Your Accountant: Since much of the documentation necessary for due diligence is financial in nature, consider including your accountant or CFO as early as possible to help prepare. The more cooperation you have from your team, the smoother the process will be.

Designate a Point Person: The point person should be the quarterback during the transaction to orchestrate communication with all parties involved and review all information before it’s released to the buyer. Many professional advisors, such as your accountant, will lose you as a client if the transaction is successful, so they may not be as motivated as you are to close the deal. Being the point person yourself, or appointing someone within the company, will help streamline the due diligence process.

Contact the Landlord Early: The lease is one of the most critical elements of the process and needs to be carefully orchestrated. Issues around the transfer of a lease are common, so the process must be handled with care. Landlords aren’t required to approve the lease transfer. Delaying the landlord’s involvement can create issues that slow down the closing or prevent it altogether. I recommend involving the landlord as early as possible in the process. 

Prequalify the Buyer: Be sure that you have pre-qualified the buyer before negotiating and accepting an offer. You want to be sure you are negotiating with a buyer who has the financial capacity to close the transaction.

Tell the Buyer You Are Prepared: If you’ve prepared your business for sale and organized all the documents, be sure to mention it in early conversations with buyers. You could say something like this:

“I’m a motivated, serious seller who has prepared my business for sale with the help of my CPA. I have all the necessary documents ready for due diligence, including tax returns, leases, equipment lists, financial statements, and more.”

It’s vital that you stay engaged and actively involved in due diligence in order to reach your ultimate goal of a smooth closing.

Benefits of Preparing for Due Diligence

If you don’t prepare for due diligence, it can turn into an expensive and time-consuming undertaking. But there are many advantages to preparing for due diligence, and I believe this is a crucial step in selling your business quickly and for peak value. The primary purpose of preparing for due diligence is to address potential problems before placing your business on the market. To attract a sophisticated buyer to your company, you must prepare for due diligence well before you begin the sales process. This is especially true for middle-market companies, as conducting pre-sale due diligence may be the difference between receiving a good price and losing a deal altogether.

Due diligence is one of the most difficult periods of any deal. And the best way for your business to emerge unscathed from this arduous process is preparation. Taking the time to resolve potential issues in your business long before you put it on the market has innumerable benefits. Let’s discuss the major ones. 

Resolve Issues Before They Become Roadblocks

When a buyer decides to pursue the purchase of your business, the buyer will conduct their own due diligence to determine what is going on with your business before they commit to purchasing it. Unexpected issues that arise in the course of the buyer’s investigation may potentially kill a deal.

You can resolve many of the issues before a buyer ever learns of them with advanced warning of any unsettled problems. Further, a problem identified in advance that can be explained will keep your credibility intact. 

Preparing for due diligence enables you to work out problems before a buyer comes into the picture. There’s nothing worse than spending time and money preparing and marketing your business for sale and finding a qualified buyer, only to lose the buyer because of an unforeseen problem with your business that could have been resolved beforehand. This scenario happens more often than sellers realize because, despite working in their business full-time, owners are often unaware of seemingly simple issues. 

But those simple issues can have a material effect on a buyer’s perception of the relative risk of a company if they aren’t resolved in advance. For example, issues with financial records, if not addressed beforehand, usually trigger demands for a lower price, more restrictive terms, or may even cause the buyer to walk away from the sale entirely.

Greatly Improve the Odds of a Successful Transaction

Preparing for due diligence allows you to correct potential problems and avoid potential pitfalls to a sale before you expose your business to buyers.

With inaccurate financial records, you run the risk of losing a buyer because once the buyer discovers the defects during due diligence, the sale must be delayed to address the problems. After spending many months finding a buyer, losing them over something that could have been corrected from the outset is a huge disappointment and a waste of valuable time, money, and resources.

Retain a third party to examine your financials – profit and loss statements, balance sheets, and federal income tax returns – and scrutinize key ratios, trends, and other data. They will then provide you with a report of their findings. The report helps uncover potential issues a buyer may find with your financial records, and allows you to address these issues before you ever receive an offer.

