“It’s in your moments of decision that your destiny is shaped”

– Tony Robbins, Author and Busine

All exit scenarios can be broadly categorized into three groups:

• Involuntary: Includes involuntary exits, such as death, divorce, or disability
• Inside: The buyer comes from within your company or family
• Outside: The buyer comes from outside of your company or family

In addition to these three exit options, you can also sell a portion of your business. This can either be an inside sale or an outside sale.

I’ll explain each exit option in more depth so you can determine the recourse that best meets your objectives.

“Failure is only the opportunity to begin more intelligently.”

– Henry Ford, American

Why don’t some businesses sell, and what can you do to ensure a successful sale and maximize the price of your company?

Most transactions die during one of the following stages:

• Marketing: These transactions never get off the ground because the seller and their M&A advisor or investment banker can’t get the traction necessary to generate meaningful discussions with buyers.
• Letter of Intent: The seller has generated interest from a buyer, but they lose interest after taking a closer look at the business. 
• Due Diligence: The buyer makes an offer, but the transaction dies during due diligence for any number of possible reasons.
• Closing: The buyer successfully concludes due diligence, but then the deal dies sometime before the closing.

In the following section, I’ll examine and analyze real-world case studies from businesses I worked with through my company, Morgan & Westfield, that ultimately didn’t sell. Reviewing these examples gives you insight into the salability of your own business, what can potentially go wrong, and steps you can take to help ensure your company sells for top dollar when you do decide to put it on the market. Let’s get started …

What follows are some actual scenarios of sales that never materialized, and why: 

• Risky: One business was considered too risky for buyers due to a recent entry of venture-backed competitors into the industry. No buyer was willing to make an offer due to the increased competitive nature of the industry.
• High Customer Concentration: One customer generated over 40% of the revenue for a business, and no buyer was willing to take the risk inherent with such a high level of customer concentration.
• Inaccurate Financials: A buyer made an offer on the business and then discovered multiple inaccuracies in the financial statements during due diligence. The buyer attempted to clarify the inaccuracies with the seller’s accountant, but the accountant couldn’t assuage the buyer’s fears in a timely fashion and the buyer walked as a result.
• Competition: A technology business generated significant buyer interest. During the process, an announcement was made that a major competitor received a large capital injection from a venture capital group. Once the news reached the buyers, they became apprehensive and downgraded their valuation of the business, which the seller was unwilling to accept.
• Personality Conflicts: An offer was made and accepted. Due diligence began smoothly, but personality conflicts between the buyer and seller developed and spiraled out of control. The parties became deadlocked on several issues, and both refused to budge. The problems mounted to the point where the transaction reached a stalemate and it died a slow death.
• High Growth: One business was growing at a rate of 30% per year. Buyers were only willing to buy the business based on the historical earnings, but the owner wanted to be paid based on the next 12 months’ projected earnings and wasn’t willing to consider an earnout.
• High Revenue, Low Profitability: A business had high revenue but was breakeven. Our marketing efforts yielded poor results because buyers dismissed the business due to its lack of profitability.
• Revenue Declined: For one business, the revenue declined by 10% between the time a letter of intent was accepted and the time due diligence was completed. The recent decline in revenue implanted fear in the buyer, and they walked as a result.
• Minority Partners: We put a business on the market, successfully generated several buyers, accepted a letter of intent, and began the due diligence process. The owner then contacted us and told us their minority partner was demanding a 200% premium for their minority share of the business. The owner refused to give in to the demands of the minority partner and the buyer subsequently walked.
• Industry: A buyer made an offer on a business in the consumer goods industry and the seller accepted the offer. But, as the buyer performed due diligence, it became evident that the impact of the changes in the industry was uncertain and difficult to predict. As a result, the buyer retracted the offer.
• Lack of Preparation: A construction-related business for sale seemed like a promising investment for a buyer in the industry and, in fact, an offer was eventually made from a competitor. During due diligence, the buyer uncovered numerous defects in the business that could have been prevented with proper preparation. Some of these defects included inaccurate financials, a lack of proper insurance (cash flow was overstated due to inadequate insurance coverage), no tax planning (the business was a C Corporation and subject to double taxation in an asset purchase), lack of approval from a minority partner, and a lack of employment agreements or retention plan with key employees.
• Third-Party Delays: A seller of a service-based firm in the Midwest accepted an offer and the buyer began due diligence. During due diligence, the buyer noticed several inconsistencies in the financial statements. The seller forwarded the questions to their CPA, but two months later the questions remained unanswered and the CPA was generally unresponsive. The buyer walked as a result of the delays.
• Lack of Financing: A potential buyer of a specialty manufacturing business made an offer and conducted due diligence, which proved to be successful. But the buyer was unable to obtain financing and didn’t have an adequate down payment for the seller to consider financing the sale.
• Owner Not Willing to Finance: A buyer made an offer on a middle-market business in the healthcare industry. The offer included an 80% cash down payment, but the seller was unwilling to finance more than 10% of the purchase price and the offer wasn’t accepted.
• Dependent on Owner: A professional services firm received significant buyer interest in a short period of time. But as most of the buyers dug deeper, they discovered the owner was inextricably tied to the business and determined that a transition would be too difficult, costly, and risky. Most of the clients were close friends of the owner and the name of the firm was tied to the owner’s name, though the owner wouldn’t allow a buyer to use the company name moving forward. As a result, no buyer was willing to make an offer despite the high cash flow and attractive price of the business.
• Key Employee Dependency: In another transaction, a valuation was performed on a business in the online education space. An offer was received and the buyer began performing due diligence. During due diligence, the buyer discovered that two employees were instrumental to the operations of the business. The seller allowed the buyer to talk to the employees to ensure they would be retained, but the employees demanded a salary increase and equity incentives that were far beyond what the buyer considered reasonable. The buyer walked as a result.
• Employees Fail to Cooperate: An offer was received on a commercial landscaping business. Once the management team received news of the offer through the grapevine, they felt slighted and were determined to derail the transaction. Despite the seller’s attempts to pacify the team, their resentment couldn’t be contained. Once the buyer received news of the lack of cooperation from the management team, they rescinded their offer.
• Tax Returns Not Reconciled to Financials: An offer was accepted on a roofing company and due diligence uncovered disparities that couldn’t be reconciled between the financial statements and federal income tax returns. The differences couldn’t be explained by the seller’s accountant and the buyer downgraded their offer, which the seller was unwilling to accept. Upon the advice of the buyer’s CPA, the buyer walked.

As you can see from these examples, there are a variety of factors that can cause a business to not sell. But, every single one of these business owners could have dramatically improved their odds of success if they had invested time to prepare their business for sale well in advance. Many of these problems could have been mitigated or prevented altogether through proper preparation. 

While some problems can’t be completely overcome, buyers often consider the totality of the circumstances. The more risk the buyer perceives, the more likely they are to walk away from the business. For example, if a business has high customer concentration but the customers are secured by a long-term contract, a buyer may view this scenario as less risky. Or if a management team is in place that has a relationship with key customers and the current owner has no personal relationships with the key customers, the buyer may feel more comfortable. Even the most severe issues threatening to kill a deal can be mitigated through preparation.

The more risk factors that are present in your business, the harder it will be to sell, the more nervous buyers will become, and the less they will pay for it. But many of these problems can be successfully prevented if you give yourself ample time to prepare your business for sale. Even if a problem can’t be completely eliminated, it may still be possible to mitigate the effects of the problem so you reduce the buyer’s perception of risk. The result of preparing your business for sale is that you dramatically tilt the odds of a successful sale in your favor. That’s the purpose of this book.

If you’re serious about selling your business and would like to maximize the value of your business, I recommend you prepare for the sale as early as possible by following the guidance outlined in these chapters. The aim is to help you identify and mitigate as many risk factors in your business as possible – well before you put your business on the market. This book contains the collective wisdom of hundreds of transactions – both successful and unsuccessful, and will help you do the following:

• Explore the ideal exit options for your business that help you maximize the price you receive.
• Evaluate the salability of your business.
• Establish a range of potential values for your business from low to high.
• Create a plan to help maximize the value of your business.
• Identify risk factors in your business.
• Identify potential deal killers in your business.

There’s a lot that can go wrong in a sale. It pays to invest time maximizing the worth of what is likely one of your most valuable assets. Let’s get started.

You’ve gone through the rigorous process of deciding to sell your business, and you’ve decided that now is the time. You may wonder, how long will it take? For all transactions since 2000, the average time on the market is 200 days or about 7.3 months. But the average time to sell a business has increased over the years, from six months in the early 2000s to ten months in recent years. That timing, however, depends on several variables.

Variables 

There are three primary variables that affect how long it takes to sell a business:

1. Your Industry
2. How Attractive Your Business Is
3. Your Marketing Strategy

Let’s take a closer look at each.

Variable 1: Industry 

All investor’s perspectives can be boiled down to two things – risk and return. The greater the returns your business offers, the more your business will be sought after. The reverse can be said for risk – the riskier your business, the fewer buyers you’ll have courting you and your business. This is precisely why certain industries are more desirable than others – because they offer the potential for outsized returns or they represent less risk for the investor. 

As a result, a strong correlation exists between the industry type and the number of days a business is on the market. Manufacturing and technology businesses tend to attract more buyers and therefore sell faster than many retail and most service-based businesses. On the other hand, many retail businesses don’t have the potential to generate significant returns, or they may be excessively risky, which is why most investors shy away from the retail sector. If your business is in an attractive industry, such as technology or manufacturing, it will likely sell sooner due to the higher demand than if it’s in a low-growth or unattractive industry. If you operate in a competitive or otherwise risky industry that offers limited returns, expect the sale to take longer than average.

Variable 2: Attractiveness

Highly attractive, and therefore sought after businesses, possess many of the following attributes:

• Improving financial trends, such as increased revenues or margins
• Low capital expenditures, inventory, or working capital requirements
• Desirable industry
• Strong industry growth, or stability
• Low risk industry – limited competition, recession-resistant, etc.
• Scalable business
• High barriers to entry
• Weak competition 
• Strong competitive differentiation 
• Strong brand awareness
• Strong history
• Strong customer loyalty or repeat business
• Minimal customer concentration
• Strong customer contracts
• Recurring revenue
• Strong management team
• Strong infrastructure
• Valuable intellectual property
• Minimal owner dependency
• Minimal dependency on key employees
• Long employee tenure

Variable 3: Your Marketing Strategy

Perhaps Sun Tzu was really contemplating M&A strategy when he said, “tactics without strategy is the noise before defeat.” As in war, so goes business. Marketing your business for sale using a strategic marketing plan through the right investment banking firm should help you sell your business faster. Find the best M&A advisor possible and give them everything they need to help you. Doing so will dramatically speed up the process.

Timeline for Selling a Business

Following is a brief description of the steps involved in selling a business and the time frames involved for each step.

• Preparing Your Business for Sale (1 to 2 Months): Preparing your business for sale includes normalizing your financial statements, valuing your business, and creating an information memorandum, teaser profile, and other key documents. Preparation is typically a controlled and predictable step and usually takes one to two months. 
• Marketing and Negotiating an LOI (1 to 9+ Months): It can take 1 to 9 months to locate a buyer, and generally one to two months to negotiate a letter of intent (LOI) once you identify the buyer. This time period is often frustrating for a seller because you may feel as if nothing is happening. But it’s important to keep your focus on your business and maintain consistent revenues while it’s confidentially being marketed for sale.
• Due Diligence and Closing (2 to 3 Months): Conducting due diligence usually takes four to eight weeks, although it can sometimes take longer depending on who the buyer is and how organized you are as the seller. Due diligence can be delayed for many reasons, such as delays in obtaining financing or as the result of inaccurate financial information. Negotiating and closing the transaction usually takes from one to two months once due diligence has been completed. In some cases, it can take several months to close the transaction due to third-party delays from attorneys, accountants, banks, or license-transfer approvals. 

These guidelines are rough estimates only, and you should be fully prepared for the transaction to take significantly longer. Most of the factors that increase the value of a business will also have an impact on the amount of time it takes to sell the business. If you want to increase the value of your business or speed up the time frame, the steps you must take are often the same.

Key Points

When planning to sell a business, attempt to maintain a balanced viewpoint. The actual time period can vary from one day to more than three years. Selling a business is a stressful, emotional event, and it involves anticipating other peoples’ actions, which are beyond your control. As a result, the data is varied, and accurately estimating the time is difficult. 

Here’s a story that highlights the importance of preparation. In the early morning after St. Patrick’s Day of 1990, celebrants would later report seeing two policemen in a hatchback pull up at the side door of the Isabella Stewart Gardner Museum in Boston, Massachusetts. But at the time, no one thought anything of it. Those two men dressed as police officers would be let in by the museum security guards, after they claimed to be investigating the fire alarm that had mysteriously gone off in the hours beforehand. Citing an open arrest warrant, the “officers” quickly handcuffed both security guards, wrapped duct tape around their eyes and mouth, then dragged them into the basement of the museum.

Over the next 81 minutes, the greatest art heist in history took place. Without the need of maps, the two men systematically worked their way through the museum, cutting canvases from their frames and unscrewing paintings from the walls. The estimated worth of their haul – $300 million. When the FBI later watched the two thieves’ movements through the museum’s infrared motion detectors, they would comment on the level of knowledge the men had of both the museum and the value of its contents.

To this day, the paintings and sketches stolen on the morning of March 18, 1990 are still missing. The thieves have never been caught. We may never know how the two men set off the fire alarm beforehand, or how long they poured over maps of galleries and auction histories. What we do know is that their preparation led to a successful heist. And when it comes to selling your business, there are lessons to be learned from art thieves.

Considering that the sale of your company may be the largest sale you ever make in business, it’s foolish to neglect preparation and potentially leave millions of dollars on the table, even though you’re not preparing to steal a Rembrandt. Unfortunately, most business owners don’t give this major life decision the attention it deserves. 

Why? 

The lion’s share of entrepreneurs have a strong bias toward action. Once they decide on a course of action, they prefer to dive right in and figure things out later. But you must realize that a lack of preparation will extend the time frame of the sale, reduce the selling price of your business, put less cash in your pocket, and lower the chances of a successful sale. 

Proper preparation, on the other hand, will elicit the opposite outcomes – you’ll increase the chances of a successful sale, shorten the time frame, command a higher selling price, and put more cash in your pocket. As with most skilled endeavors, preparation makes execution look effortless. Or, as the eccentric mathematician, E. Kim Nebeuts once said, “a good preparation takes longer than the delivery.” So, channel your inner art thief. Prepare for the event just as if you were prepping to rappel through the Louvre and prance off with the Mona Lisa. Doing so will not only ensure the process unfolds as smoothly as possible, but you’ll likely walk away with a higher return.

Types of Preparation

I offer dozens of strategies in this book to prepare your business for sale. Act on them. In over twenty years of selling companies, I can tell you that taking action to prepare is the one strategy that’s nearly failproof. 

But, no two exits are alike. Each exit must be deliberately planned. There’s no templated process you can follow to prepare your company for sale. Rather, the preparation stage involves creating a plan, prioritizing your plan, and then executing your plan. When I’m approached by a potential client, we usually start by preparing an assessment, which includes a customized exit plan or strategy. But in the absence of a custom plan, you can follow the general guidelines outlined in this book.

If you’re willing to take the time to prepare your business for sale, you should also be sure that the firm you hire can assist you before you begin the sales process. This exercise is formally known as “exit planning.” Many M&A advisors and investment banking firms are heavily biased toward action and prefer to put a company on the market and sell it as quickly as possible. They may not be as concerned with maximizing the sale price and doing the hard work necessary to ensure a successful exit. Be sure whoever you hire is willing to help you in the preparation stage.

If you aren’t intending to spend time preparing your business for sale, then be honest with your advisors, and be willing to accept far less than top price for your company. Luckily, most professionals are accustomed to dealing with clients in situations that are less than ideal and will appreciate an owner who’s upfront regarding how much time they can invest in getting their company ready to be put on the market.

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:

• What are my long-term goals? 
• Would selling my business help me achieve my long-term goals? 
• What am I trying to accomplish now? 
• Which of my goals are the most important?
• How does the sale of my business help me achieve my goals?

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:

• What are my financial goals? How do these fit into my long-term plans? 
• What’s more important – my financial goals or other goals I have set? 
• What am I going to do with the money? 
• Is my goal to take money off the table and diversify my risk? If not, what am I going to do with the money?

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:

• Am I happy? Am I really happy? 
• Is my business making me unhappy? 
• Would selling my business make me happier? 

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:

• Am I burnt out? 
• Have I taken a vacation recently? 
• What other options have I considered or attempted to cure my burnout?

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:

• Is competition becoming stronger in my industry? 
• Are new venture-backed entrants threatening my market share? 
• Do I have enough capital to fight a competitive industry war? 
• Are indirect competitors threatening to permanently change the structure of my industry (e.g., Uber vs. the taxi industry, Airbnb vs. the hotel industry, online news vs. traditional news)? 

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:

• Have I had my business appraised recently? 
• Am I aware of current multiples in my industry? Have multiples remained steady within my industry, or have there been significant variations over time? 
• Do I know what changes I need to make to unleash the value of my business? Do I know what my business would be worth if I made these changes?

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:

• What are my options for exiting my business? 
• Should I consider selling or gifting my business to family members? 
• Is my management team, or someone on the inside, a potential fit? 
• Is a sale to a competitor most practical? 
• Is a private equity firm likely to buy my business?

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:

• How salable is my business right now? 
• Are there deal-killers present in my business that need to be fixed? If so, how long will it take to fix them? 
• Is it worth the time and energy to attempt to straighten out these issues, or is it best to sell my business in its current state? 
• What is my personal ROI if I fix these issues before selling my business? 
• What is my lost opportunity cost in attempting to cure these potential deal-killers? 
• Could my time be better used elsewhere?

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:

• Ask the Expert: Links to common M&A questions and answers. Ask any question related to buying, selling, or valuing a business.
• Downloads: Links to forms and other useful resources for selling your business.
• Books: A complete list of my books on selling, valuing, or buying a business, and all other topics related to M&A.
• Glossary: A glossary of terms used throughout this book. Don’t be confused or intimidated by any terms or abbreviations in the M&A world. You’ll find answers here.
• M&A Encyclopedia: The most exhaustive encyclopedia in the industry with over 800 pages of insight on every step of the process of selling, buying, or valuing a business.
• M&A Talk: The #1 podcast on mergers and acquisitions, produced by Morgan & Westfield and hosted by Jacob Orosz. At M&A Talk, we bring you exclusive interviews with a wide variety of experts in mergers and acquisitions, private equity, investment banking, business valuations, law, finance, and all topics related to M&A, buying, selling, and valuing businesses. 
• M&A University: Complete courses related to buying, selling, or valuing a business. Courses are led by industry experts with decades of industry experience and are designed to give you in-depth knowledge regarding every aspect of the process of preparing your business for sale, valuing it, and closing the deal.

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

• The Art of the Exit – The Complete Guide to Selling Your Business: This is the definitive guide to planning your exit, broken down into 10 simple steps from preparing your business for sale to orchestrating the closing. Selling a $500 million company requires an entirely different process than selling a small to mid-sized business. This handbook contains essential tips for owners of both Main Street and lower middle-market businesses valued at $500,000 to $10 million. The Art of the Exit is loaded with proven strategies on the art and science of selling a small to mid-sized business.
• A Beginner’s Guide to Business Valuation – Lessons Learned from 20 Years in the Trenches: This book walks you step by step through valuing a business with $1 million to $50 million in revenue. You’ll learn the fundamental factors that determine the value of any small to mid-sized business and simple methods for maximizing value when it comes time to sell. This practical guide is based on what I’ve gleaned from 20 years in the trenches selling businesses. It’s written for the layman, specifically meant to address the real-world methods buyers use to value businesses. 
• The Exit Strategy Handbook – A Complete Guide to Preparing Your Business for Sale: This comprehensive handbook demystifies the process of preparing your business for sale and helps you unlock real value in your business to dramatically increase your odds of success once you finally decide to go to market. Selling a home is child’s play compared to selling a business. You only get one chance – and The Exit Strategy Handbook shows you how. Planning to sell is all about building a business buyers want to buy. By preparing well in advance, you’ll ensure you’ll receive the highest price possible. The Exit Strategy Handbook arms you with simple steps you can take to dramatically improve your company’s value and marketability.
• Closing the Deal – The Definitive Guide to Negotiating the Sale of Your Company: This book teaches you the art and science of negotiating the sale of your business. You’ll learn the fundamentals of every step of the process, from the letter of intent to the closing. This essential field manual offers you an effective blueprint to maximize your negotiating leverage and foolproof strategies to optimize your deal structure and after-tax proceeds. Closing the Deal is for owners of businesses valued from $1 million to $50 million and contains proven tactics for avoiding the most common pitfalls in negotiating the sale of your company. 

Other Resources

• If you’re interested in selling your company, please visit morganandwestfield.com to schedule a free consultation.
• If you’d like the author of this book, Jacob Orosz, to perform an independent assessment of your business before you begin the sales process, please visit morganandwestfield.com/sellers/step-1/ .

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

• ABA: American Bar Association
• APA: Asset purchase agreement
• B2B: Business-to-business
• B2C: Business-to-consumer
• CA: Confidentiality agreement
• CapEx: Capital expenditure
• CIM: Confidential information memorandum
• CPA: Certified public accountant
• CRM: Customer relationship management database system
• DBA: Doing business as
• DCF: Discounted cash flow
• DPA: Definitive purchase agreement
• EBITDA: Earnings before interest, taxes, depreciation, and amortization
• EEOC: Equal Employment Opportunity Commission
• ERISA: Employee Retirement Income Security Act
• ESOP: Employee stock ownership plan
• FIFO: First in, first out
• FBNS: Fictitious business name statement
• FMV: Fair market value
• FOMO: Fear of missing out
• GAAP: Generally accepted accounting principles
• IOI: Indications of interest
• IP: Intellectual property
• IRR: Internal rate of return
• LIFO: Last in, first out
• LOI: Letter of intent
• LTM: Last twelve months
• LTV: Lifetime value
• MAC: Material adverse change
• MAE: Material adverse effect
• MBO: Management buyout
• MIRR: Modified internal rate of return
• MOIC: Multiple of invested capital
• NDA: Non-disclosure agreement
• NWC: Net working capital
• P&L: Profit and loss statement
• PE: Private equity
• PEG: Private equity group
• ROI: Return on investment
• ROIC: Return on invested capital
• SPA: Stock purchase agreement
• TTM: Trailing twelve months
• UCC: Uniform Commercial Code
• VC: Venture capitalist
• WIP: Work in progress
• YTD: Year-to-date

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

“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: 

• Collecting and disbursing closing funds according to escrow instructions.
• Distributing final transaction documents to all parties.
• Drafting escrow instructions according to the terms and conditions of the purchase agreement.
• Filing and recording all necessary documents with the appropriate authorities.
• Filing UCC-1 Financing Statement with the secretary of state when seller financing is involved.
• Holding earnest money in a safe, secure escrow account pending the closing.
• Ensuring that secured creditors are satisfied and coordinating any necessary payoffs.
• Notifying and obtaining clearances from county, state, and federal agencies as required.
• Notifying the county tax collector.
• Obtaining a copy of all real estate leases and coordinating and confirming the lease assignments with the landlord.
• Obtaining a corporate status report of all entities involved in the transaction from the secretary of state, and confirming that the entities exist and are in good standing.
• Obtaining written evidence of the proper authority for an entity to sign the purchase agreement and related documents to consummate the transaction.
• Overseeing UCC-3 terminations, amendments, and releases of liens. 
• Performing a UCC-1 lien and business personal property tax search on the business to ensure a clear title can be conveyed.
• Preparing estimated closing statements prior to the closing of escrow.
• Preparing fictitious business name statements.
• Preparing final closing statements for the parties and accounting for the disposition of all funds deposited in escrow.
• Preparing separate buyer’s and seller’s settlement statements reflecting that all funds are being handled through escrow.
• Prorating and paying the rent, deposits, taxes, and other expenses required out of the sales proceeds.
• Prorating taxes, interest, rents, and security deposits, among others, as instructed.
• Requesting demands from existing lienholders and receiving claims.
• Requesting publication, recording, and UCC lien searches for state and county.
• Securing releases of all contingencies or other conditions imposed on the particular escrow.
• Securing tax clearances.

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

• Allocation of the Purchase Price: This document breaks down the purchase price into separate asset classes for IRS purposes. The tax implications for asset and stock sales can be substantially different and vary based on how the purchase price is allocated among the assets. 
• Assignment of Contracts: This document transfers third-party contracts from the seller to the buyer upon the closing. These include advertising, equipment leases, lease agreements, and other third-party agreements. 
• Assignment of Intellectual Property: This exhibit transfers any registered intellectual property from the seller to the buyer, such as patents, trademarks, or other intellectual property. It can also transfer non-registered intellectual property, such as phone numbers, websites, and content.
• Assignment of Shares (for a stock sale): This document transfers shares of the entity and is used for stock sales only.
• Bill of Sale (for an asset sale): This is the actual document that transfers possession of the assets at the closing, in the case of an asset sale. The bill of sale should list all tangible and intangible assets included in the sale. I do not recommend stating values for each asset. Some advisors list intangible assets separately and transfer them using a separate set of exhibits. Titled assets such as vehicles and real estate must be transferred separately.
• Buyer’s Disclosure Statement: This further reduces your liability post-closing for any disclosures the buyer may not have made. This is replaced by a more thorough set of representations and warranties for larger transactions.
• Closing Adjustments and Prorations: For smaller transactions, multiple adjustments and prorations must often be made (lease payment(s), utilities, personal property taxes, accounts receivable, etc.) at the closing to account for timing differences between when bills are paid and when a change of possession occurs. 
• Consulting, Employment, or Independent Contractor Agreements: The independent contractor agreement is necessary if the seller is to continue working for the buyer in some capacity, although it can also take the form of a consulting or employment agreement.
• Corporate Resolution: A corporate resolution is required in an asset sale if the seller is an entity and is selling a majority of the assets of the company. Technically, the seller in an asset sale is the entity (corporation or LLC), and a corporate resolution is typically required in the Corporate Bylaws for taking major actions, such as selling all assets of the company. This resolution is not required if the seller is selling the entity, such as in a stock sale.
• Deed of Sale of Entity (if selling the entity or stock): This document is required if the seller is selling the shares in the entity.
• Lease Assignment: The assignment of lease transfers the lease for the premises. The seller usually remains as a guarantor for the lease until the lease expires. This document must be signed by the landlord; however, it is not necessary if a new lease is created.
• List of Assets: This is a detailed list of all tangible and intangible assets included in the sale. Although it isn’t necessary for stock sales, it’s wise to be clear on which assets are owned by the corporation or LLC and are included in the price, and which assets may be personal and are not included in the price. Doing so can help prevent litigation regarding which assets were included in the sale.
• List of Titled Property: This includes a list of titled property, such as real estate or vehicles that are included in the sale. Titled assets require a separate set of transfer procedures.
• Non-Competition Agreement: The non-competition agreement contains a description of what the seller may and may not do, and specifies the length of time the agreement stands. Almost all sales include a non-compete agreement. Sometimes, this agreement is included as a clause in the purchase agreement, and sometimes, it’s listed as an exhibit. The non-compete agreement should be voided if the buyer defaults on payments to the seller.
• Promissory Note: An agreement used if the seller is financing a portion of the sale in which the buyer (the note issuer) promises to pay the seller (the note’s payee) the sum and interest specified in the note.
• Release of Holdback: Savvy buyers will request that a percentage of the purchase price be held in escrow until the training period is complete. In some middle-market transactions, this amount can be held in escrow for up to 6 to 24 months to cover any additional unknown variables, such as customer warranty claims, gift certificates, and others. This typically varies from 5% to 20% of the purchase price.
• Security Agreement: A document that provides the seller a security interest in the assets of the business, which are pledged as collateral, until the seller note is paid in full. The security agreement accompanies the promissory note. 
• Seller’s Disclosure Statement: A written statement made by the seller regarding any material adverse conditions of the business that the buyer should be aware of to prevent potential litigation. The seller’s disclosure statement is replaced by representations and warranties in larger transactions.
• Share Pledge Agreement (if the seller is financing the stock sale): A document that provides the seller a security interest in the shares of the entity until the seller note is paid in full. A share pledge agreement is used in stock sales in lieu of a security agreement in an asset sale.
• Training Agreement and Log: This document spells out the seller’s agreement to train the buyer. Logging the completion of the training period is also a good practice to prevent potential future litigation. Having the buyer sign off on the training when it’s complete can prevent future legal disputes. If you fail to do this, the buyer could refuse to make payments later, offsetting the note by claiming you failed to train them properly.
• Uniform Commercial Code (UCC) Financing Statement: This is a form that the seller files with the local or state governmental authority that allows the seller to give notice to the public that they have a security interest in the property listed in the filing (i.e., the assets of the business) until the note is paid in full. A UCC-1 is used to record the lien. A UCC-3 is filed to record a change of information in the original filing. Most UCC liens must be periodically renewed every few years to remain valid.

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: 

• Earnest money deposit
• Down payment
• Additional funds to be deposited with escrow upon conclusion of due diligence
• Amount of seller financing
• Third-party financing
• Holdback amount

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:

• All assets are in good repair.
• All taxes will be paid at the closing.
• Seller has the legal capacity to sign the agreement.
• Seller has complied with all laws. 

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

• Description of any real estate owned
• Recent equipment inspections
• Equipment leases
• Equipment list 
• List of all assets included in price
• List of all titled assets
• Inventory list

Financial/Tax

• Accounts payable schedule
• Accounts receivable aging schedule
• Annual personal property tax certificate
• Backup data of adjustments to financials
• Bank statements
• Breakdown of sales by customer
• Breakdown of sales by product type
• Copies of existing loan or financing agreements
• Customer or client agreements
• Documentation for add-backs to financial statements
• Federal income tax returns
• Financial budgets and projections
• Full accounting software file
• General Ledger or detailed list of all transactions and expenses
• List of monthly sales since inception
• Merchant account statements
• Payroll tax reports
• Profit and loss statements
• Sales and use tax reports
• Utility bills

Insurance

• Health insurance policies
• Liability insurance policies
• Workers’ compensation policies and history

Legal

• Articles of incorporation/organization
• Business license
• Certificate of Status/Good Standing from the secretary of state
• Copies of all licenses, permits, certificates, and registrations
• Copies of all key contracts
• Corporate/LLC by-laws or operating agreements
• Corporate/LLC minutes
• Description of environmental liabilities
• Fictitious business name statement (DBA)
• Financing agreements
• Information for copyrights
• Information for patents
• Information for trademarks and service marks
• List of liens against the business
• Other third-party agreements or contracts
• Pending lawsuits
• Phase 1 and 2 environmental studies
• Preliminary UCC search results
• Previous purchase agreement and related business documents
• Resale permit
• Seller’s disclosure statement

Operations

• Advertising contracts
• Customer list
• Inventory count
• List of key competitors
• Marketing material
• Operations manual
• Preliminary equipment inspection 
• Premises lease
• Summary of key lease terms
• Supplier and vendor list
• Supplier and vendor contracts

Staff

• Benefit plans
• Compensation arrangements
• Detailed schedule of payroll expenses
• Employment, agency, and independent contractor agreements
• Job descriptions
• List of outside contractors
• Other employment-related agreements
• Overview of personnel turnover
• Schedule of owners, officers, employees, independent contractors, consultants and their titles, length of service, and compensation benefits
• Summary biographies of key management

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:

• Ask the Expert: Links to common M&A questions and answers. Ask any question related to buying, selling, or valuing a business. Receive expert advice from industry professionals with real-world experience.
• Downloads: Links to forms and other useful resources for selling your business.
• Books: A complete list of our books on selling, valuing, or buying a business, and all other topics related to M&A.
• Glossary: A glossary of terms used throughout the M&A world. Don’t be confused or intimidated by any terms or abbreviations in the M&A world. You’ll find answers here.
• M&A Encyclopedia: The most exhaustive collection of M&A articles in the industry with over 800 pages of insight on every step of the M&A process. This encyclopedia includes comprehensive articles on every topic having to do with buying or selling a business. 
• M&A Talk: The #1 podcast on mergers and acquisitions, produced by Morgan & Westfield and hosted by me. At M&A Talk, we bring you exclusive interviews with a wide variety of experts in private equity, business valuations, law, finance, and all topics related to M&A. 
• M&A University: Complete courses related to buying, selling, or valuing a business. Courses are led by industry experts with decades of industry experience and are designed to give you in-depth knowledge regarding every aspect of the process of preparing your business for sale, valuing it, and closing the deal.

“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: 

• Deciding whether you should sell your business is a personal decision that should be based on your values.
• Preparing your business for sale and building a valuable business takes time. The sooner you begin the process, the better.
• Valuing your business has several components. The ranges of value for a business are wide, primarily because perception of value of a business varies considerably from buyer to buyer.
  • The first determination is whether to use SDE or EBITDA to value your company.
  • 95% of businesses will be valued based on a multiple of SDE or EBITDA and fall within a range of 20% to 50%.
  • An experienced intermediary can advise you regarding the range of possible values for your business.
• Building a team is critical. Your broker and attorney will play the major roles.
  • For smaller transactions, your attorney will be less involved unless you are negotiating with a direct competitor or institutional investor, which is less common for smaller businesses.
  • For mid-sized and larger businesses, your attorney will play a critical role in the transaction.
  • Make sure your financial statements are squeaky clean. Ask your accountant to clean up your financials before the sale or hire a third party to review them.

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.

• By the time you talk with a buyer, they will have been screened and received information on your business in the form of a CIM and adjusted financials. With these meetings, buyers are seeking to learn more about your company – and you.
• The critical part of these meetings is maintaining negotiating leverage. You should be motivated to sell but not desperate or in a hurry. Always maintain your options.
• By preparing in advance, you will have confidence that your business is bulletproof and that there are no undisclosed problems. Send the message to the buyer that you are prepared; importantly, this can help justify a shorter due diligence period.
• Maintain emotional objectivity. Let your intermediary handle all negotiations. 
• Don’t take your hands off the wheel. Focus on running your business regardless of how well you feel your meetings went. 

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:

• By preparing for the sale in advance, you can often negotiate a shorter due diligence period, which helps you maintain your negotiating leverage.
• By preparing for due diligence, you speed up the process and reduce the chance that the buyer will discover material problems, which they can use against you to renegotiate the price or terms.
• If due diligence unfolds smoothly, which it should if you are prepared, there should be few surprises in the first draft of the purchase agreement.

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:

• Financial 
• Legal 
• Operational 

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:

• What documents are typically given to the buyer before they make an offer?
• What documents are usually given to the buyer during due diligence?
• How should you manage buyers that request too much information before they make an offer?
• How long does due diligence usually last?
• What can you do to speed up due diligence?
• What are representations and warranties (reps and warranties) and how do they impact due diligence?
• What is the typical due diligence process?
• How should you prepare your business for due diligence?

“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:

• Be professional and respectful of their time and needs when making the arrangements – send them the message that you are professional and cooperative, but not a pushover.
• Be prepared. Be sure to have access to a computer and your CIM when you talk so that you can easily answer any questions they have.
• If you talk with the buyer on the phone or have a conference call scheduled, plan to talk in a quiet place.
• Be sure to schedule enough time so you can hold the meeting without any distractions.

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:

• How can the ability of the buyer to finance the sale affect the value of your business?
• How do most buyers finance the purchase of a business? 
• How much cash do buyers usually put down on a business? 
• How common is it for a seller to carry a note? If they do, what are the typical terms of a seller note?
• How common are bank loans to purchase a business? 
• Are most bank loans an SBA loan?
• What is a typical transaction structure?

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:

• Limited Information: There is a limited amount of information available to accurately value small to mid-sized businesses.
  • Information on the business and its industry and comparable transactions is usually limited, biased, unverifiable, or inaccurate.
  • The value of other businesses, which is necessary information for comparable transactions, can only be determined once, when the business is sold, and information on small business transfers is scarce. There is therefore a lack of accurate information on comparable transactions. 
• Forecasting: The value of a business can be impacted by future events and human behaviors, which are impossible to anticipate.
  • Predicting human behavior is futile.
  • Predicting future cash flow in a business is difficult, if not nearly impossible.
  • Predicting the impact of future external factors, such as changes in the economy or industry, is impossible.
• Buyers: There is a wide universe of potential buyers with diverse criteria who will pay widely different prices.
  • Perceptions of risk, and therefore price, vary across a wide group of buyers.
  • Lost opportunity costs vary among buyers, especially for small businesses.
  • The value of synergies is difficult to estimate, and can’t be accurately predicted until the business is sold.
• Judgment: Biases and conflicts of interest can cloud an advisor’s judgment.
  • Appraisers lack real-world experience in selling companies.
  • Appraisers’ unconscious biases cloud their judgment.
  • The structure of a broker’s compensation may affect their opinion.
• Time and Effort: Properly valuing a business requires significant time and effort, and software tools are inadequate.
  • Properly valuing a business takes significant time, and most business owners don’t want to pay an expert to invest hundreds of hours appraising their business.
  • Most valuation software is not designed for M&A transactions.

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. 

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:

• Final Inventory Count: If the business has a substantial amount of inventory, an inventory count should be performed on the day before closing by both you and the buyer. Alternatively, an inventory valuation service can be hired to perform the count. The buyer usually pays the seller for inventory, based on the original cost of inventory, in cash at closing. You may liquidate or dispose of any obsolete inventory as long as the buyer’s approval is obtained. 
• Final Walk-Through: You should perform a final walk-through of the business with the buyer and ensure there are no surprises at 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:

• Accounts Receivable: The seller typically retains ownership of the accounts receivable in most transactions. If you are retaining ownership of the accounts receivable, you should keep the entity and bank account open so you can collect any outstanding accounts receivable post-closing. You should also meet with the buyer to discuss how to collect the accounts receivable post-closing and the possibility of notifying customers. Typically, the seller continues to invoice customers using the business address, and the buyer receives the payments and hands them over to the seller. This can often be simplified if you are working with the buyer at the business performing the training during the same period. 
• Client List: You will need to provide the buyer with a list of customers or clients and assist with the transition of these relationships.
• Employee Meeting: You and the buyer will want to meet with the employees to inform them of the change in ownership. The guidelines for telling employees vary widely and largely revolve around the dynamics of your current relationship with employees. I recommend that the buyer presents a solid and persuasive vision of the company moving forward and ensures employees of their continued employment. The meeting should be positive and upbeat.
• Telephone Service: An arrangement should be made to transfer telephone services before closing.
• Training: You should work with the buyer to complete the training and transition period. You will both need to document the completion of the training in a training log to minimize the possibility of disputes in the future regarding whether or not the training was successfully conducted.
• Transfer Key Assets: You should provide the buyer with the following at closing:
  • Computer access codes, safe combinations, and alarm codes
  • Keys to file cabinets, premises, and vehicles 
  • Owner’s manuals, instruction manuals, and information on any warranties
• Transfer of Equipment Leases: Any equipment leases that are to be assumed must be properly transferred from you to the buyer.
• Transfer of Third-Party Contracts: These include advertising contracts, equipment leases, etc.
• Transfer Key Relationships: You and the buyer should jointly meet with all key relationships following the closing and assure them that the transition will be a smooth, seamless process. These include key customers, vendors, and other relationships.
• Transfer of Utilities: The parties should contact the utility providers to transfer the utilities from the seller to the buyer.
• Transfer Vendor Accounts: You and the buyer should contact all vendors and suppliers after the closing to notify them of the ownership change.
• Transfer of Technology: You and the buyer will need to work together to transfer all technology to the buyer. This includes websites, domain names, phone numbers, and other asset transfers.
• Uniform Commercial Code (UCC) Financing Statement: You should file a notice or a lien with the appropriate filing office if there is a seller note.

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:

• Collecting and disbursing all closing funds according to escrow instructions.
• Distributing final transaction documents to all parties.
• Drafting escrow instructions according to the terms and conditions of the purchase agreement.
• Filing and recording all necessary documents with the appropriate authorities.
• Filing UCC-1 Financing Statements with the secretary of state when seller financing is involved.
• Holding earnest money in a safe and secured escrow account pending the closing.
• Providing a Notice to Creditors of Bulk Sale, if included in the instructions.
• Ensuring that secured creditors are satisfied and coordinating any necessary payoffs.
• Notifying and obtaining clearances from county, state, and federal agencies, as required.
• Notifying the county tax collector.
• Obtaining a Corporate Status Report from the secretary of state of all entities involved in the transaction, and confirming the entities exist and are in good standing.
• Pro-rating and paying the rent, deposits, taxes, and other expenses out of the proceeds, as required.
• Performing a UCC-1 lien and property tax search on the business to make sure that clear title can be conveyed.
• Preparing estimated closing statements prior to the close of escrow.
• Preparing fictitious business name statements.
• Preparing final closing statements for the parties and accounting for the disposition of all funds deposited in escrow.
• Preparing separate buyer and seller settlement statements reflecting that all funds are being handled through escrow.
• Requesting demands from existing lien-holders and receiving claims.
• Handling UCC-3 terminations, amendments, and/or releases of lien. 

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: 

• Corporate authority
• Brokers’ fees 
• Insurance 
• Compliance with laws 
• Employee benefits
• Product liability and warranties 
• Material contracts 
• Capitalization 
• Intellectual property 
• Title to assets
• Taxes
• Real property
• Personal property 
• Financial statements
• Inventory
• Customer agreements 
• Environmental issues

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:

• “To the best of Seller’s knowledge”
• “To Seller’s actual knowledge”
• “To Seller’s knowledge”

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: 

• Intellectual Property: Can often be as long as 36 months. 
• Environmental: Can be unlimited.
• Tax: Unlimited, or the full period of limitation under local, state, or federal law.
• Employment: ERISA and employment matters can range from two years to unlimited.
• Organizational and Title: Can be unlimited.
• Compliance with Laws: Can be unlimited.

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:

• Incentivizes the buyer to bear some of the risk: This is similar to an insurance deductible. If the basket, or deductible, were zero, the buyer would have nothing to lose by submitting numerous frivolous claims.
• Acknowledges that no transaction is perfect: With a basket, the parties accept that problems will arise, and agree to not submit claims until a material threshold is exceeded. This simplifies the transaction by requiring the parties to submit only material claims.
• Improves transaction efficiency: The process goes smoothly by eliminating immaterial claims.
• Encourages the buyer to be more thorough: They will take more time to do their due diligence.

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:

• Intellectual property (IP)
• Title to assets
• Employee matters
• Employee benefits and Employee Retirement Income Security Act (ERISA)
• Environmental issues
• Tax issues
• Organizational issues

Guidelines for Baskets, Caps, and Survival Periods

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

Tips for Negotiating Reps and Warranties

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

• Understand the purpose of reps and warranties: No business is perfect. Reps and warranties aren’t intended to insulate the buyer from every imaginable problem that can arise. The purpose of reps and warranties is to protect the buyer from undisclosed, material risks that occur outside the ordinary course of running the business. 
• Past events only: Representations should primarily cover past events. They shouldn’t be designed to provide the buyer with assurance regarding the future.
• Maintain an excellent relationship: You should attempt to maintain an excellent working relationship with the buyer after the closing. If you’re “friends” with the buyer, it’s easier to work out problems.
• Be prepared to give in at times: Be prepared to negotiate and occasionally give in on some points. Disputes are expensive and time-consuming, and even if you win, you lose.
• Make concessions known: Never make a silent concession.
• Analyze indemnity provisions using a matrix: Use a matrix to analyze indemnification provisions.
• Understand underlying motivations: Buyers propose specific reps and warranties for a reason. Find out the reason and address their concern directly.
• Beware of financial representations: Before signing representations concerning accounting or financial matters, have your CPA review them to ensure they are accurate. 

Tips for Limiting Your Exposure

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

• Tighten the Language:
  • Limit the language of each representation individually.
  • Limit “joint and several” liability in which responsibility is shared by two or more parties.
  • Add knowledge qualifiers, such as “to the best of the Seller’s knowledge.”
• Reduce Financial Exposure (Money):
  • Increase the basket, or deductible, that must be met before a claim is paid.
  • Reduce the maximum payout, or cap. 
  • Reduce the amount of the escrow.
• Reduce the Length of Exposure (Time):
  • Reduce the survival period.
  • Reduce the length of the escrow.
• Limit Indemnification:
  • Limit indemnification based on your knowledge of a representation or warranty. 
  • Limit the indemnification to actual losses, as opposed to other types of damages, such as punitive or speculative damages.
• Pre-Sale Due Diligence: Conduct pre-sale due diligence to identify and address problems before beginning the sale process. 
• Team: Hire an experienced negotiator, such as an investment banker or M&A advisor, to manage negotiations.
• Auction: Conduct an auction to improve negotiating posture – the more buyers with whom you are negotiating, the stronger your position will be.
• Credibility: Conduct yourself in a trustworthy manner at all times.
• Milestones: Include milestones in the LOI, such as dates for completion of due diligence and preparation or signing of the purchase agreement.
• Alternatives: Consider alternatives to escrowing part of the purchase price, such as an offset to the seller note, an earnout, or a consulting agreement with a right of offset.
• Reps and Warranties Insurance: Purchase reps and warranties insurance to minimize the potential liability of breaches. The price is normally 4% to 8% of the coverage amount and depends on the scope of the reps and warranties, the industry in which your business operates, the deductible, and the term of the coverage.
• Buyer Insurance: Require the buyer to insure against any risks that are potentially insurable. Maintain your existing policies if the policies are made on a claims basis vs. an occurrence basis. 

Sample Representations 

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

• The seller is not delinquent regarding the payment of taxes.
• There are no judgments, claims, liens, or proceedings against the seller.
• The information the seller has given the buyer, including financial information, is accurate.
• The seller is a corporation in good standing and has the authority to enter the transaction.
• The assets being sold constitute all of the assets of the business, are in good repair, and are free and clear from liens, encumbrances, pledges, or claims.
• The seller is in compliance with all laws, including licensing, permits, zoning, environmental regulations, etc.
• The inventory is sufficient, unused, and salable.
• The seller is not in default on any obligations or contracts.
• There are no hazardous substances used in the business.
• All accounts receivable are bona fide, have arisen in the ordinary course of business, and are not subject to offset.
• There are no undisclosed liabilities, legal proceedings, orders, or judgments.
• There are no undisclosed employment, consulting, bonus, or other agreements with employees or any third parties.
• The seller has disclosed all material facts that would affect the buyer’s decision to purchase the business.

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.

• If you’ve made it this deep into the section, you know that reps and warranties are one of the few elements of a purchase agreement that “survive” the closing, which can come back to bite you in the butt if you’re not careful. The antidote? Be careful. Pay attention.
• As a seller, you need to meticulously read the representations and, as noted above, not blindly sign them as if they were boilerplate. They’re not. 
• A breach of a rep or warranty – unwitting or not – can kill a deal at worst or lighten your bank account in less extreme circumstances. Obviously, neither outcome is desirable. 

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:

• Stock Purchase Agreement (SPA): This transfers the shares of the entity that owns the assets of the business. By purchasing the shares of the entity, the buyer owns the entity’s assets. Shares in an LLC are technically called “membership interests.” For the sake of simplicity, most parties refer to the transaction as a “stock sale.”
• Asset Purchase Agreement (APA): This agreement transfers the individual assets from the seller to the buyer by signing a bill of sale. The seller retains ownership of the entity while the buyer forms a new entity to purchase the assets.

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:

• Due Diligence: The extent of the negotiations is based on the facts discovered during due diligence. The purchase agreement should be prepared in tandem with the due diligence process so you and the buyer can negotiate the language as soon as possible in the transaction.
• Buyer’s Attorney: Usually prepares the purchase agreement, which includes standard language focused on the likelihood and amount of potential exposure for the buyer. 
• Seller’s Attorney: Lists any exceptions to the purchase agreement in the disclosure schedules.
• Negotiations: Representations and warranties (reps and warranties) are one of the most hotly negotiated components of the purchase agreement, other than price and terms, especially when the seller wishes to retire and avoid lingering obligations. The scope of negotiations is based on the aggressiveness of the buyer’s attorney’s initial draft, and the bargaining positions and alternatives of each party. The current state of the market impacts not only the price of companies but also the terms of the transactions, such as the strength of the reps and warranties. Buyers aim for a long exclusivity period to reduce the seller’s bargaining power later in the process when the purchase agreement and reps and warranties are being negotiated. As the seller, your leverage evaporates once the LOI is signed.
• Content: The purchase agreement contains more representations concerning the seller because the buyer has much more to lose than the seller does. 
• Survival: Reps and warranties survive the closing and can have implications for both parties for years thereafter. The other elements of the purchase agreement, such as price and terms, conditions, and covenants, have no further implications after closing has taken place. 
• Closing: For you, the seller, the “real closing” occurs when:
  • You have fulfilled your transition obligations.
  • Post-closing adjustments have been made, such as those involving working capital. 
  • You have received all the money due.
  • Earnout periods have expired.
  • You have satisfied the terms of employment and consulting agreements.
  • Indemnification period has elapsed.

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:

• Negotiating skills, postures and bargaining strengths of each party.
• Structure of the transaction – asset vs. stock sale.
• Financial strength of the seller to indemnify the buyer:
  • If the shareholder group is dispersed, and the seller’s entity ceases to exist after the closing, the buyer will seek other protective deal measures, such as escrow.
• Buyer’s knowledge of the business and industry:
  • If the seller’s management team is purchasing the company, they will be familiar with the business and may request less-stringent reps and warranties.
• Nature of the business and its industry:
  • Businesses with more risks will be subject to more stringent reps and warranties.
• Extent of issues discovered during due diligence.
• Buyer’s ability to conduct thorough due diligence:
  • The more thorough due diligence is, the weaker the protective provisions can be, in theory.
• Buyer’s assessment and perception of the seller’s character.
• Buyer’s perception of the business’s risks.

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

• Hiring an experienced negotiator, such as an investment banker or M&A advisor to manage negotiations.
• Holding an auction to improve negotiating posture – the more buyers involved in negotiations, the stronger your position will be.
• Conducting pre-sale due diligence to identify and address problems before beginning the sale process.
• Presenting yourself in a trustworthy manner at all times:
  • Always be on time and do what you say you will do.
  • Maintain your composure during negotiations, make conservative estimates, etc.

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:

• Key Terms:
  • Purchase Price: This defines the amount of the purchase price. It’s typically broken down by the earnest money deposit, down payment, additional deposit upon conclusion of due diligence, how the purchase price is to be paid (cash vs. stock), amount of seller financing, third-party financing, and the holdback amount. It also details whether an earnout is involved.
  • Inventory: This section contains a description of the inventory included in the sale as well as who will count the inventory – the buyer, the seller, or an inventory valuation service. It also provides adjustments to the purchase price based on differences in inventory between signing and closing, and a representation of the condition and salability of the inventory.
  • Allocation: The price for tax purposes.
  • Transaction Structure: Such as asset vs. stock sale.
• Conditions and Covenants That Do Not Survive the Closing:
  • Conditions: Events that must occur before a closing can take place, such as financing or landlord approval. A common condition for closing is that the reps and warranties must be true as of the closing date – also called a “bring-down.”
  • Covenants: Responsibilities of the parties during the period between signing the purchase agreement and closing. These include the seller agreeing to operate the business as normal, the seller agreeing to retain a certain percentage of employees, or fulfilling outstanding purchases. These are rarely negotiated.
• Protections Afforded To the Buyer That Do Survive the Closing:
  • Reps and Warranties: Promises and disclosures made by each party, such as assertions that the seller has paid all taxes due, or there is no outstanding litigation, which serve as “warranties” or “insurance” for each party in the event that a representation later proves to be untrue. Reps and warranties comprise the majority of the content in a purchase agreement and vary significantly based on the type of business. For example, manufacturing companies may have environmental and employee concerns while technology companies have intellectual property concerns. Reps and warranties are worded in the affirmative, and exceptions are listed in “Disclosure Schedules.” Examples of representations you might make as a seller include:
    • All assets are in good repair. 
    • All taxes will be paid at the closing. 
    • Seller has the legal capacity to sign the agreement. 
    • Seller has complied with all laws.
  • Reps and Warranties Can Be Limited by the Following:
    • Knowledge and Materiality Qualifiers: If you aren’t 100% sure regarding a representation, that representation should contain a knowledge qualifier such as “to the best of the Seller’s knowledge” or “to Seller’s knowledge.” 
    • Exclusions: Exclusions are documented in the disclosure schedules.
    • Survival Periods: The reps and warranties normally expire after 18 to 24 months. 
  • Indemnification: This section governs how disputes will be handled and outlines an obligation to cover costs of the other party for breaches of contract. This is usually covered by escrowing 10% to 15% of the purchase price. Indemnification is limited by baskets, or minimums, and caps, or maximums.
    • Minimum Basket: Minimum thresholds that must be triggered, which are similar to an insurance deductible. The average size is 0.75% of the purchase price. Baskets can be tipping or non-tipping, or the deductible can be shared between the buyer and seller.
    • Cap (Maximum): The maximum limit of indemnification. The average size is 10% to 20% of the purchase price.
    • Parties: The buyer seeks to obtain protection from as many parties as possible, such as shareholders and key managers. If multiple shareholders exist, they shouldn’t agree to “joint and several liability.” 
    • Scope: What is the scope of indemnification?
    • Remedies: Is indemnification the exclusive remedy?
    • Indemnification Process: How are indemnification claims handled?
  • Escrow Account – Not Normally a Separate Section in the Purchase Agreement:
    • Amount of Money: Usually ranges from 10% to 20% of the purchase price. Size is based on the likelihood and magnitude of potential risks.
    • Time Period: Usually ranges from 18 to 24 months. 
    • Conditions: Who controls its release, which is normally mutual, and how disputes are handled. 
    • Interest: Who should receive interest on the amount held in escrow?
• Miscellaneous: This section can include clauses regarding expenses, notices, jurisdiction, governing law, severability, assignment, waivers, and other provisions that generally apply to all legal agreements.

The purchase agreement may also contain the following exhibits:

• Assignment of Contracts: This document transfers third-party contracts from you to the buyer at the closing. This document may not be necessary for stock sales, as some agreements are transferable despite a significant change in the entity’s ownership.
• Assignment of Intellectual Property: This exhibit transfers any intellectual property from you to the buyer, such as patents, trademarks, or other registered intellectual property. It can also transfer non-registered intellectual property, such as phone numbers, websites, and content.
• Allocation of Purchase Price: This document breaks down the purchase price into separate asset classes for purposes of filing IRS Form 8504. 
• Asset List: This is a detailed list of all tangible assets that are transferred. This list isn’t necessary for stock sales, although it doesn’t hurt to be clear on which assets are owned by the corporation or LLC and which assets are owned by you personally. Keeping an accurate list of assets can help prevent future litigation regarding which assets are included in the sale.
• Assignment of Shares for a Stock Sale: This document transfers shares of the entity and is used for stock sales only.
• Bill of Sale: The bill of sale transfers possession of the assets at the closing if the sale is structured as an asset sale. The bill of sale should list all tangible and intangible assets included in the sale. Some advisors list intangible assets separately and transfer them using a separate set of exhibits.
• Buyer’s Disclosure Statement: This provides the buyer with the opportunity to make any necessary disclosures in writing.
• Consulting Agreements: The independent contractor agreement is necessary if you, as the seller, will continue working for the buyer in some capacity, although it can also take the form of an employment agreement.
• Corporate Resolution: A corporate resolution is required in an asset sale if the seller is an entity. Technically, the seller in an asset sale is the entity, such as a corporation or LLC, and a corporate resolution is required in the corporate bylaws when taking major actions such as selling all assets of the company. This resolution isn’t required if you are selling the entity, such as in a stock sale.
• Deed of Sale of Entity: This document is required if you are selling the shares in the entity.
• Disclosure Schedules: These are exceptions to the reps and warranties.
• Holdback Agreement for Training: Holdbacks are common and require a third party to hold back a portion of the purchase price to reimburse the buyer for any covered items until the holdback period has expired.
• List of Titled Property: A list of titled property includes such assets as real estate or vehicles. These assets require a separate set of transfer procedures.
• Non-Compete Agreement: The non-competition agreement contains a description of what you may and may not do and specifies the length of time the agreement stands. Almost all M&A transactions include a non-compete agreement. Sometimes this agreement is included as a clause in the purchase agreement, and sometimes it’s listed separately as an exhibit. The non-compete agreement should be voided if the buyer defaults on payments to you.
• Promissory Note: A promissory note is necessary if seller financing is involved. The promissory note is often personally guaranteed by the buyer for smaller transactions. The promissory note outlines the terms of repayment, and the security agreement is a document allowing you to place a lien on the assets of the business until the buyer pays in full. A UCC-1 financing statement also needs to be filed to perfect the lien.
• Security Agreement: The security agreement enables the buyer to offer the assets of the business as security, or collateral, for the seller note until the seller is paid in full. This allows the seller to place a lien on the assets of the business and prevents the buyer from selling the business or further encumbering the assets of the business without your permission. 
• Seller’s Disclosure Statement: This provides you with the opportunity to make any necessary disclosures in writing. This is a statement made by you, as the seller, regarding any adverse conditions of the business that the buyer should be aware of. Notifying the buyer in writing of any material adverse conditions of the business prevents potential litigation.
• Share Pledge Agreement: If there is a seller note and a stock sale, there may be a share pledge agreement. For stock sales, shares of the entity can be held in trust or escrow until you are paid in full, which is similar to placing a lien on the assets of the company. It’s good practice to have a third party physically hold onto the shares until the note is paid in full.
• Training Log: Logging the completion of the training period is a good practice to prevent potential future litigation.

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:

• Seller shall have performed all acts and covenants required in the purchase agreement.
• All seller representations and warranties are true as of the closing date.
• All seller approvals and consents required are delivered to the buyer.
• All seller actions have been taken to convey the intellectual property to the buyer.
• The assets of the business are free and clear.
• The parties shall have obtained all necessary third-party consents.
• The business has not suffered a “material adverse change” (MAC). This is a new invention since the 2008-2009 crash and is far beyond the scope of this book.

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:

• Allocation of the Purchase Price: You will both need to agree on the allocation of the purchase price as early in the process as possible to eliminate any delays due to disagreements regarding how the price is allocated.
• Calculate Work in Progress: You should both prepare a spreadsheet to calculate work in progress so it can be prorated at closing.
• Equipment Inspection: Plan to inspect the equipment with the buyer well before the closing to eliminate last-minute surprises. This will allow you ample time to repair or replace any equipment, if necessary.
• Preliminary Inventory Count: You also want to conduct a preliminary inventory count with the buyer as early in the process as possible to prevent any confusion. 
• Seller’s Entity: Check the status of your entity to ensure it’s in good standing. The closing can’t occur or can be significantly delayed if the seller’s entity is not in good standing.
• Tax Clearances: You will need to obtain the following tax clearances before the closing:
  • Payroll Tax Clearance: Ensures that your payroll taxes are paid and current before closing.
  • Sales Tax Clearance: If the business collects sales tax, you must obtain a clearance certificate prior to the closing. Failure to do so could expose the buyer to unpaid taxes.
  • Other Tax Clearance Certificates: Clearance may often be required from other state agencies for other taxes.
• Third Parties: You will need to obtain closing documentation and approval in the following areas, where applicable:
  • Financing Approval: If third-party financing is involved, multiple additional documents must often be completed, such as business plans, projections, and others. Many third-party lenders also require that escrow conduct the closing.
  • Franchisor Approval: The franchisor must approve the sale, if applicable, and the buyer must usually attend training and sign the franchise agreement before the closing.
  • Lease Assignment: If the landlord must approve a transfer of the lease, I recommend contacting the landlord as early in the process as possible to eliminate potential surprises.

Following are tips to help ensure a successful closing:

• Expect Last-Minute Problems: The sale or purchase of a business never goes as smoothly as expected. Problems often remain even after the closing. For this reason, it’s best that you and the buyer maintain an excellent working relationship so you can easily cooperate to solve any problems.
• Keep Agreements Simple: Legal documents that are simple, direct, and straight to the point are more easily understood and are more likely to be useful. If the documents and sales process are easy to understand, problems are avoided, and litigation is less likely to occur. The faster the transaction, the lower the transaction costs for all parties involved. The plainer the document, the less chance of misunderstanding or misinterpretation and the less chance of any future conflict or recrimination. In the unfortunate event a document needs to undergo litigation, a court, jury, or arbitrator can comprehend the document more quickly. The faster they understand its meaning, the faster the proceeding and the lower the legal costs. 

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

• Selling a business is an emotional shock to some people. It may have been a part of your life for so long that you feel empty afterward. Be prepared to deal with the loss.
• You will find that a little preparation now will save you stress and anxiety about your future as you navigate the complex process of selling your business.

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. 

• Asset Sale: Your tax rates will primarily be determined by the allocation of the purchase price. 
• Stock Sale: The majority of the proceeds will be taxed at capital gains tax rates, with some minor exceptions. Amounts paid directly to the owners, such as non-competition agreements or consulting agreements, are subject to income taxes. 

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:

• Structure a portion of the sale as the sale of the owner’s personal goodwill, which is not a personal asset. Check out the legal case of Martin Ice Cream Co., 110 T.C. 189 (1998). www.casetext.com/case/martin-ice-cream-co-v-commissioner
• Structure the sale as a stock sale, which is primarily subject to capital gains tax rates, although non-competition, consulting, and earnout agreements may be subject to income tax rates if they’re paid directly to the owner.

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

• Tax implications can have a significant impact on the realized value of a business for both you and the buyer. 
• Consider how a sale is going to be structured from the outset and attempt to agree on the allocation of the purchase price as early as possible. 
• Keep in mind that advanced planning is essential to maximize the price of your business.

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:

• 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

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

• Allocation: None 
• Comment: These assets are not normally included in the purchase for smaller transactions. If the business is mid-sized and working capital is included, of which cash is a component, these assets are listed at face value.

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

• Allocation: None 
• Comment: These assets are not normally included in the purchase. If they are included, they are listed at face value.

Class III: Accounts Receivables

• Allocation: None. 
• Comment: These assets are not normally included in the purchase for smaller transactions. The seller normally retains ownership of the accounts receivables as of the closing date, and the buyer receives the outstanding payments and remits them to the seller post-closing. If the business is mid-sized and the accounts receivables are included, they are often at face value.

Class IV: Stock in Trade or Inventory

• Allocation: Normally valued at the seller’s original cost.
• Comment: As a result, there is no gain for the seller, and therefore no tax due on the amount allocated to this asset.

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

• Allocation: Normally valued at current market value, often “replacement value.” Note that the buyer may have to pay sales tax on the amount of allocation to this class of assets.
• Comment: Any gain on the sale of tangible property is taxed based on ordinary income rates to the seller, and the buyer can begin to depreciate these assets based on their stepped-up value.

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

• Allocation: Normally less than a few percentage points of the purchase price.
• Comment: The seller must pay ordinary income taxes or capital gains taxes based on the amount allocated to intangible assets, depending on whether the non-compete is considered compensatory or capital. The buyer can normally amortize this cost over 15 years.

Class VII: Goodwill of a Going Concern

• Allocation: The balance of the purchase price is normally allocated to goodwill.
• Comment: Gains on goodwill are treated at capital gains tax rates for the seller, and the buyer can amortize goodwill over a 15-year period.

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.