Speed Up the Due Diligence Process

Having your financial records in order before selling your business can speed up the due diligence process once you have a buyer, resulting in a higher chance of closing the deal. This is because a buyer who has issues with your financial records will most certainly conduct due diligence thoroughly to look for problems in other areas, as well.

Maximize Your Sales Price

Conducting pre-sale due diligence maximizes the value of your business by identifying issues early on to avoid complications that can affect the transaction.

Accurate financial records help maximize the sale price of your business by attracting buyers who are confident in your company. Simply put, the more organized your business’s financial records appear, the quicker you are likely to sell your business and receive top dollar.

A thoughtful evaluation of your business before the sale process begins will make the undertaking more manageable, efficient, and cost-effective.

The advantage to preparing for due diligence is you’ll have the opportunity to resolve any issues on your own time, without the added stress of the transaction being dependent on its outcome.

Additional Advantages of Conducting Pre-Sale Due Diligence

Conducting due diligence offers many benefits because it: 

Through the process of preparing for due diligence, members of your adviser team will come to know and understand your company as well as you do – and far better than a potential buyer. This understanding enables your transaction adviser to prepare a confidential information memorandum and other marketing materials that fully describe and highlight the strengths of your business. Highlighting your business’s strengths and being fully prepared to explain the intricacies will put you in the best position to sell your business at the optimal price.

How to Prepare for Due Diligence

What To Do Before Your Business Is Put on the Market

Preparing your business for due diligence is straightforward. It involves assembling and organizing the documents most buyers request and review during the due diligence period. You should then retain a third-party expert to review these documents and identify any issues the buyer may discover during due diligence. You should then address any issues once they are uncovered. 

The advantage to preparing for due diligence is that you’ll have the opportunity to resolve any issues on your own time, without the added stress of the transaction being dependent on its outcome. The need for having your financial documents prepared and organized – as well as ensuring everything is ready from an operational and legal standpoint – can’t be understated.

Preparing for financial due diligence is one of the most important parts of successfully closing the sale of your business. Because the number one deal-killer of business sales is incomplete or inaccurate financial records, this should prompt you to make it a priority to ensure your financials are in order. Otherwise, you risk losing the buyer because financial inaccuracies will likely be discovered during due diligence. 

No one wants to invest enormous amounts of time with a buyer only to lose them due to something that could have been prevented. Therefore, pre-sale financial due diligence should be conducted by a third party, preferably a CPA. Ideally, this should be performed at least three to six months before beginning the sales process. This will give you ample time to resolve any issues uncovered during the process.

Preparing Documents Before Due Diligence

Preparing your business for sale dramatically increases your chances of success. Laying the groundwork for due diligence helps convince the buyer to agree to a shorter due diligence period and decreases their perception of risk in your business. 

By organizing the documents so they are ready for review, you’ll ensure the process is quick and straightforward. Immediately after you accept an offer, the buyer can start reviewing the documents. Time is your greatest enemy. Time can kill all deals. By preparing for due diligence from the outset, you potentially speed up the process and dramatically improve your chances of closing the deal.

You also increase the chances of receiving an offer. Often, buyers are reluctant to make an offer on a business because they don’t want to risk the time and financial investment in performing due diligence only for there to be an undisclosed problem. Preparing for due diligence mitigates these concerns for buyers.

I highly recommend you prepare for due diligence as early as possible. This is where your accountant or CFO can help with gathering the documents you need. 

In one recent transaction I worked on, due diligence was significantly delayed because the seller didn’t have copies of bank statements on hand, and it took several weeks to obtain the statements from the bank. This delay resulted in a price concession because the economy took a dip during this time.

You also demonstrate to the buyer that you’re serious when you take the time and effort to prepare your business for sale. Buyers prefer dealing with motivated, prepared sellers. Buyers are more likely to spend time with a seller they know has prepared for the sale.

Key Points

When evaluating a house for sale, a buyer can quickly form an opinion on the value and suitability of the structure and hire an inspector. Houses and other tangible purchases often require little to no due diligence. But buying a business involves assessing many intangible factors that aren’t readily apparent and are more difficult to assess and evaluate.

Purpose of Due Diligence

Businesses are complicated – there are hundreds of factors buyers must take into consideration when deciding if they want to move forward with the transaction. As a result of this complexity, purchasers of businesses go through a lengthy and thorough due diligence process before deciding whether to move forward with the transaction. This process begins the moment you accept an offer. 

With a business, your representations are verified during due diligence only after you mutually agree upon a letter of intent. If all buyers conducted their due diligence before making an offer, you would spend a tremendous amount of time with many buyers and risk a confidentiality leak. 

Conducting due diligence simultaneously with multiple parties may also lead you to lose focus on your business, causing the value of your business to decline as a result. The buyer must accept your initial representations before an offer is accepted; only after an offer is accepted does the buyer have the opportunity to verify your representations.

Before accepting an offer, you should be cautious regarding what information you show to a buyer. You should be helpful to the buyer, but you shouldn’t show them everything they ask to see. At some point, you should politely and tactfully ask the buyer to make an offer.

Explain to the buyer that a thorough investigation can only be conducted after an offer is accepted. Point out that once an offer is accepted, the buyer will have plenty of time to perform their due diligence and verify the accuracy of your representations. 

List of Documents and When They Are Shared

Here’s what to share before the offer is accepted:

Here’s what to share during due diligence after the offer is accepted:

This list isn’t typical for every business since each business will have a unique due diligence process and list. Also, many due diligence requests are more extensive than the list above. 

In most circumstances, the buyer can walk away from the transaction if they are unsatisfied for any reason during due diligence.

Length of Due Diligence

Due diligence can take any period of time, as long as both you and the buyer agree. The typical due diligence period for most small to mid-sized businesses is 30 to 60 days.

The length of due diligence should be based on the following:

Outcome of Due Diligence 

The outcome of due diligence can actually determine the scope of the reps and warranties. The buyer’s due diligence may be less thorough if you are willing to provide more extensive reps and warranties. But reps and warranties should not be a substitute for thorough due diligence. Likewise, thorough due diligence shouldn’t be a substitute for thorough reps and warranties. Instead, the two should work hand in hand.

Bear in mind that due diligence will never uncover every problem in a business. There is always the possibility that something may slip through the cracks during the due diligence process. Because of that possibility, buyers rely on reps and warranties to offer them protection for issues they may not uncover during due diligence. 

The scope of due diligence and the reps and warranties are driven by the type and size of the business. An industrial business will require an entirely different due diligence and reps and warranties framework than a technology business. Regardless, due diligence and the reps and warranties should work in concert with one another. By preparing for due diligence, you’ll have the opportunity to reduce the potential scope of the reps and warranties in the purchase agreement.

The Importance of “Representations” and “Warranties”

Due diligence is never perfect – it can never uncover every potential problem with a business. A buyer can never be absolutely assured that the business is without problems. In fact, there is no such thing as a “perfect” business. 

If due diligence doesn’t ensure that the business is problem-free, what can be done?

“Representations” and “warranties” are statements and guarantees by the seller relating to the assets, liabilities, and other elements of the business being sold. In the purchase agreement, you will have to make factual statements regarding the condition of the business, covering nearly all aspects of the company. These are referred to as representations and warranties, or “reps and warranties.” 

The reps and warranties collectively mitigate the risk of any material defects that aren’t discovered during due diligence. Essentially, you’re assuring the buyer that your representations are true, and if proven to be otherwise, the buyer is entitled to seek legal remedies, which could result in you reimbursing the buyer for damages. 

Reps and warranties in the purchase agreement assure the buyer that legal remedies are available if you fail to disclose any material facts regarding the business that aren’t discovered during due diligence. This ensures the buyer that additional protection is available if you aren’t fully forthcoming during due diligence.

The parties normally begin preparing a draft of the purchase agreement during due diligence.

The Process

Here’s a summary of how due diligence fits into the sales process: