Location, location, location. 

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

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

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

When To Contact the Landlord

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

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

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

Assignment vs. Sublease

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

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

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

In a sublease, there are actually two leases. 

• Lease 1: Landlord to you, also called the master lease.
• Lease 2: A lease from you to the buyer, also called a sublease.

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

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

Fees and Deposits

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

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

Problems Negotiating With the Landlord

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

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

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

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

Here is a sample due diligence checklist:

Operations

• 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

Insurance

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

Assets

• Description of any real estate owned
• Equipment inspection
• Equipment leases
• Equipment list 
• List of all assets included in price
• 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 QuickBooks or 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

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

Legal

• Articles of incorporation/organization
• Business license
• Certificate of Status/Good Standing from the applicable Secretary of State
• Copies of licenses, permits, certificates, registrations, and other documents from all governmental authorities
• 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

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

Other Specialists 

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

• Environmental: You may want to consider hiring an environmental consultant if your business handles hazardous materials or is subject to environmental regulations. Buyers often hire environmental experts if they are purchasing land or buildings and suspect the property may be contaminated. Many jurisdictions impose strict liability for all past owners of real estate when environmental issues arise. Such issues represent the highest exposure levels for the parties. Retaining a consultant in advance may give you time to discover and address problems before they arise with the buyer. 
• Employee Benefits: Employee benefits are the next-largest area of risk exposure for buyers. You should consult with experts in this area well in advance of the sale to ensure assets exceed liabilities in the case of retirement plans. Also, ensure that a smooth transition of benefits can occur in the case of other benefits, such as deferred compensation, profit-sharing, stock options, employee stock ownership, health insurance, and life insurance. In most cases, the plans will be terminated and you will be obligated to fulfill the termination requirements while the employees continue under the buyer’s plan.
• Code Audit: When purchasing a software company, most buyers retain a third party to perform a code audit to be certain the software code is clean and well documented. A wise seller will hire a third party to perform the audit and clean up the code before the company is put on the market. The results of the audit and cleanup can then be used as negotiating leverage to provide the buyers with some level of comfort regarding the documentation, accuracy, and organization of the code.

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

Tips for Conducting Due Diligence

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

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

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

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

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

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

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

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

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

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

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

Benefits of Preparing for Due Diligence

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

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

Resolve Issues Before They Become Roadblocks

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

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

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

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

Greatly Improve the Odds of a Successful Transaction

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

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

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

Speed Up the Due Diligence Process

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

Maximize Your Sales Price

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

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

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

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

Additional Advantages of Conducting Pre-Sale Due Diligence

Conducting due diligence offers many benefits because it: 

• Prepares your business and management for a sale.
• Helps accelerate the sales process.
• Optimizes the price and structure of a prospective transaction.
• Helps eliminate surprises and any resulting delays during the sales process.
• Gives you a greater ability to control the timing and presentation of information.
• Gives you extra leverage throughout the process because buyers, by contrast, use problems to generate leverage.
• Provides you an opportunity to fix problems and increase the asking price.

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

How to Prepare for Due Diligence

What To Do Before Your Business Is Put on the Market

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

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

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

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

Preparing Documents Before Due Diligence

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

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

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

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

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

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

Key Points

• I strongly recommend you invest time preparing your business for due diligence. Most business owners skip this step altogether. By preparing for this process, you will significantly improve the chances of a successful sale. 
• Demonstrating to the buyer that you have prepared for due diligence increases the buyer’s confidence in your business and reduces their perception of fear. 
• Due diligence can be heaven or hell. If you have your financial documents in order and all is well from an operational and legal standpoint, chances are due diligence will be uneventful. Your business deal will take flight and bring you one step closer to the closing of your dreams. 
• If you are unprepared and the buyer finds things amiss during due diligence, you’ll find yourself on the horns of a dilemma. Being prepared can go a long way in facilitating the outcome you want.

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

Purpose of Due Diligence

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

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

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

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

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

List of Documents and When They Are Shared

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

• Confidential information memorandum (CIM)
• Profit and loss statements (P&Ls)
• Balance sheets
• Summary or abstract of the lease, but not the entire document
• Equipment list
• Sales literature and brochures

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

• Federal income tax returns
• Bank statements
• Invoices and receipts
• Full copy of the premises lease
• Equipment leases
• Third-party contracts, such as supplier or vendor contracts
• Sales and use tax reports
• Staffing and payroll-related documents, including job descriptions and employment contracts
• Insurance-related documents, such as workers’ compensation, as well as health and liability insurance
• Equipment inspection reports
• Licenses and permits
• Marketing, advertising, and promotional documents
• Environmental documents and inspections
• Franchise-related documents

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

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

Length of Due Diligence

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

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

• Availability of Information: If you respond promptly to the buyer’s document requests, the due diligence period can be shorter.
• Turnaround Time: If you provide concise, organized, and clear information, you’ll speed up the due diligence period.
• Communication: If you are easily accessible and available to the buyer, this may also shorten the due diligence period.

Outcome of Due Diligence 

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

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

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

The Importance of “Representations” and “Warranties”

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

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

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

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

• Representations: 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, all inventory is salable, there are no hazardous substances used in the business, the business has operated in compliance with all laws, or the seller has the legal capacity to sign the purchase agreement. 
• Warranties: 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. 

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

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

The Process

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

• Letter of Intent: The parties negotiate and accept the letter of intent.
• Due Diligence: The due diligence period begins immediately after the letter of intent is accepted by the parties. 
• Purchase Agreement: The parties normally begin preparing a draft of the purchase agreement during due diligence. The purchase agreement often takes several weeks to negotiate and finalize, so the process usually starts during due diligence to ensure an efficient closing with minimal delays.
• Conclusion of Due Diligence: At any point during due diligence, or upon its expiration, the buyer may decide they’re satisfied with their investigation of the business and will proceed with the transaction. When this happens, the buyer and seller sign an agreement stating that due diligence has concluded. This signifies the completion of due diligence and the parties’ decision to end the investigation and proceed to a definitive agreement.
• Additional Deposit, if Applicable: For smaller transactions, the buyer will place an additional deposit with the escrow company upon signing off on completion of due diligence. If the transaction is canceled due to the buyer’s fault before a definitive agreement is signed, the buyer will forfeit both the initial and additional deposits. Otherwise, these deposits will be applied to the final purchase price.
• Contingencies That Survive Due Diligence: Often, some contingencies survive due diligence, such as bank financing, franchisor approval, lease assignment, or license transfers. These remain as contingencies and are resolved between the conclusion of due diligence and the closing. The buyer may cancel the transaction if these contingencies aren’t resolved prior to the scheduled closing date.
• Closing: Once the contingencies are resolved, the closing may occur. In most cases, the purchase agreement is signed at closing, although it may sometimes be signed prior to closing.

When a business changes hands, most buyers will expect you to sign a non-competition agreement, or non-compete, at closing. Few buyers will purchase a business without a commitment from you to not compete with them after you sell the business. 

Non-competes are more heavily negotiated in certain industries, such as professional practices or service-based businesses, in which the seller may retain a strong ability to compete with the buyer after the sale. 

They are not as important in other industries where replicating the business would be difficult for the seller after the sale, such as industries involving a large investment in infrastructure. These would include storage facilities or hotels, or retail businesses with a small market area and a long-term lease in a prime location, such as a high-profile restaurant.

Employer/employee non-competes are illegal in some states, such as California. But a non-compete involving the sale of a business is legal in all 50 states.

What if you want to stay in the industry after the sale? What is a typical time frame for a non-compete? What about geographic boundaries?

Most buyers will expect you to sign a non-competition agreement, or non-compete, at closing. 

Typical Time Frame and Geographic Boundaries of Non-Competes

The time frame for most non-competes usually varies from three to five years. The geographic area covered by the non-compete typically coincides with the market area served by the business. For example, if your customers come from a 5- to 10-mile radius, most parties will negotiate a 10-mile non-compete.

Often, the seller has no intention of re-entering the business. In these cases, most sellers offer a liberal non-compete, such as for five or more years, and covering entire counties or states. Some sellers tell us they are willing to offer the buyer a 100-year non-compete.

Enforceability of Non-Competes

Some believe a shorter non-compete is more enforceable, although the degree to which this is true varies from state to state. Most attorneys I have spoken with agree that a three- to five-year non-compete is enforceable. 

Non-Competes for Franchises

When selling a franchise, signing a non-compete may be unnecessary, as this is often addressed in the franchise agreement. The seller, or franchisee, has most likely signed a non-compete with the franchisor that would prohibit the seller from competing if the seller sells the franchise.

This agreement would bind the seller after the sale. But, it doesn’t hurt to offer the buyer a non-compete to make them feel comfortable. Additionally, you must generally be a party to an agreement to have the capacity to enforce it, so the buyer wouldn’t have the capacity to enforce a non-compete unless the buyer were a party to the agreement.

Other Considerations When Signing a Non-Compete

You should also ask yourself the following questions:

• Am I solely obligated to sign the non-compete, or does my spouse also have to sign? 
• Is the non-compete assignable if the buyer sells the business at a later date? 
• Is the non-compete revocable if I finance a portion of the sale and then the buyer later defaults? 
• Is the non-compete revocable if I have to take the business back and occupy the premises? 
• What are the methods of enforcement and remedies for violation? 
• Can I work as an employee for another company after the sale? 
• What types of businesses can I engage in after the sale? 
• Does the non-compete address solicitation of the employees, customers, and vendors?

Determining the terms of a non-compete is an integral part of the process of buying or selling a business. Give careful thought to the issues covered here and make sure you are clear on the specifics in order to ensure a solid non-compete is part of the sales transaction.

Staying In the Business

If you’re selling your business and want to remain in the business or industry, it’s best to state your intentions to the buyer clearly. Discuss your plans with the buyer and what you would like to do after the sale. An experienced attorney can then draft a non-compete that expresses your mutual agreement.

A non-compete should be specific as to what activities are permitted. A well-drafted agreement will clearly define a “competitive business,” and it will define the capacity, such as employee or owner, in which you can become involved. Competition can be direct, as an owner, or indirect, such as being a passive investor, or it can come in many other forms. This definition can also be inclusive, as in “The seller is allowed to …” or exclusive, like “The seller is prohibited from …”. Again, an experienced attorney will ensure the agreement meets the parties’ needs.

Conclusion

The intricacies of the offer stage are vast and can seem overwhelming, but if you look at each component carefully and understand how they function, you will be able to separate the good deals from the rest. Earnouts, holdbacks, and non-compete agreements all have their place in transactions, but it comes down to understanding how they work, when and why to include them, and if they fit your goals of selling your business in the first place. 

Too often, sellers will jump at receiving an LOI and celebrate, thinking they have sold their business. Buyers know this, and riddle offers with mechanisms to their benefit. Armed with an understanding of these mechanisms, you can protect yourself, get the most for your business, and get it sold. 

“The intellect is always fooled by the heart.”

– François de La Rochefoucauld, French Author

When buying or selling a business, an M&A transaction can generally take one of two forms: It can be structured as an asset sale or a stock sale. Fundamentally, there are few differences between the two transaction structures. 

In an asset sale, the entity, such as a corporation or LLC, sells the individual assets it owns, such as furniture, fixtures, equipment, customer list, etc., to the buyer.

In a stock sale, the seller – say, John Smith, as an individual, sells the actual ownership of their entity – Corporation, LLC, or another type of entity – to the buyer. This would be similar to owning a share of Ford Motor Company and selling this share of stock to another individual.

If the value of a business is less than $10 million, chances are the deal will be structured as an asset sale. Most buyers prefer an asset deal due to certain tax advantages and the lower level of risk. In a stock sale, the buyer is inheriting all of the seller’s liabilities, also called contingent or unknown liabilities. In an asset sale, by contrast, the buyer is only inheriting those liabilities the buyer is explicitly agreeing to assume in the purchase agreement, along with successor liabilities, which the parties can’t avoid regardless of the form of the transaction. For the seller, asset sales are usually less desirable because gains on hard assets are subject to higher ordinary income tax rates.

Why Most Transactions Are Asset Sales

The majority of small transactions are structured as an asset sale for two primary reasons:

1. Tax Purposes: If a buyer purchases your entity, they inherit your tax basis. But, if they purchase your assets, they can often begin depreciating those assets again and experience more advantageous tax benefits. Asset sales dominate smaller business sales because the buyer can write up the value of the assets and depreciate the costs. On the other hand, in a stock sale, the buyer inherits your tax basis, with a few minor exceptions, and receives fewer tax benefits. 
2. Risk: If a buyer purchases your entity, they are inheriting unknown legal risks associated with your entity. These are known as “contingent liabilities.” For this reason, buyers prefer to form a new entity that doesn’t have any unknown risks.

One of the few reasons a buyer may want to purchase your entity has to do with the continuation of contracts or licenses. 

If your business has valuable contracts or licensing that may be interrupted by a transfer of ownership, the sale is sometimes structured as an asset sale. Be careful, though, as many contracts have a “change of ownership” clause that states if there is a substantial change of ownership of the stock in the company, this is treated as an effective change of ownership, and explicit consent is required.

The bottom line is that you can assume your transaction will most likely be structured as an asset sale if the value of your business is less than $10 million.

Definition of Buyer and Seller

When I refer to “Buyer” or “Seller” in a legal context, such as a reference to a party to an agreement, I am referring to the individual or entity participating in the transaction. 

If the seller is an entity such as a corporation or LLC, the Seller is the entity – for example, Acme Seller Incorporated. If the buyer is an individual, the Buyer is, for example, John Smith. This distinction is important in the context of understanding the key differences between an asset and a stock sale.

Asset Sale – Asset Purchase Agreement (APA)

In an asset sale, the buyer as an individual, or the buyer’s entity, purchases the individual assets of the business from you, the seller. You retain ownership of the entity after closing. 

The Purchase Agreement used in an asset sale is normally called an Asset Purchase Agreement (APA) and is synonymous with a “Definitive Purchase Agreement.” The only difference is that the former includes an indication that the purchase is structured as an asset sale.

In an asset sale, there is a transfer of specific assets and liabilities from the seller to the buyer. The buyer forms an entity, and that entity purchases the individual assets of the seller – technically, the seller’s entity. The parties jointly decide which assets and liabilities are included in that transfer.

The sale typically includes all hard assets necessary to operate the business, such as supplies and inventory. You usually retain ownership of the accounts receivable, cash, and working capital. But, working capital is often included if the buyer is a private equity group or sophisticated corporate buyer.

Stock Sale – Stock Purchase Agreement (SPA)

In a stock sale, the buyer purchases the seller’s entity. By purchasing the seller’s entity, the buyer then owns the assets owned by the entity. Shares in an LLC are technically called “membership interests.” But, for the sake of simplicity, most parties refer to the transaction as a “stock sale.”

The Purchase Agreement used in a stock sale is normally called a Stock Purchase Agreement (SPA) and is also synonymous with a “Definitive Purchase Agreement.” The name “Stock Purchase Agreement” indicates the transaction is a stock sale. Generally, in a stock sale, the Buyer purchases everything owned by the Seller’s entity – including unknown liabilities.

Few small business transactions are structured as a stock sale. Buyers typically structure a stock sale if they want to transfer something your entity owns that can’t be independently transferred. 

For example, some contracts are owned by an entity and can’t be transferred without the explicit permission of the counterparty. 

In those cases, structuring the transaction as a stock sale ensures these contracts are passed to the buyer, assuming the contract doesn’t state that a change in control requires the consent to an assignment of the contract, also known as a “change in control provision.”

Most small business sales are not structured as stock sales due to the potential for the buyer to assume “contingent liabilities” and because the buyer inherits the tax basis of the seller’s entity. 

A contingent liability is a liability you don’t know exists, so you don’t know what you’re inheriting. If you purchase the company’s stock, a number of unknown liabilities could exist, and you will assume liability for those issues when purchasing the entity. 

On the heels of many seemingly smooth business deals, a buyer may have doubts. Sometimes they question whether specific details of the business meet regulatory standards. They may also be concerned with potential misrepresentation. To quell their apprehensions, many buyers request a holdback.

In a holdback, a portion of the purchase price, normally 10% to 20%, is held in escrow for a period of time after the closing, normally 18 to 24 months, and is used to satisfy any indemnification claims in the purchase agreement. If there are no claims, the money is released to the seller once the time period expires. The majority of mid-sized transactions include some form of holdback, also called an escrow. 

Escrows give the buyer assurance that money will be available to reimburse them if any of the seller’s representations or warranties later prove to be untrue or for other breaches in the purchase agreement. 

For example, let’s examine the sale of a manufacturing plant that includes expensive machinery. The seller may have represented that the machinery is operable and in good repair. If a piece of machinery breaks after the closing, and the seller determines that there was deferred maintenance on the machine and the problem was concealed by the seller, the buyer will file a claim to seek reimbursement from the seller to repair the machinery.

The money is held in an escrow account with a neutral third-party escrow agent. This offers protection and a guarantee that the funds are there if the buyer is not willing or unable to make payments later on. The funds are governed according to an escrow agreement. In most cases, the funds may only be released upon the mutual consent of the buyer and seller. If there are no claims, the money is released to the seller once the escrow period expires.

If a buyer isn’t comfortable with taking a seller at their word over certain aspects of the transaction, they may request a holdback.

Situations That Can Prompt a Holdback

If a buyer isn’t comfortable with taking a seller at their word over certain aspects of the transaction, they may request a holdback. Buyers find all manner of things with which to concern themselves. Most of the time, they are simply being prudent. But there are situations that have merited previous buyer holdbacks. 

Here are some examples of typical situations that might prompt a buyer to request a holdback:

• A buyer purchasing a manufacturing company may be concerned about the environmental condition of the property. Any type of business that has industrial activity is at risk for contamination. Assessment and cleanup of the property can be expensive, time-consuming, and risky.
• A buyer may be apprehensive that hazardous materials have leaked onto the property or that they have been stored improperly. This could cause concern for the buyer about future liability to employees working on the property or nearby dwellings and their inhabitants.
• Buyers may be worried about fraud within the business. We are facing a time when fraudulent activities are at their height. 

In each of these examples, a prudent buyer might request a holdback in order to assure that they are protected from the threats of purchasing a business. Most M&A transactions include some form of deferred payment, and nearly any deferred payment can also function as a form of escrow if it contains a right of offset. 

Here are several alternatives to escrow:

• Promissory Note: The promissory note can include language that affords the buyer the right to withhold future payments in the event of a breach. This may also be called an “offset” or “setoffs.”
• Earnout: Earnouts can also include a right of offset, but the likelihood of the seller receiving any earnout payments should be considered.
• Consulting or Employment Agreement: Consulting and employment agreements can also include a right of offset. However, this may not be allowed in certain states that prohibit setoffs against employment agreements. 

Sellers are likely to resist a right of offset against guaranteed, deferred payments, such as a promissory note and consulting or employment agreements, because such an arrangement affords the buyer a significant amount of leverage since the buyer “controls” the money. Allowing the buyer to simply withhold payments may afford the buyer too much power, and sellers may justifiably prefer an escrow.

Major Terms of the Escrow Agreement

The parties should consider the following terms of the escrow agreement:

• Amount of Money: Most transactions include an escrow that ranges from 10% to 20% of the purchase price. The size of the escrow should correlate to the likelihood and magnitude of the potential risks and whether other forms of deferred payments also contain an explicit right of setoff. 
• Time Period: The time period for most transactions ranges from 18 to 24 months, but I have seen time periods as short as 12 months and as long as 36 months. Most buyers prefer to prepare a full year’s P&L statement and close the books so they can examine an entire accounting period, which is why time periods tend to be at least 18 months. In most cases, two years is more than sufficient to uncover potential risks.
• Conditions: The escrow agreement should prescribe the conditions of the escrow, who controls its release – normally mutual, and how disputes are handled. 
• Interest: Who should receive interest on the amount held in escrow?

Successor Liability

Regardless of the transaction structure, there is a possibility of successor liability. This can be mitigated to a certain extent with thorough reps and warranties, an escrow, or other protective measures, but the risk can never be completely eliminated. In certain matters, such as for tax or environmental issues, successor liability can never be eliminated. 

In other matters, such as employee issues, successor liability can be mitigated by reducing the possibility of being labeled a “continuation” if the sale is an asset sale. The business is considered a successor, or continuation, if the product lines, employees, and other aspects of the business are substantially similar both before and after the closing. In other words, if the business is essentially the same, the courts may characterize the business as a “mere continuation” and impose successor liability. This happens in most M&A transactions, meaning that successor liability exists in most M&A transactions. As a result, many of the reps and warranties are designed to address these potential areas of liability.

It’s essential to understand what happens to debt when you sell your business. In some instances, the debt is absorbed in the transaction as part of the sale. But this isn’t the case most of the time.

The fate of any debt in the sale of a business is largely determined by how the transaction is structured. There are two ways to structure a deal – either as a stock sale or as an asset sale. 

The overwhelming majority of businesses that sell for less than $10 million are structured as asset sales. This type of sale is when specific assets and liabilities are individually transferred from the buyer to the seller at closing through a bill of sale. In contrast, in a stock sale, the buyer purchases your shares or membership interests and assumes everything that the business owns or owes.

In the following section, I will further explain the differences between a stock sale and an asset sale, and discuss the various ways debt can be handled at closing.

It’s essential to understand what happens to debt when you sell your business, and the two ways to structure a deal – a stock sale or an asset sale.

Stock Sale

A stock sale occurs when the buyer purchases the stock (or membership interests for an LLC), of your entity, such as a corporation or LLC, and assumes everything your entity owns or owes, including its assets and liabilities. Only a minority of businesses that sell for under $10 million are structured as stock sales. 

A buyer may decide to purchase the entity if they want to inherit something your entity owns that can’t be transferred if the sale is structured as an asset sale, such as a lease, or other valuable contract.

For example, some contracts are specific to a corporation, LLC, or entity, and structuring the transaction as a stock sale would ensure these pass along to the new owner, assuming the contract does not state that a “change in control” requires the consent of assignment of the contract. 

When structuring a transaction as a stock sale, you must determine what assets are being purchased and what liabilities are being assumed. At closing, you sign over the stock certificates to the buyer, and the buyer becomes the owner of your entity, making them an indirect owner of all the assets and liabilities that your entity owns.

Three exceptions to when liabilities and debt will continue to be your obligation after the closing in a stock sale include when:

1. The liabilities are personally “owned” by you, as an individual, unless those liabilities are separately transferred.
2. The buyer requires that you pay all debt at closing.
3. You agree to be responsible for the debt post-closing, even though the entity may be legally responsible, such as a lawsuit.

Asset Sale

In an asset sale, specific assets and liabilities are individually transferred to the buyer at closing via a bill of sale. The parties pick and choose which assets and liabilities they would like to include in the sale. Most asset sales include all assets required to operate the business and exclude all of the liabilities associated with the business.

To affect the sale, the buyer usually forms an entity, then that entity purchases the assets of your entity. 

The following assets are sometimes included in the purchase price:

• Inventory: The buyer usually purchases all of the salable inventory, but it’s typically calculated separately from the purchase price and added to the price in asset-intensive businesses.
• Working Capital: Most larger transactions include the working capital and accounts receivable, even if the sale is structured as an asset sale.

Most small-business transactions are structured as asset sales because of the possibility of contingent, or unknown, liabilities. The amount of a contingent liability is unknown – thus “contingent” – therefore, the buyer can’t calculate the amount of the liability. Examples include litigation or product liabilities. 

Asset sales are more complicated than stock sales because the individual assets and liabilities must be purchased and sold, but this concept usually only applies to larger transactions. 

In a stock sale, by contrast, all you have to do is sign over the stock certificates. All other assets should be transferred automatically unless they’re owned by the seller or the individual. 

Exceptions to Paying Debt at Closing

There are a couple of exceptions to when debt may be paid at closing. 

Exception 1: Leased Equipment

If equipment is leased by an individual, that lease or asset would have to be transferred separately, regardless of whether the transaction is structured as an asset sale or a stock sale. 

Exception 2: Successor Liability

There is potential for successor liability in the purchase of a business, which means the buyer could assume the risk for certain liabilities, even if they didn’t agree to assume those liabilities directly. Successor liability occurs as the result of state law and may allow a creditor to seek recovery from the buyer for liabilities, even if the sale is structured as an asset sale and even if the buyer didn’t specifically agree to assume those liabilities. 

Successor liability is most common in the areas of product liability, environmental law, employment law, and for payment of certain types of taxes, such as sales tax. Successor liability is a function of state law, and the laws may vary significantly from state to state.

Handling Debt at the Closing

There are three options for how to handle debt at closing:

1. You could pay off the debt with cash prior to the closing.
2. The buyer could assume the debt.
3. The debt could be paid at closing, through escrow, out of your seller’s proceeds before they are released to you.
   • For example, if you’re selling a company for $10 million and you have $2 million in debt, escrow will deduct $2 million from the proceeds at closing and the remaining $8 million will be paid to you at closing.

In the complex world of buying and selling a business, coming to an agreement on the proper price for a business can be difficult. An earnout is one element that may be a factor, but it’s a complex element. Earnouts are difficult to administer and are prone to litigation. You should give careful consideration to an earnout before you agree to one.

The Basics of Earnouts

Definition of an Earnout

An earnout is a useful tool in the M&A world and is commonly used by businesses in a variety of industries. An earnout is an arrangement where the buyer pays the seller additional money based on a specific metric, such as the business’s performance after the closing. An earnout essentially means the seller must earn part of the purchase price. Part of the purchase price is paid at closing, with the remainder paid after the closing based on the future performance of the business or some other metric that’s agreed on. 

How Earnouts Work

The typical term of an earnout is one to three years at approximately 10% to 25% of the purchase price. Earnouts are popular with private equity groups that lack the operational expertise and manpower to run a business and want to keep the owner incentivized following the closing. 

For example, if a seller thinks their business is worth $5 million and the buyer thinks it is worth $4 million, they could settle on an initial price of $4 million, and the $1 million difference would be structured as an earnout, which would only be paid to the seller if the business performs well.

An earnout is an arrangement where the buyer pays the seller additional money based on some metric, such as if the business performs well after the closing.

Why Earnouts Are Used

What is the value of a business? That depends on who you ask. The seller, who is emotionally invested in their business, often believes it should be valued higher than what the buyer thinks the business is currently worth. Lawyers, accountants and other advisors might tell you a third answer altogether. 

When there’s a difference in perception of the value of a company between the buyer and the seller – or a difference in perception of the current value or the future growth of the business – an earnout can be a useful tool to bridge that price gap and finish a deal. 

When To Use an Earnout

For being such a common tool in many industries, many assume an earnout will be part of their deal structure. That is not always the case. Here are some examples of when an earnout is most beneficial:

• When selling your business, use an earnout if you’re willing to bet on the future growth of your business and if you want to be involved in the business after the sale. 
• If you believe your business has a lot of unrealized potential, an earnout may be suitable for you. 
• This tool is also commonly used in larger business sales in the middle market, where the buyer wants to incentivize the seller to realize goals in the future.

Benefits of Using an Earnout

Earnouts are more than a financial tool to bridge price gaps. When using one, they have a series of advantages, both financial and non-financial, on both sides of the transaction. Let’s first take a look at the benefits of an earnout for the buyer:

• Offers the buyer protection against overpaying for a company that doesn’t meet its goals. 
• Forces the seller to keep some skin in the game.
• Provides some financial incentives for the seller to be involved with the business after the closing.

Next let’s examine the benefits for you, the seller, for including an earnout in your sale structure:

• Potentially increases the value of your business. 
• Provides the opportunity to sell your business for a higher price than what the buyer would be comfortable paying outright.

The Mechanics of Earnouts

Deciding To Use an Earnout

When deciding to structure a sale as an earnout, use caution. Earnouts are prone to litigation. There’s a lot of risk in any transaction that involves future conditions, especially when you’re expected to essentially work for a new boss. 

You should realize that you are no longer in control of the business after the closing and during the earnout period. You, who were once the owner and sole decision-maker of your business the day before closing, must now understand that the conditions of the earnout must be met on the buyer’s terms because the business is now owned by the buyer.

Calculating the Amount

First, determine how much of the purchase price you’re willing to risk on the earnout portion of the transaction. Most earnouts are tied to the future performance of the business over a one- to three-year period. 

• For high-tech and service-based companies, the earnout may be as high as 60% to 80% of the transaction price. 
• For most companies, the earnout represents 10% to 25% of the value of the business. 

The amount of the earnout primarily depends on the risk involved. For example, if there is a customer concentration issue and most of the revenue is generated by one or two customers, the earnout may be a higher percentage of the purchase price.

Deciding on the Basis for the Earnout

A critical question to ask and consider is this: What is the earnout based on? Is it based on revenue, earnings, or some other criteria? 

Here are five ways an earnout can be structured. Each has pros and cons and the circumstances of the specific sale will determine what the earnout should be based on.

1. Revenue: Preferred by sellers and is the easiest to calculate, although revenue can be easily manipulated.
2. Net Income: Preferred by buyers, although these numbers can also be manipulated.
3. Non-Financial Targets: Includes the retention of customers.
4. Earnings, Typically EBITDA: Can be manipulated through inflating expenses.
5. Gross Profit: Eliminates the possibility of the buyer inflating expenses.

Earnouts are easily manipulated and should only be used if there is complete trust between the parties.

Manipulating the Amount of the Earnout

As previously noted, a buyer can inflate the expenses or apply corporate overhead from the parent company to the acquired company’s books, resulting in a reduction of the earnout. Earnouts are easily manipulated and should only be used if there is complete trust between the parties. If one of the parties wants to, they can easily manipulate the calculation of the earnout. 

Take Google, for example. Google used to use earnouts extensively when purchasing companies and would base the earnouts on milestone-based compensation and other criteria. Now, however, they have stopped using earnouts because they found it was too difficult to calculate the earnouts because the data they were based on was so easily manipulated.

A buyer can inflate the expenses or apply corporate overhead from the parent company to the acquired company’s books, resulting in a reduced earnout.

Other Factors To Consider When Negotiating an Earnout

Many sellers and buyers forget to take into account several other factors that can influence the earnout. Here are some considerations, in the form of questions, that can affect an earnout and should be considered before entering into one.

• What if the buyer sells the business after the closing?
• What if the buyer merges the business after the closing with another entity?
• Will you have a right to inspect the buyer’s books after the closing?
• Will the purchase agreement allow you to leave the business in your control or largely unchanged after the closing?
• Who will decide on the final calculations of the earnout?
• How will the progress of the earnout be evaluated?
• When will the progress calculations take place? At the end of a set time period? Is it monthly, quarterly, or annually? Is it allocated on a regular basis or in one lump sum?
• Will the purchase agreement define all payments as non-refundable? This would prevent the buyer from later trying to reclaim some of these payments if the seller does not meet the predetermined goals.

When structuring an earnout, avoid all-or-nothing cliffs. Earnouts should not be all or nothing. Rather, they should be based on a graduated scale. 

For example, if you must achieve $10 million per year in revenue, but you only achieved $9.9 million, then you shouldn’t forfeit the entire earnout payment. Instead, you should still receive a portion of the earnout. 

Whenever there is a cliff in the calculation of the earnout, there tends to be a lot of disagreement and manipulation of the calculation, especially if the calculation is close to the edge.

Finally, hire the best advisers you can, because earnouts are frequently subject to litigation. Have the right professionals in place to help the earnout be a success.

When Earnouts Work Well

Earnouts work quite well when your company has a track record of meeting budgets and projections. Earnouts are used commonly in the following scenarios:

• If there is a concentration of customers, clients, key employees, where the earnout would be contingent on retention of customers, clients, or key employees after the sale.
• For volatile industries, where there are major changes within an industry and you still want to sell despite those changes.
• With supplier retention issues, or if the business is highly dependent on one supplier, and the earnout is structured on the retention of that supplier.
• For distressed businesses.

Earnouts tend to work best when the buyer is going to run the business the same after the closing as you ran the business before the closing. Certain types of companies that often use earnouts include the following: consulting companies, companies where the owner is responsible for much of the sales, companies where there is no formal management team, companies whose family members are heavily involved in the company, and professional practices.

Tax Implications of Earnouts

Earnouts are mostly treated as installment payments, which allows the taxes to be deferred. They are also used for tax strategies in mergers and acquisitions. Consult with your CPA or tax advisor to consider the tax implications of the earnout before considering one.

Key Points

• An earnout is an indispensable tool to close more transactions, but selling a business in this way has its share of risks – take precautions when using an earnout. 
• Hire the absolute best advisers you can and carefully draft the purchase agreement to accurately and completely address the earnout. 
• Earnouts are often subject to litigation, so hire an experienced attorney. When used properly, earnouts are a powerful tool to bridge price gaps and sell businesses in a way that benefits all parties involved.
• If you’re still considering an earnout after reading this, visit our Morgan & Westfield page for a thorough article on earnouts. It includes sample wording and even more in-depth information and tips regarding how to structure an earnout. www.morganandwestfield.com/knowledge/earnouts/ 

“It ain’t over ‘til it’s over.”

– Yogi Berra (1967), American Professional Baseball Player

A common question is “Should I take my business off the market when I accept an offer?” While this may be tempting, there are many factors to take into consideration.

Many sellers take their business off the market after accepting an offer. This is a critical mistake. I recommend keeping your business on the market until a purchase agreement is signed and all contingencies have been removed unless you’ve signed a no-shop agreement with the buyer. If you want to maintain your negotiating position, keep your business on the market, continue to show it, and accept backup offers. This will keep the buyer on their toes and prevent them from playing games later in the sales process.

As a seller, you have the most negotiating leverage early in the transaction. This is the time when you can negotiate key deal terms that will make a tremendous difference in how your transaction progresses. Take advantage of this leverage while it exists. The most intelligent way to do so is to have experts advise you along the way.

Here’s my advice…

Focus on Running Your Business: The number one mistake sellers make when they accept an offer is getting too excited and losing their focus on the business. The sad truth is, over half of business sales don’t make it to the closing table, even after an offer is accepted. If you want to close the deal, focus on running your business throughout the due diligence process until the closing.

Keep Your Business on the Market: Keep your business on the market until you sign the documents at the closing table and the money clears. Note that this is not possible in mid-market deals where nearly all sophisticated buyers, such as companies, and private equity groups, require exclusivity once you accept a letter of intent. In these cases, negotiate as short of an exclusivity period as possible.

For smaller companies, keep your business on the market until the day of the closing. Doing this helps you maintain your negotiating position. Additionally, continue negotiating with other buyers throughout the process, so you always have a backup plan in place.

Avoid Deal Fatigue: Avoid deal fatigue by keeping your options open and maintaining your emotional objectivity. Sophisticated buyers are aware of the natural tendency of business owners to experience fatigue as the process wears on. They may take advantage of this by drawing out the process and nibbling at the last minute. The most common way to avoid this, again, is by maintaining a strong negotiating position. Always have other options available in case the buyer attempts to renegotiate the price.

The best option for avoiding deal fatigue is preparation – by preparing your business for sale, you minimize the chance the buyer discovers a material fact they can use against you during due diligence.

Earnest money deposits are common in small-business sales and less common in middle-market transactions. They demonstrate good faith by the buyer to show that they’re serious about purchasing your business. 

Private equity groups and sophisticated corporate buyers almost never provide an earnest money deposit. They view the time and effort they spend conducting due diligence as an equal substitute for an earnest money deposit.

If the buyer of your business is an individual, I feel it’s important to push for an earnest money deposit, especially if they’ve never owned a business. The buyer will request a lot of information on your business, but you don’t want to divulge sensitive information to anyone unless you have received an earnest money deposit.

Why shouldn’t you expect an earnest money deposit from a sophisticated corporate buyer or private equity firm? 

Private equity firms are professionals who buy and sell companies for a living. Their reputation is critical to their success. 

Still, you should carefully screen any company claiming to be an investment or private equity firm – such groups regularly approach us at Morgan & Westfield, and quite a few are nothing more than someone working in their basement. It’s important to screen the firm and ensure they have committed funds before accepting a letter of intent from such a group. 

When it comes to corporate buyers, such as competitors, we sometimes request an earnest money deposit from smaller companies that have never acquired a business. If the company has made acquisitions in the past, it’s customary not to request an earnest money deposit because they have already evidenced their ability to complete an acquisition.

What is a typical amount for an earnest money deposit? What should you do if a potential buyer refuses to pony up? I address these and other earnest money issues in the section that follows.

Details About Earnest Money

What is the process for using earnest money?

If the seller accepts the LOI or offer of purchase, the buyer will place the earnest deposit with a third party, normally an escrow company. The earnest money deposit is typically 5% of the purchase price, although the amount is negotiable. 

This earnest money is applied toward the purchase price at closing. A higher earnest money deposit carries more weight and leads to a more cooperative seller. The lack of an earnest money deposit may lead to an uncooperative seller.

Do you recommend obtaining earnest money?

I always recommend asking for an earnest money deposit when dealing with an individual unless the buyer has completed multiple acquisitions in the past. Earnest money deposits serve two purposes:

They offer demonstrable proof that the buyer is serious about buying your business. 

If the buyer defaults on the purchase agreement after due diligence and other contingencies have been removed, the earnest money deposit typically serves as liquidated damages to the seller. 

Always ask for an earnest money deposit. This demonstrates good faith on behalf of the buyer and lets you know the buyer is serious. This also psychologically commits the buyer to a greater degree. You share a lot of private and financial information with the buyer, so obtaining an earnest money deposit is a reasonable request to make.

What are the typical amounts of an earnest money deposit?

Would you, as a business owner, take an offer for your $1 million company seriously when it’s accompanied by a good faith deposit of only $5,000? Would you allow someone to tie up your million-dollar business for 30, 45, 60 days, or more with only $5,000 in escrow?

An offer with a higher earnest money deposit carries more weight. Many buyers know this and are willing to put down a larger deposit. The earnest money deposit is usually held by a third party, such as an escrow company or attorney. 

Who keeps the deposit if the buyer backs out?

Some sellers erroneously believe that if a buyer backs out, they automatically receive the earnest deposit. This isn’t true. Before a third party will release the deposit, both the seller and the buyer must agree to do so. If there’s no agreement, you may have to go to court to obtain release of the earnest deposit.

Earnest money deposits are common in small-business sales and less common in middle-market transactions. The earnest money deposit is typically 5% of the purchase price.

Refusing To Provide a Deposit

Why would the buyer refuse to provide an earnest money deposit? 

There are two general reasons why a buyer may refuse to put down an earnest money deposit. One is valid. One is not. Let’s explore each.

Reason 1: The buyer is a private equity group, competitor, or larger company.

Let’s collectively call this group “companies.” Now, this doesn’t refer to small businesses, such as a small retail business, which may be seeking to purchase another location, unless they have made multiple acquisitions before. If the company is a small business, and they have never made an acquisition, they should be treated as an individual. Details on that situation are discussed in Reason 2. 

Why do “companies” refuse to put down an earnest money deposit? It’s simple – they view their financial investment in due diligence as an equal substitute to an earnest money deposit. And they’re right.

In other words, they believe that the investment they make in performing due diligence demonstrates their earnest intent. These fees can easily run into tens of thousands of dollars on smaller transactions and even hundreds of thousands of dollars on larger transactions. Fees are often paid to outside advisors such as accountants, attorneys, and consultants, as well as to internal staff.

Individuals, on the other hand, usually conduct due diligence themselves and don’t normally retain outsiders, with the exception of an accountant, to conduct due diligence. As a result, the fees they incur in conducting due diligence are significantly less than what a corporate buyer may incur.

There are rare occasions when a competitor’s primary objective is to obtain competitive information, but there are mechanisms you can use to protect yourself in these scenarios. In circumstances such as these, you should carefully observe the buyer’s actions. 

Are they spending money on professional advisors, or are they going straight for the heart and asking you for your customer list or other competitive information? 

You can also release information to buyers in phases, such as releasing highly sensitive information to the buyer later, during due diligence.

Earnest money deposits are rare in mid-sized transactions, though they may occur if the seller is in a strong bargaining position or if multiple parties are in negotiations with the seller. Otherwise, consider that an earnest money deposit is not the norm if you’re selling a larger business.

Reason 2: An individual is not serious or is overcome by fear.

This second reason isn’t a valid one. Yes, a buyer can become fearful. But acquiescing to the buyer will only set up false expectations with them and make it nearly impossible to manage their expectations for the remainder of the transaction. At Morgan & Westfield, when we are working with an individual who refuses to put down an earnest money deposit, we tread cautiously, or sometimes not at all.

The circumstances will dictate if we decide to work with a particular buyer. If the individual is a serial entrepreneur who has owned many businesses, and if they don’t own a competitive business, we will likely choose to work with this buyer. But we will carefully consider if we grant this buyer exclusivity. 

If the buyer owns a competitive business and competitive information will have to be shared with them, we’ll press hard for an earnest money deposit. We will also spend significant time drafting and negotiating the LOI and include other protective measures in the LOI, such as milestones and a clause addressing attempts at retrading.

If, on the other hand, the buyer is a corporate escapee who has never owned a business, we will tactfully demand an earnest money deposit. We may attempt to reassure the buyer, but we’ll be careful not to provide too much reassurance when doing so. If the buyer isn’t willing to place a refundable earnest money deposit, then we won’t consider this buyer to be serious, and we will move on.

Put the buyer’s motivation and other actions in perspective. Does the buyer seem serious to you? Do they own a competitive business? Are they financially qualified? How much liquid cash are they offering to put down? How many other businesses have they looked at? How long have they been looking for a business? Have they made any offers? Are their expectations realistic?

Evaluating the buyer’s motives can be difficult unless you have significant experience selling businesses. If you’re unsure, consider obtaining advice from an experienced professional to ensure you are protected.

Many sellers take their business off the market after accepting an offer. This is a critical mistake.

Once a buyer is prepared to make an offer, they will submit an LOI. Most sellers are in a rush to sign the LOI and move on with the transaction, as they impatiently eye the end-zone. “Just a few more yards to go,” they think. Not so fast! When accepting an LOI, you’re still on the 30-yard line, meaning there’s 70 more yards to go. It’s important to understand what an LOI does, how it functions, and how you should think about it. Let’s discuss that here. 

The Term Sheet

A term sheet is used to start negotiations by allowing the parties to focus on the key terms of a transaction. Its primary objective is to enable each party to focus on the key elements of the transaction before preparing a detailed LOI or purchase agreement. 

The term sheet is a short bullet list of the key points of the transaction, such as the selling price, earnest money deposit, down payment, financing terms, length of time for due diligence, training agreement, non-compete agreement, contingencies, and other essential terms.

I have seen many parties spend dozens of hours and thousands of dollars in attorney fees when they haven’t agreed on the basic terms and structure of a transaction. A term sheet can be as simple as a sheet of paper with your agreement regarding the basic terms. 

You don’t need to involve your attorney until you agree on the essential elements.

Use a term sheet for discussion purposes only. It allows you to focus on structuring the key elements of the transaction without concerning yourself regarding the language required to document those terms. If you can agree on the term sheet, you can move straight to an LOI or a purchase agreement.

You’ll want to agree on the following basic terms of the transaction:

• Selling price
• Earnest money deposit, if applicable – corporate buyers don’t usually provide an earnest money deposit
• Down payment
• Holdback, if applicable
• Seller note, if applicable – including amortization period and interest rate
• Due diligence length
• Training length
• Non-compete agreement
• Any contingencies

It doesn’t make sense to prepare a lengthy purchase agreement if you can’t agree on the basic terms listed above. I see many sellers make the mistake of calling an attorney before they have an agreement. You don’t need to involve your attorney until you agree on the essential elements.

A term sheet isn’t usually necessary if the buyer is a private equity group or sophisticated corporate buyer – in these cases, the buyer usually prepares an LOI and presents it directly to you.

Shifting Positions of Power

When buying or selling a business, it’s important to understand the shifting positions of power between the buyer and seller as the transaction progresses. Naturally, both buyer and seller will push for concessions when they’re in the greatest positions of power and try to limit concessions when they’re in a weaker negotiating position. 

As the seller, you have the greatest leverage early in the process. But this leverage instantly shifts to the buyer the moment an LOI is signed. Before an LOI is signed, you’re free to negotiate with multiple parties, but once the LOI is signed, you’re limited to exclusively negotiating with one buyer, assuming the LOI contains a “no-shop” clause, which most do. This obligation for you to exclusively negotiate with the buyer dramatically reduces your leverage from the moment you sign the LOI and throughout until closing. 

The Role of the Letter of Intent 

What is the difference between an LOI and a purchase agreement? 

An offer is usually one to five pages long and doesn’t contain all the language necessary for the closing. It’s signed immediately before the due diligence period begins and is normally structured to be binding. An earnest money deposit often accompanies an offer. An LOI is similar in length but usually isn’t intended to be binding. The purchase agreement is signed after due diligence is finished, normally at the closing, and is often 20-to 50-plus pages long. 

What happens after the LOI is signed?

Once the LOI is signed, the arduous process of due diligence begins. Unfortunately, most sellers are woefully unprepared for just how grueling the remaining 70 yards can be. The process from signing the LOI to closing can take several months or more, and less than half of companies make it to the endzone.

This is the most critical stage of the process for you. Your leverage instantly evaporates the moment you sign the LOI. Unfortunately, many sellers are excited and impatient at this stage and prefer to blindly sign the LOI while overlooking other crucial terms once they agree on a price. Caution is advised. The LOI contains critical provisions that will govern the dynamics of the relationship between the parties all the way until closing.

In most cases, the majority of the terms in the LOI are non-binding, with the exception of a few clauses, such as confidentiality and exclusivity. Most LOIs also state that the parties will begin preparing the purchase agreement within a certain timeframe. They will also stipulate that the purchase agreement will contain the representations, warranties, covenants, and indemnification-obligation language customary for a transaction of the size and type being contemplated. 

The process from signing the LOI to closing can take several months or more. As the seller, you have the greatest leverage early in the process. 

The LOI never includes the full scope of the reps and warranties, but the parties may choose to document any potentially contentious reps and warranties in the LOI in an attempt to avoid these becoming deal breakers later on. 

It’s best to negotiate contentious issues during the LOI stage instead of delaying their negotiation until later in the transaction. If an M&A advisor suspects that certain issues may become contentious, they’ll work to negotiate comprehensive language addressing these potential issues upfront before the LOI is signed. It’s better to negotiate these issues early on and potentially risk losing the buyer than to spend tens of thousands of dollars and several months negotiating with a buyer only to be hit with a last-minute deal-killer. If these issues are held until later, the buyer will have significant negotiating leverage over you, and it’s likely you will simply cave to the buyer’s demands, even if they’re unreasonable.

Here is sample language that may be included in the LOI:

The Purchaser will prepare and deliver to the Seller within 10 days of the conclusion of Purchaser’s Due Diligence Review a definitive Purchase Agreement (the “Purchase Agreement”). The Purchase Agreement will contain terms and conditions customary in transactions of this type (including standard representations, warranties, covenants, and indemnifications), or which are reasonably necessary as a result of the Due Diligence Review. Representations regarding the Company will, for most items, survive closing for three years, and for other items, including without limitation, environmental, taxes, ERISA, and title, the survival shall be for longer periods (and in some cases indefinite).

Following is sample language that may be included in the LOI that addresses reps and warranties made in the LOI:

The purchase transaction contemplated under these proposed terms is subject to the following conditions: Negotiation and execution of a definitive agreement setting forth representations and warranties of the two entities, covenants, and any other provisions customary in transactions of this nature. 

Unfortunately, LOIs don’t include all of the important terms of the transaction, so you can’t assess the full scope of the terms until later in the transaction. For example, LOIs often contain language that the purchase agreement will include “representations, warranties, and indemnification that are customary for a transaction of this size and type.” But customary based on whose definition? Some LOIs include specifics regarding more contentious issues, such as the amount of earnouts and escrows. Less frequently, the LOI may include information regarding thresholds, such as caps or baskets.

Timing and Due Diligence

When negotiating an LOI, the buyer hasn’t performed due diligence and has limited information on the business; therefore, the buyer isn’t in a position to know exactly what reps and warranties they will request from you. Only after the buyer has conducted due diligence will they be in a position to pin down the specifics. Ideally, the purchase agreement should be prepared in tandem with the due diligence process so the parties can negotiate the language as soon as possible in the transaction.

Sunk Cost Principle

Some buyers attempt to use time to their advantage and will attempt to wear you down using the “sunk cost” principle. The buyer figures that the more time and money they can get you to invest, or sink, in the negotiations, the more likely you will give in on major deal points later in the transaction to recover those sunk costs. This strategy can be countered by including milestones in the LOI, such as the dates for completion of due diligence and preparation or signing of the purchase agreement. 

The more buyers with whom you’re negotiating, the stronger your negotiating posture will be.

How Leverage Changes Throughout a Transaction

As a seller, you have the most leverage early in the transaction, before the LOI is signed. Once you sign the LOI, you lose leverage and are beholden to the buyer’s timetable. Most LOIs contain an exclusivity clause and require you to take your business off the market and cease negotiations with other parties, which further weakens your negotiating posture. For this reason, you should carefully negotiate all the terms of the LOI. If you’ve never sold a business before, it’s critical that you hire an experienced professional to handle the negotiations on your behalf. 

The more buyers with whom you’re negotiating, the stronger your negotiating posture will be. If you’re negotiating with multiple parties, it may be suitable to move to a much more detailed LOI and outline in detail the components of the purchase price, such as price, terms, escrows, caps, baskets, survival periods, earnouts, and allocation of the purchase price. This will help you evaluate offers as opposed to blindly accepting an LOI with vague terms, only for it to blow up later in the process. 

The Impact of Current Market Conditions on Negotiations

The current state of M&A activity – and the extent to which it’s a seller’s or buyer’s market – heavily influences the scope of negotiations. Market conditions impact not only the price of companies but also the terms of the transactions – and may dictate the prevailing definition or notion of what’s considered “reasonable” or “fair.”

Market conditions can influence the following:

• Price and Terms
  • EBITDA multiples
  • Terms, such as the amount of cash down and the amount of equity purchased vs. rolled over
  • Amount of contingent payments, such as earnouts 
• LOI Terms
  • Exclusivity periods, which are much shorter in a seller’s market
• Protective Mechanisms
  • Scope of indemnification
  • Size of escrow or holdback
  • Indemnification limitations, such as baskets and caps

The Process

The LOI doesn’t contain the necessary language for a closing since it will be replaced by a purchase agreement prior to the closing. Still, it allows both parties to agree to the essential terms of the transaction so they can begin the process of due diligence. 

The individual who writes the offer exerts the most control over the timing and structure of the deal. I suggest that you prepare the offer if the buyer is an individual or a smaller company. If the buyer insists on preparing the offer, it’s customary to let them do so.

Once the offer or LOI is accepted, the parties begin due diligence, and the purchase agreement is usually prepared simultaneously while due diligence is being conducted. 

Here are the primary elements of the LOI or offer:

• Transaction Structure
  • Asset sale vs. stock sale
• Purchase Price and Terms
  • Earnest money deposit
  • Seller note, including length and interest rate
  • Bank financing
  • Earnout
  • Holdback
• Due Diligence – Length
• Contingencies
  • Bank financing
  • Third-party approvals, such as landlord, franchisor, and distributor approvals
  • Licensing 
• Exclusivity or No-Shop Provision 
  • This prohibits you from negotiating with other buyers during the exclusivity period. A “no-shop” or “go-shop” clause may be included in this section.
• Confidentiality
  • Some offers include language addressing confidentiality that supplements the initial non-disclosure agreement.
• Expiration Date
  • The LOI should include an expiration date so you don’t have an open-ended commitment.

When is an LOI versus an offer customarily used? 

LOIs are common for large transactions when the buyers are larger corporations or private equity groups. These types of buyers generally have credibility and have sometimes successfully completed dozens of transactions. For smaller transactions, I recommend accepting an offer to purchase along with an earnest money deposit. For an individual, walking away is too easy with a non-binding LOI and no earnest money deposit. On the other hand, buyers of larger companies invest a significant amount of money and time, and this negates the need for earnest money deposits in cash.

Here is a list of the factors that can affect the scope of the negotiations.

• Negotiating Skills and Posture
  • The negotiating skills of each party
  • The negotiating postures and bargaining strength of each party
• Legal Structure
  • The structure of the transaction, as in an asset vs. a stock sale – reps and warranties in stock deals are more comprehensive than in asset deals
• Financial Strength and Credibility of Seller
  • The financial strength of the seller to indemnify the buyer 
  • The buyer’s assessment and perception of the seller’s character
• Industry
  • The buyer’s knowledge of the business and industry
  • The nature of the business and its industry – businesses with more risks will be subject to more stringent reps and warranties
  • The buyer’s perception of the business’s risks
• Due Diligence
  • The extent of issues discovered during due diligence

The buyer’s ability to conduct thorough due diligence – the more thorough due diligence is, the weaker reps and warranties can be, in theory

The seller and buyer have opposite objectives when negotiating an offer or letter of intent.

Following are the seller’s objectives:

• Maximize the purchase price.
• Receive maximum cash down at closing.
• Pay minimum taxes.
• Reduce contingent payments, such as earnouts and escrows.
• Reduce the scope and breadth of reps and warranties.
• Reduce the strength of indemnification.

Following are the buyer’s objectives:

• Minimize the purchase price.
• Put minimum cash down at closing.
• Maximize the tax-deductibility of assets acquired by increasing the tax basis in these assets.
• Increase earnouts and escrows.
• Increase the scope and breadth of reps and warranties.
• Increase the strength of indemnification.

All of these components should be taken into consideration on a collective basis during negotiations. When negotiating, concessions should never be made in isolation. 

For example, if the buyer proposes a lower purchase price, the seller can concede but may request more cash down at closing or reduce the size of the earnout. Or, if the seller insists on providing minimal representations to a buyer, the buyer may concede but may tighten up other elements of the transaction structure, such as escrow, knowledge qualifiers, or thresholds.

As the seller, the more assurances you are willing to provide to the buyer, the lower the risk for the buyer and the higher the purchase price the buyer can potentially afford to pay given the amount of risk they’re assuming. Risk and return are directly related. The higher the risk, the lower the return – and vice versa. By lowering the risk for the buyer, you can potentially realize a higher purchase price. 

The following are the most fiercely debated elements of the transaction:

• Price and Terms
  • Purchase price
  • Terms of the seller note
  • Post-closing purchase price adjustments, such as working capital adjustment
  • Escrow: size and length
  • Contingent payments, such as earnouts and escrows
  • Specific terms of employment and consulting agreements
• Deal Structure
  • Allocation of purchase price, which affects the tax implications of the transaction
• Protective Mechanisms
  • Reps and warranties, including survival period, knowledge, and materiality qualifiers
  • Indemnification, such as caps, baskets, and survival period
• Miscellaneous
  • Conditions to closing, including material adverse change (MAC)

The higher the risk, the lower the return – and vice versa. By lowering the risk for the buyer, you can potentially realize a higher purchase price.

Here is a summary of the buyer’s and seller’s objectives. Not unsurprisingly, the buyer and seller usually have opposite motives.

Which offer would you accept?

Offer 1: $13 million purchase price with $3 million cash at closing and a $10 million earnout.

Offer 2: $10 million purchase price with $8 million cash at closing; a $1.5 million seller note; and a $500,000 escrow.

Trick question! You can’t decide. You don’t have enough information to make a decision. 

Don’t negotiate any terms in isolation.

Before I could evaluate either offer, I would need answers to the following questions:

• For Offer 1: 
  • What are the terms of the earnout? Is it based on revenue? EBITDA? How many years?
  • Who will have control of the business post-closing? 
  • What is the allocation of the purchase price?
  • What is the extent of the representations and warranties (reps and warranties), indemnification, and escrow?
• For Offer 2:
  • What are the terms of the seller note, such as the number of months, and the interest rate? 
  • What is the extent of the reps and warranties, indemnification, and escrow?
  • What is the allocation of the purchase price?
• About the Buyer: 
  • What is the creditworthiness of the buyer? This is relevant for earnouts and a seller note. You don’t want to accept an earnout or note from a buyer who is not creditworthy.
  • What is the related experience of the buyer?
  • Is the buyer requesting exclusivity?
  • Does the buyer have the cash, or is the LOI contingent on the buyer obtaining third-party financing?
  • How many acquisitions has the buyer successfully completed in the past?
• Timing:
  • How long does the buyer need for due diligence?
  • How long after the completion of due diligence can the buyer close?
• Escrow:
  • What are the terms of the escrow? 
  • How long is the escrow period? 
  • What are the limitations of indemnification, such as caps and baskets?
• Transaction Details:
  • Is the transaction structured as an asset sale or a stock sale?
  • What are the conditions for closing?
  • What is the survival period of the reps and warranties?
  • Is the buyer requesting that the seller remain with the business? If so, what are the terms of the employment agreement?

Unfortunately, I am approached all the time by sellers who have an offer in hand with terms similar to one of the offers above. It’s common for sellers to focus only on the price. Yes, the language in the LOI might look impressive – but 90% of it may be boilerplate, and the terms may be vague enough that the buyer can rewrite them later. 

Don’t negotiate any terms in isolation. That’s because the price is one of many pieces that constitute the overall transaction structure. The trade-offs and tensions can be summarized as follows:

It was ancient Greek storyteller Aesop who said, “Honesty is the best policy.”

It is I who says, “Honesty is the #1 weapon in M&A transactions.”

• Is it possible to conceal a few warts on your business from buyers during the sales process? 
• If you hide a few material facts that you should have disclosed, does the buyer have recourse if they find out about these facts after the closing?

Honesty is an underused tool in merger and acquisition transactions. Trust is critical to successfully selling your business, and the easiest way for you to build trust is to be honest in all your dealings with buyers. 

Acquiring a business is a risky endeavor for any buyer. And the value of a business is directly related to risk. 

If the buyer doesn’t trust you, they may reduce their risk by:

• Increasing the strength of representations and warranties (reps and warranties).
• Structuring part of the price as an earnout or a promissory note, subject to a right of setoff.
• Increasing the scrutiny or length of their due diligence.
• Reducing the purchase price, which is also called re-trading.
• Requesting a credit report or background report on you.
• Changing other material terms of the transaction, such as demanding they talk to key customers or employees, even if they previously agreed not to.

Being honest saves you time and can increase the value of your business due to perceived lower risk. It can also reduce the thoroughness of a buyer’s due diligence and make negotiations far less contentious.

You can take that to the bank.

Honesty Is the Best Policy

Not only is an honest person respected by all parties, but being fully transparent can increase the value of your business by reducing the perception of risk, thereby making your business easier to sell. Being honest reduces the buyer’s perception of risk, which means they may be willing to pay more for your business.

There are some additional benefits of being honest from the outset:

Save Time: Being authentic and forthright also saves you time from having to remember any half-truths you may have told. It gives you freedom because you have nothing to hide.

Smoother Due Diligence: Building trust through honesty and proper disclosure can reduce the intensity of the buyer’s scrutiny during due diligence and can reduce the possibility of re-trading. Speaking the truth prevents you from having to remember what you may have said, which reduces the stress of due diligence.

Maintain Integrity: Selling a business is a protracted endeavor and concealing material facts is difficult. It’s nearly impossible to conceal material facts in perpetuity. Your odds are slim-to-none for concealing a material defect all the way to the closing table, and even less after the closing. A sophisticated buyer will perform excruciating due diligence and is likely to discover any material facts. If the buyer discovers a fact you failed to disclose during due diligence, you’re doomed. I guarantee you that the terms of your transaction will change. 

Limit Exposure: Buyers have recourse for issues they find via reps and warranties. As a seller, your exposure can last years due to reps and warranties and other safeguards buyers often include in the purchase agreement. If the buyer discovers a material misstatement – even after the closing – they may seek damages pursuant to the reps and warranties you signed in the purchase agreement. Even worse, they may offset any payments due to you via a set-off.

Lower Perceived Risk: Honesty reduces a buyer’s perception of risk. Reducing risk increases value. How do buyers assess risk? They use a combination of legal, financial, and operational due diligence, along with gut feelings. Different buyers use “gut feel” to varying degrees. 

• For individuals who have never owned a business, fear is the one element most likely to hold them back, and these buyers will be highly sensitive to their intuition. If the seller doesn’t make them feel 100% comfortable, they will disappear fast.
• Individuals who have owned a business before are more willing to take risks. But they will still be sensitive to any signs of untrustworthiness coming from the seller. If they sense you’re anything less than completely straightforward, they may include safeguards in the purchase agreement or transaction structure to reduce risk, or drown you in due diligence requests.
• Financial buyers are sophisticated. Many have completed dozens of transactions. The ability of these buyers to judge a seller’s character has been carefully honed from experience, and they’re likely to be adept at pruning out untrustworthy individuals. Consider how you speak to different buyers and modify your conversation as needed, but keep in mind that it’s critical you’re honest regardless of who you deal with. 

Trust Streamlines Negotiations

You will likely have a short- or long-term relationship with the buyer post-closing. Honesty builds trust and serves as the foundation for this relationship, and frankly, it’s easier to negotiate with a friend than a foe.

From personal experience, I can recount dozens of transactions in which the buyer told me they trusted the seller and agreed to expedite due diligence and immediately move to the closing. I often hear the same from sellers – it’s refreshing to hear when a seller trusts a buyer and has built a strong relationship with them. If the seller trusts the buyer, the seller is often more comfortable disclosing sensitive information to the buyer during due diligence, which can speed up the due diligence process. This would not be possible without trust, honesty, and disclosure, which are the foundations of building a solid relationship.

Put yourself in the other party’s shoes. Who would you feel more comfortable writing a $10 million check to? 

• Vinny, a shady, unscrupulous business owner who paints an unrealistic and overly optimistic view of his company’s future, who claims revenue could easily triple in three years with a little effort, and who attempts to hide numerous material facts and never gives a straightforward answer to a question, or 
• William, a forthright, trustworthy business owner who voluntarily discloses his business’s weaknesses and always gives an honest answer when asked.

Here is how William and Vinny would likely respond to the following scenarios:

What was your revenue last year?

• Vinny: Well, you shouldn’t look at the numbers. Let me tell you the real story behind the numbers. First of all, there is a lot of cash (wink, wink) in the business. 
• William: $7.3 million.

Who is your top competitor?

• Vinny: Haha, we don’t have any real competitors.
• William: KidsExchange: They are a great company. I know the owner, and they do a few things better than we do, but I think we have one major advantage over them – our return policy. If you aren’t happy, simply bring back your purchase, and we will …

If you’re a buyer, who are you going to be more likely to do business with, all other factors being equal? Being transparent and honest can go a long way.

Increase the value of your business by reducing the perception of risk.

How to Use Honesty and Disclosure to Build Trust

Voluntarily Disclose Material Facts as Early as Possible: This gives you the opportunity to put a positive spin on any problems before the buyer discovers them. Doing so allows you to go on the offensive. The alternative – being defensive – always makes you look bad, regardless of the veracity of your position. 

Anticipate and Disclose What the Buyer will Ask: This gives you the opportunity to put your own spin on the situation and engenders trust. If the buyer uncovers a material fact before you disclose it, you could experience a loss of trust that might take weeks or months to regain. Full disclosure avoids this possibility and builds trust. 

Avoid Hype, Boasting, and Exaggeration: If you wish to introduce positive opinions regarding the state of your industry, do your research. Find articles that have been written by trustworthy sources and share them with the buyer. If caution is in order – if, for instance, the author of a particular article is overly optimistic – say so. The buyer will respect your discreet perspective.

Focus on Building a Strong Relationship: If you focus on building a strong relationship first, everything else is more likely to fall in place as the transaction progresses. Naturally, different buyers have different feelings regarding the importance of the relationship, and you should adapt your approach accordingly. 

Put Your Best Foot Forward: Point out the positive traits regarding your business, but be sure to balance these with a discussion of any potential downsides. As an entrepreneur, you’re likely to be an optimist, but you must temper your optimism with realism. Show humility when possible. There is no better tool for building trust than humility.

Be Careful With Unscrupulous Buyers: You may have to modify your position and style depending on the type of buyer with whom you are negotiating. If you lack M&A experience, it’s best to rely on an advisor’s opinion. A skilled advisor will know when a buyer is acting aggressively or taking advantage of you. You must know when to modify your position and style based on the buyer’s approach, and you must know when to dig in. 

Be Careful What You Put in Writing: Put only the absolute facts in writing. Always convey subjective information through a phone call or a face-to-face meeting, not in writing. Your CIM should contain a careful analysis of your business and industry. It may include definitive statements regarding the state of your industry and the potential for growth. You will have ample time for this document to be scrutinized carefully and refined by your team of advisors – including your attorney, CFO, M&A advisor, and others – before it’s released to a buyer. Imagine anything you put in writing before a judge. Collectively, your statements could be used against you post-closing if the business fails, or if there is a material misstatement or other breach of contract. 

Plant Seeds of Optimism, but Let the Buyer Form Their Narrative: Provide the raw material via third parties, as discussed above, so the buyer can come to their own assumptions that serve as the basis for any projections. In other words, tell the buyer where the tortillas, beef, lettuce, and cheese are in the kitchen, but let them prepare their own burrito. Give the buyer the facts and let the buyer tailor them to their specific needs, desires, or tastes. Their conclusions will have more credibility and be more meaningful in their minds than any assumptions that you have spoon-fed them.

• Wrong: If we introduce our new product “XYZ” to the marketplace, it will generate $20 million in revenue.
• Right: There are 500,000 potential customers for XYZ. This product could be priced at $500, and the market penetration for most products in this space is 8%. The product is currently being user-tested, and we expect to begin production in 90 days.
• Comment: Every buyer will do the math, often in their heads while talking to you. I couldn’t help but do the math in my head as I was writing this. It’s a natural instinct for most business people. In this case: 500,000 people x 8% penetration = 40,000 customers x $500/each = $20 million in revenue. There is a vast difference between the two scenarios, especially if you delicately handle the conversation so the buyer has to extract the raw data from you. 

The trick is to get the buyer to ask you what the ingredients are and let them assemble their own recipe. For example, let’s say you mentioned that you have a new product in development. 

• Buyer: “What do you think you will price it at?” 
• You: “$500. I think the market for this is pretty big.” This is a vague statement designed to entice the buyer to ask for specifics. 
• Buyer: “Interesting. How big do you think the market is for this?” 
• You: “The ABC Association estimates the market at 800,000 people for XYZ, but that might be too optimistic. I think 500,000 is more realistic. However, that is obviously just the potential market – I think our penetration would be much lower.” 
• Buyer: “What do you think your penetration would be?” Here you’re teasing the buyer with the goal for them to ask you follow-up questions for specifics regarding key assumptions they will use to perform the math.
• You: “Well, the EFG product had a market penetration of 14%, but I think 8% is more realistic.”

Note: In this scenario, you capitalized on two immutable human traits: curiosity and greed. The buyer may want to get in on the action before other buyers do, also known as a fear of missing out (FOMO). By teasing the buyer with information, you entice them to ask you for specifics. They may then perform the calculations in their own head – or on the back of the proverbial napkin – often employing dramatically more aggressive calculations than you may have offered. Again, whose projections are the buyer more likely to believe – yours or their own?

Conclusion

Here is a reminder of the sequence of events for this stage of the sales process:

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

The Golden Rule is critical during your conversations with potential buyers. The maxim, “Honesty is the best policy,” does indeed have merit. Be careful regarding any ad hoc representations or documentation you create – stick to the facts. If you wish to garnish the facts, avoid doing so in writing. 

Also, make sure you are focused on continuing to run your business through this period of meetings and negotiations so you continue to have a strong company to sell and maintain your emotional objectivity. 

Throughout this process, you will deal with a wide variety of buyers. Some buyers take a zero-sum game approach and will attempt to win at all costs, doing little to hide their aggressiveness. Others may be more subtle regarding their approach. They may hide their true intentions and attempt to use your honesty against you. A firm but respectful position is best in these cases. Regardless, employ a professional if you lack experience, and remember – the best weapon in M&A when selling your business is candor.

How important are negotiating skills during the sales process? 

High-level negotiating skills are not as crucial as you might think. And that’s good news for those of us not named Henry Kissinger, the former U.S. Secretary of State who’s widely considered one of the greatest negotiators in history.

You’re not entirely off the hook, however. What you may lack in negotiating prowess needs to be made up for in preparation and positioning. 

That means anticipating and resolving any adverse issues before the buyer beats you to the punch. It means avoiding any appearance of desperation. It means entertaining multiple potential buyers. It means maintaining emotional objectivity.

The section that follows addresses all of this and more, including:

• What you can do before negotiations begin to improve your negotiating posture.
• When most transactions die and how you can prevent your deal from dying.
• Why negotiating skills are overrated.
• The key to negotiating (hint: it has nothing to do with negotiating).
• How to maintain your cool during negotiations.
• Why you should focus on running your business instead of negotiating.
• The number one tactic sophisticated buyers use to drive the price down and how to combat it.
• What you can do to motivate the buyer to speed up the due diligence process.

Since preparation is key, let’s start preparing…

How to Maximize Negotiating Posture

Ideally, you will want to anticipate and resolve any issues before a buyer discovers them. Put yourself in the buyer’s shoes and assess your business as early in the sales process as possible by performing due diligence on your own business. 

While this is optimally done just before putting your business on the market, it’s never too late to do this. You can even conduct pre-sale due diligence if your business is already on the market. If you haven’t already done so, make this a priority. Have your financials reviewed and in order, and retain a third party to perform legal and operational due diligence on your business as well.

Many business sales fall apart during the due diligence process when issues are discovered. If the buyer discovers problems that weren’t disclosed, you will lose your negotiating posture and will likely have to concede to a price decrease. Make no mistake about it. Each item the buyer finds fault with during due diligence enables them to claw back at the purchase price, if they don’t abandon the transaction altogether. 

Your goal is not only to sell your business and move on to the next phase of your life but to receive top dollar for your business. By conducting pre-sale due diligence, you help ensure that you maintain your negotiating posture throughout the sales process.

Assess your business as early in the sales process as possible by performing due diligence on your own business.

The Importance of Negotiating Position

The key to positioning is wanting to sell but not having to sell.

Negotiating skills are overrated. At the same time, positioning is underrated or forgotten altogether.

The key to negotiating is positioning. When you’re in the market for a new car, is it easier to negotiate the purchase when you desperately need a vehicle or when you couldn’t care less if you walk off the lot with a car? Avoid desperation – or the appearance of desperation – at all costs. 

Here are some scenarios that will strengthen your position:

• The more options you have, the stronger your position will be. 
• The more buyers interested in your business, the stronger your position will be. 
• The better your business is performing, the less desperate you will be to sell. 
• The more negotiations you are involved in, the stronger your position will be. 
• The less emotional attachment you have to the idea of selling your business, the stronger your position will be. 

By creating as many options as possible, you will put yourself in the ideal negotiating position. 

Once you have created one or more of these options, you must subtly communicate to the buyer that you are negotiating from a strong position. Deal with buyers in an interested, professional, but somewhat dispassionate tone. Communicate to the buyer that you’re prepared and motivated but not dependent on the outcome of the sale. Convey that you love what you do, but it’s best for you to move on now. In essence, you should send a message to the buyer that you’re motivated to sell but not desperate.

Maintain Emotional Objectivity

Stay calm and collected throughout the process. Buyers will become nervous if you lose your cool. If an exchange becomes heated, and it will, wind down the discussion and ask to continue at a later date. Otherwise, do your best to remain emotionally objective throughout the process.

Here are some tips for maintaining emotional objectivity:

• Use a third party, such as an intermediary or broker, as a buffer between you and the buyer.
• Don’t be dependent on the outcome. Don’t spend the money before you receive it or make elaborate plans until you complete the closing. Be aware that fully half of accepted offers don’t close. Assume your deal won’t go through.
• Keep your interest and focus on the business by maintaining or increasing your revenues. Doing so will increase the value of your business and put you in a stronger negotiating position.

Many arbitrators recommend ploys or other tricks when negotiating. These may work, but there are risks. The best situation is always an actual position, as opposed to a manufactured or fabricated one.

Focus on Running Your Business

The number one mistake sellers make when they accept an offer is to get excited to the point where they lose focus on their business. They may not realize that many, if not most, LOIs don’t make it to the closing table, even after they’re signed. If you want to close the transaction, focus on running your business throughout the due diligence process until the closing.

If revenues slip during the process, expect the buyer to negotiate a lower price. If, on the other hand, revenues increase during the process, you can expect to lock in your negotiating position.

Keep your business on the market until the day of the closing.

Keep Your Business on the Market

Keep your business on the market until you sign the documents at the closing table and the money clears. Note that this isn’t possible in mid-market deals where nearly all sophisticated buyers, such as companies and private equity groups, require exclusivity once you accept a letter of intent. In these cases, negotiate the shortest possible exclusivity period.

For smaller businesses, keep your business on the market until the day of the closing. Doing so helps you maintain your negotiating position. Additionally, continue negotiating with other buyers throughout the process, so you always have a backup in place.

Avoid Deal Fatigue

Avoid deal fatigue by developing options and maintaining your emotional objectivity. Sophisticated buyers are aware of the natural tendency of business owners to experience fatigue as the process wears on. They may take advantage of this by drawing out the process and nibbling at the last minute. The most common way to avoid this, again, is through positioning. Always have other options available in case the buyer attempts to renegotiate the price.

The best option for avoiding deal fatigue is preparation – by preparing your business for sale, you minimize the chance a buyer will discover a material fact they can use against you during the due diligence process.

Be Humble 

Humility goes a long way in a transaction. Price is inversely related to risk. The lower the risk, the higher the price. Who do you trust more: a pompous, arrogant person or a humble individual? The more humility you show throughout the process, the less likely the buyer will go to extremes during due diligence.

The best way to demonstrate humility is when you’re communicating the prospects of your business to the buyer. Always strive to be humble and conservative when sharing any subjective information.

Listen Before Speaking

Many roadblocks in negotiations can be avoided by implementing basic communication skills such as listening and clearly making your points. I recommend reading Getting to Yes: Negotiating Agreement Without Giving In by Roger Fisher and William Ury (Penguin Publishing, 2011).

Two tips for maintaining clear communications:

• Listen to the buyer’s point in full before responding. 
• If the buyer attempts to dig in on a point, find out what their true concern is.

Trust is critical to successfully selling your business, and the easiest way for you to build trust is to be honest in all your dealings with buyers.

Buyer meetings are far more than a means of answering questions. Through these meetings, you are selling not only your business but yourself. You want to assure your buyer that you are prepared, honest, composed, and serious about selling. Working to foster a healthy relationship with your buyer will not only save you time and effort in the long run, but can actually increase the value of your business as a whole. It is a key aspect of selling a business that is often overlooked. Here’s how to do it right. 

Set a Meeting

While private equity firms and other corporate buyers are comfortable making an offer on a business without physically seeing it, few individuals are willing to do so. The majority of the information in this chapter, therefore, pertains to individual buyers.

Once the potential buyer has signed the NDA, they will get their first detailed information about your business from the confidential information memorandum. At Morgan & Westfield, when we prepare this for our clients, we include only two or three pictures in the CIM. Why? So we can leave some curiosity in the buyer’s mind and give them a reason to meet and view the business.

Interested buyers usually prefer to ask a few specific questions on the phone before setting up a face-to-face meeting and seeing the business. The goal of the initial phone call should be to set up a physical meeting, because the chances of a successful transaction improve once you personally meet with a buyer. 

Set up a face-to-face meeting and then use this time to establish a trusting relationship. Asking the buyer to invest their time in a personal meeting is also the most effective method for screening their motivation level.

Agenda for the Meeting

Immediately show your business to the buyer after a short get-to-know-you introduction. At this point, the buyer usually hasn’t seen the business and is anxious to go on a tour. Don’t sit down and engage in small talk. The only thing on the buyer’s mind is seeing the business, so don’t waste their time or yours. Show your business, then have a discussion afterward. 

My clients find that the initial meetings with buyers typically are low-key and stress-free. The buyer wants to see your business and typically has a few questions that weren’t addressed in the CIM. This is why your CIM should be designed to eliminate the basic questions every buyer asks. 

Let the buyer ask as many questions as they want, and answer them in as clear and straightforward a manner as possible. You can get to know each other during the tour when you ask questions about the buyer and share information about yourself, too.

While showing the potential buyer around, explain your business and its operations as much as you can. Show pride in your business by adding interesting tidbits about its history. You can also mention tips about growth potential, as well as what you like and dislike about your business.

Avoid the following:

• Discussing financial aspects of the transaction during the meeting
• Disclosing proprietary or trade secrets
• Negotiating the purchase price
• Discussing other terms of the transaction
• Showing your tax returns, bank statements, or other documents that are customarily only shown after an offer or LOI is accepted

When meeting with a potential buyer, keep in mind the Golden Rule: Treat others how you want to be treated.

The Importance of Honesty

Be honest. You will have more credibility if you’re honest about your business’s downfalls or any dislikes you may have. For instance, point out aspects of your business the buyer might consider changing if they purchase it, such as using updated marketing methods to more effectively promote the business.

The Importance of Consistency

Thoroughly read your CIM to memorize the information it contains. Present information about your business consistently to buyers because any inconsistencies will be noticed. If a buyer doubts what you say because your claims are inconsistent, you’ll lose the sale. For example, if you say your markup is 35% in the CIM, but later claim it’s 40% when you meet with the buyer, the buyer will feel they need to validate all your claims, and will take little of what you say at face value.

After the Meeting 

What happens after the meeting? Don’t fill the buyer’s head with too much information all at once. Keep the meeting the right length. Tell the buyer you’ll go into further detail and show them more about the business if they’re willing to come back for a second meeting. 

If the buyer is intrigued, they’ll return. Some buyers make an offer after the first meeting, and some don’t. So don’t try to sell your business at the first meeting. 

There’s no magic formula, but the right number of meetings is usually between one and four. The purpose of the first meeting is to set up the second meeting, and the purpose of the second meeting is to set up the third, and so on.

When is it time to move on?

Is the buyer requesting a sixth or seventh meeting? In such cases, don’t waste your time – move on to the next interested buyer.

Remember, when selling a business, you’re making certain representations regarding your income and other factors. These representations aren’t verified before the buyer makes an offer, so five or six meetings shouldn’t be necessary. Save the in-depth investigation of your business until you’ve accepted an offer from the buyer. This time period for investigation and verification is called due diligence.

A few meetings should be enough for the buyer to decide whether they want to make an offer and move forward. If the buyer can’t make up their mind after the fourth or fifth meeting, another meeting is unlikely to do the trick. At some point, the buyer must tackle their fears head-on and make the leap of faith. Additional information rarely appeases these buyers’ fears.

The chances of a successful transaction improve once you personally meet with a buyer. 

Is it necessary to meet the buyer face to face? 

I highly recommend meeting the buyer face to face if the buyer is an individual so you can assess their motivation level and other qualifications in person. Doing so allows you to vet the buyer and helps ensure the buyer is serious. There are far too many “keyboard warriors” who love to look at businesses online and might have viewed dozens or more businesses in the last few years but lack the courage to make the leap. Meeting the buyer is part of the phased screening process and helps you determine if they are serious. It generally isn’t necessary to meet corporate buyers.

Why is the buyer requesting so many meetings? 

Fear is the biggest deal-killer for the sale of small businesses, specifically the universal fear of the unknown. Perhaps the buyer has never owned a business and is scared to take the chance. Your job is to make them feel as comfortable as possible. If you’re financing a portion of the sale, mention that you wouldn’t finance the sale if you didn’t have faith in your business. Explain to the buyer that they will have plenty of time to perform their due diligence if an offer is made.

Sharing Information

When should you send additional information to a buyer?

It’s common to send a potential buyer financial information about your company before a meeting happens, provided there’s a signed non-disclosure agreement in place. 

If confidentiality is still a concern, there are some steps you can take to help maintain control of highly sensitive business details. You want to keep control of your business information to prevent it from getting into the wrong hands, such as a competitor, or being released at the wrong time, such as early in the process before you’re satisfied you have a serious buyer.

Enter the concept of “phased release.”

With a phased release, information is given to the potential buyer in stages. As the buyer demonstrates their continued interest in your company, you will release more data to them, with the most sensitive information reserved for later in the process. 

A phased release doesn’t guarantee that information won’t get leaked, of course, but it offers a level of protection from the tire kickers.

The following section contains more information about when and how to send your financials to potential buyers, including details on the phased release. I will also describe steps that my team at Morgan & Westfield takes as we work with our clients.

Send Adjusted Financials Before Meeting

Most M&A intermediaries and business brokers send a set of normalized or adjusted financial statements to buyers before meeting them, providing the potential buyer with an idea of the current state of the company. Nearly all business brokers and M&A intermediaries require a non-disclosure agreement before releasing the financials.

Use a Phased Release of Information

If you’re concerned about confidentiality, the best option is to use a phased release of information. Information is given to the buyer at different stages of the sales process, with more sensitive information released later in the process. Information can be provided in summary form early on and then in more detail later. For example, if a buyer has inquired about your business for sale, it may make sense to email the buyer a snapshot of your financial statements before emailing them a profit and loss (P&L) statement. This summary could contain only the gross sales, gross profit, and EBITDA or SDE for several years. More detailed information can be released later in the process, such as when you physically meet with the buyer. 

Any buyer who refuses to release information to you regarding their qualifications signals that they are either not serious or unqualified.

What Financial Information To Send the Buyer 

Always send normalized or adjusted financial statements. Never send your raw financial statements unless your financials don’t require any adjustments. Most buyers prefer to receive at least three years of P&L statements. A list of your monthly revenue for the previous three years is also helpful in identifying any seasonal or cyclical trends in your business.

We send the buyer normalized financial statements, including a common size analysis, and information on percentage changes from year to year. We send these financials to a buyer in a spreadsheet format, which allows the buyer to perform their own analysis, make notes, and perform projections. 

When To Give YTD Financials to the Buyer

At some point in the sales process, a prospective buyer is likely to request to see year-to-date (YTD) financial records for your business before they make an offer. You should be in a position to provide this information, but there are a few important points to keep in mind:

• Make it Normalized: Don’t send your raw or unadjusted financials to the buyer. Be sure you send adjusted or normalized financials. 
• Compare YTD with the Previous Year: Don’t send the buyer just your YTD financials. Send them a comparison of this year’s and last year’s results. If it’s October and the buyer is requesting to see the January to September P&L statement, send them January to September for the current year and January to September for the previous year. This allows the buyer to account for seasonality in the business and see how the business is performing relative to the same period last year.
• Revenue Recognition: This is the story behind the numbers. Beware of timing differences in recognizing revenue and expenses. You may have just landed a big six-figure job, and this may skew the results significantly. Alternatively, you may have just paid a large expense that would inflate your expenses. Most small and mid-sized businesses don’t perform proper accrual accounting and use either a cash-based or hybrid system that consists of both cash and accrual accounting. Additionally, since you’re working off interim financial statements, your accountant will not have made the final entries into your system for items like depreciation. For these reasons, it’s important to tell the buyer the story behind the numbers.
• Monthly Revenue Chart: I also recommend showing the buyer a chart of the monthly revenue for your business. Focusing on short-term trends can skew a buyer’s perspective. Show the buyer a chart of your business’s monthly revenue to prevent this inaccurate perspective.

You can also use your YTD financials as a tool to gauge interest and further qualify an interested buyer. I recommend intentionally withholding your YTD financials from your CIM. Doing so forces the buyer to request them directly, which allows you to:

• Further Screen or Qualify: If the buyer is requesting additional documentation or clarification from you, this gives you an opportunity to dig a little deeper and qualify them more. 
• Gauge Interest Level: If the buyer goes out of their way to ask you for updated financial statements, you can reasonably assume they have some level of interest in your business.

Warning: If the buyer sends you a detailed request for additional documents, such as tax returns, they are likely attempting to shop your business for financing. This is a warning sign – the buyer should request your permission to share your confidential information with third parties before doing so. If the buyer is shopping the business for financing early in the process, this may mean that the buyer doesn’t have the down payment, or they misled you by telling you that the down payment would be coming from a bank. This is rare, but it does happen. Stop the process immediately and talk with the buyer. You don’t want them shopping your business without your knowledge or consent.

Further Screening Buyers

A mutual exchange of information is reasonable and to be expected during a transaction. Any buyer who refuses to release information to you regarding their qualifications signals that they are either not serious or unqualified. Therefore, it makes sense to deeply screen buyers. Let’s examine some of the reasons next. 

Screen Buyers in Phases to Determine Their Interest

Requiring buyers to jump through a number of hoops also allows you to determine their interest level. Most buyers understandably get frustrated or offended if you attempt to pre-screen them all at once early in the process. The solution is to use a phased process, both in screening and in releasing information to the buyer.

How to Screen Companies

When screening companies, you can ask for financial statements, references, a buyer profile, a disclosure statement, and a list of past transactions. You can also independently research the key people you are dealing with by Googling their name, email address, or phone number, or checking their social media profiles. In addition, you can obtain someone’s IP address from the metadata in emails and documents, which can supplement your search. We frequently identify suspect individuals who initially contact us and arouse our suspicions after searching their background.

Managing Due Diligence

Sensitive information can be held in a centralized room or office at your home or business. This allows you to give the buyer access to this room and the sensitive information without making copies or sending the information over the internet. Alternatively, you can create an online data room in the cloud. If you’re comfortable with the buyer and confident with the transaction, you can, at that point, provide the buyer with hard copies of all information.

Key Points

• A phased release of information is best, especially if you have any looming concerns with regard to confidentiality. 
• The safest route to take before providing sensitive information is to ensure you’re working with a qualified buyer who is serious about the purchase and financially able to complete it. 
• Ensure that a confidentiality agreement is signed before any sensitive material is released to safeguard you and your company against any unauthorized use of information or intellectual rights to your business as a whole. 

High-level negotiating skills are not as crucial as you might think.

How long does a buyer stay in the market and keep looking for a business before they decide to either pull the trigger or give up their search – or, to use a technical phrase, “fish or cut bait”? 

What affects how long an individual stays in the market? Is there a difference between first-time buyers and previous business owners? How long is too long to be looking? How can you assess a buyer’s motivation level? How do you avoid tire-kickers?

If you’re selling your business, recognizing these different types of buyers – including their motivations and perspectives – will help you understand the reasons behind their behaviors. This knowledge can help you assess if a buyer is serious and likely to make a move, or if they’re merely fishing. 

Companies

Let’s first address companies. Once a company decides to grow through acquisitions as opposed to growing organically, they generally stay in the market indefinitely or until they change their strategy. Companies are less likely than individuals to be kicking tires.

Financial Buyers

Private equity groups (PEGs) and other financial buyers continually buy companies as part of their fund-management process, but this varies based on the current age of their fund. Most private equity groups have multiple funds in different stages of their lifecycle and are constantly searching for acquisitions.

Individuals

Now, on to individual buyers. 

The time span that individual buyers stay in the market varies widely based on several factors. Many business owners are often unaware of just how long individuals stay in the market looking for a business. Some individual buyers remain in the market for years. 

Let’s examine the factors involved.

Motivation Level

Buyers’ motivations vary. Some are highly motivated, set a goal, and buy a business as quickly as possible. Others impulsively decide they want to buy a business after a bad day at work and change their minds the next week. These buyers enter and exit the market frequently. 

First-Time vs. Previous Business Owners

Buyers who have previously owned a business are accustomed to making decisions with less-than-perfect information. They’re more likely to make an offer on a business than a buyer who hasn’t owned a business before. Previous owners are also aware that there is no perfect business – after all, they wouldn’t have sold their own business if it was “perfect.” 

Employees, on the other hand, often don’t understand what it means to be a business owner. They may not be accustomed to making decisions based on limited information or a gut feeling. These potential buyers are more risk-averse by definition – because they‘re currently employees. They’re less likely to make an offer on a business than a buyer who has previously owned a business.

I estimate that less than 5% of individuals looking to buy a business will ever buy a business.

Lure of the American Dream

Everyone wants to own a business. Ask the average American on the street what their dream is, and most will say their dream is to become an entrepreneur. American culture celebrates self-made entrepreneurs, praising them in newspapers, magazine articles, movies, social media, and online. 

Elon Musk, Bill Gates, Mark Zuckerberg, Richard Branson, Larry Page, Henry Ford, Thomas Edison, Andrew Carnegie, Jeff Bezos, Sam Walton – nearly every American can name the companies these people created.

Douglas McMillon, Rex Tillerson, John Hammergren, Stephen Hemsley, Larry Merlo, Mary Barra – do you recognize any names on this list? It’s unlikely. They have each been a CEO of a Fortune 500 company, yet few Americans have heard of them. Why? Entrepreneurs are idolized, while CEOs are often disregarded.

Still, the “American Dream” is to own a business, not land the perfect dream job. As a result, a lot of people are looking to buy a business. Unfortunately, the majority will never pull the trigger – that’s why it’s called the American “Dream” and not the American “Reality.” I estimate that less than 5% of individuals looking to buy a business will ever buy a business.

Finances

Many buyers are unrealistic regarding how much cash is required to buy a business, and most are undercapitalized. As a result, buyers often stay in the market for a long time because they don’t have enough liquid cash to buy a business. These undercapitalized buyers may make offers on businesses that are contingent on bank financing, although most of these deals are turned down by the banks, often months later.

Deals Gone Wrong

Then there are situations when a deal goes wrong. A buyer makes an offer on a business and a seller accepts. The buyer then invests several months of time negotiating the deal and performing due diligence, only for the transaction to fall apart for any number of reasons. Many of these buyers will re-enter the market later. 

Beware of Buyers Who Have Been Looking Too Long

Beware of buyers who stay in the market too long. Buyers generally stay in the market for an extended time due to one of two reasons:

• Searching for the Perfect Business: Many buyers are searching for a business without flaws. Obviously, no such business exists. If it did, it wouldn’t be for sale, or a friend or competitor would quickly purchase it.
• Aversion to Risk: Many buyers are scared to take the leap. Buying a business requires confronting one’s fears. At some point, the trigger must be pulled. Unfortunately, the prospect of cutting a check for millions of dollars is a proposition that’s just too scary for many first-time buyers. 

A motivated buyer will eagerly jump through hoops.

Practical Applications 

Once you understand the type of buyer you’re dealing with and their behaviors and expectations, it’s time to dig deeper. Just as the buyer will perform due diligence on you and your business, it’s critical that you perform due diligence on the buyer. 

Understanding more about your buyer will allow you to sort the wheat from the chaff, thereby spending more time on serious buyers, and less on the dreamers. Let’s look at some practical applications for assessing buyers. 

Motivation

A key part of your initial due diligence should be to assess the buyer’s motivations. How motivated do they appear to be? Do they quickly return your calls and emails? Are they eager to move forward, or do they appear to be overly critical of your business? 

I see many buyers who are overly critical, often bordering on being cynical, which may make them feel intellectually superior to you. They may take pride in criticizing your business. They can be critical because they don’t have serious intentions of buying a business.

Have you ever taken a car for a test drive, attended an open house, or gone “window shopping” for an expensive item that was for sale, knowing you had no intentions of buying it? If so, you likely came across as either disengaged, overly critical, or cynical to the salesperson. You may have critiqued the quality of the ride on the test drive, or commented on how the spare bedroom was not big enough. You probably didn’t exhibit genuine signs of interest. People looking to buy a business give off equally clear signals of their intent.

What’s the most accurate way to assess a buyer’s motivation level? A motivated buyer will eagerly jump through hoops. They will quickly return phone calls and emails. Despite any potential roadblocks, they will appear keen to move forward. You don’t have to chase motivated buyers down – instead, they chase you down.

In 1964, Justice Potter Stewart was asked to define hard-core pornography, and he responded: “I shall not today attempt further to define the kinds of material I understand to be embraced … but I know it when I see it …”

My response is the same when attempting to identify a motivated buyer – I know one when I see one. If you’re in doubt, it’s unlikely they’re truly serious about buying a business.

First-Time Buyers 

First-time buyers are great buyers – if and when they decide to pull the trigger. Assessing their tolerance for risk, on the other hand, is difficult. Weak motivation is easily overwhelmed by one’s fears. And buying any business requires some degree of risk, and therefore confronting one’s fears directly. A buyer will only buy a business if they conquer their fears.

Previous Business Owners

If a buyer has already been a business owner and pursued and lived the American Dream, their motivation is more clear. If they have already owned a business, their expectations tend to be much more realistic than someone who has not.

Time Frames

Buyers should be able to identify a business and make an offer within 6 to 12 months. They should be able to close on a business within a year of starting the process. If the buyer has been in the market for longer than that, there could be problems. 

Occasionally, I see buyers who have been in the market for one to two years. I almost always dismiss a buyer if they have been looking for more than two years. One to two years is a coin flip.

Keep in mind that how long a buyer has been in the market is quite different from the amount of time your business has been on the market. How long it takes to sell your business is a completely different question. This discussion has centered on the factors that may influence how long a buyer is in the market looking for the right business. The more you understand about the potential buyers for your business, the more successful you will be in selling your business.

Don’t get emotionally involved with any one buyer.

Why Buyers Disappear

Buyers can leave for any number of reasons. A common scenario I see often, however, plays out like this:

Day 1

Seller: “I have a buyer who contacted me last week and is interested in buying my business. I want to see what happens with this buyer before I do anything.” 

Day 5

Seller talks to the buyer, and they schedule a meeting for next week.

Day 11

Seller and buyer meet, and the meeting goes great. Seller calls me and says, “I think he is going to buy it. I want to hold off before we do anything else.”

Day 13

Seller calls the buyer to move the ball forward. No answer. Seller leaves the buyer a voicemail.

Day 16

No answer from the buyer. Seller calls the buyer again and leaves a message.

Day 20

Still no answer from the buyer. Seller calls a third time and leaves a message.

Day 25

No answer from the buyer yet. Seller calls a fourth time and leaves a message.

Day 28 

The seller calls me, exhausted, and doesn’t know what to do.

I hear this story all the time from my clients. What has happened here, and what can be done about it? Why do interested buyers disappear?

Buyers are like everyone else – they’re busy and are likely considering multiple alternatives to acquiring your business. A buyer may initially appear interested and may later change their mind after considering another business. 

It may be easier for them to duck your phone calls and emails than tell you they’re no longer interested in your business. While this may be useful information to know, it’s irrelevant because it doesn’t change the process you should follow.

Selling a business isn’t easy. But if you keep it simple and try not to get emotionally involved in the process, you can greatly reduce the stress associated with selling your business.

The solution is simple:

Don’t get emotionally involved with any one buyer. This doesn’t mean you shouldn’t be aggressive about selling your business. You should be a go-getter, but keep a level head and focus on running your business during the process and remain emotionally detached from any one buyer.

Get ready for the sale upfront by preparing a confidential information memorandum (CIM) so that little energy is expended prescreening buyers, which allows you to remain emotionally detached.

Focus on running the business and don’t become too emotionally attached to selling it. Many sellers seem overly eager to sell their business and spend far too much time and effort thinking about the process, so they end up neglecting their business in the short term. 

Key Points

• Keep cool and focus on running your business. 
• Prepare a simple plan to sell and execute it with precision. 
• Don’t become emotionally attached to the idea of selling your business or to any single buyer.

Conclusion

Once you have identified potential buyers for your business, you can determine how to best reach them. You may decide to go fishing by placing ads in the marketplace and letting buyers come to you. Or you may choose to use a targeted hunting campaign aimed at specific potential buyers. Don’t overlook other possible areas to look for buyers, such as through your personal and professional contacts.

As you start the marketing process, the importance of maintaining the confidentiality of your business information comes to the forefront. You can do several things to maintain confidentiality, starting with deciding what information gets released, controlling who gets that information, and dealing swiftly with any breaches. 

Confidentiality agreements and NDAs are critical components to be used with buyers seeking information about your company. Releasing information in stages allows you to keep control of your information and screen buyers at each step of the sales process. Screening potential buyers will also help ensure you are dealing with serious buyers with the means and determination to follow through on the purchase, saving you time and money in the long run. Understanding the differences between various buyer groups will help you determine how to best approach marketing your business while maintaining confidentiality. 

After identifying a possible buyer, the next step will be meeting them, so read on for more expert advice.

Here is a potential investor scenario to consider:

I am selling my business. A buyer replied with, “My father-in-law is the investor and has the cash. I can sign the NDA as long as you are aware that this is between me and my investor.” How should I respond to the buyer?

For small businesses, I rarely see “investor deals” happen. For this reason, it makes sense to heavily screen these deals so you don’t waste your time. Communicate directly with the investor as if they were one of the purchasers because, well, they are. Do you really think the investor is going to hand over hundreds of thousands of dollars without reviewing at least some information on your business?

The investor and the buyer should both sign your NDA. After all, the investor will receive confidential information on your business, so they should sign the NDA as well.

If the buyer who initially contacted you doesn’t have enough cash to buy your business, are you going to take their word that their investor has the funds to buy your business? If so, then any buyer would use the, “I have an investor” wildcard to avoid having to qualify themselves.

How you handle this conversation with the buyer is important and will set the buyer’s expectations for how they treat you during the remainder of the transaction. If you’re passive and naïve enough to accept the buyer’s word that “they have an investor, and the investor wishes to remain private,” you can bet that the buyer will treat you as a naïve, unsophisticated business owner. 

Selling a business is a complicated matter, and the balance of power is critical throughout the transaction. It’s important to portray yourself as an intelligent, experienced entrepreneur throughout the process, so be sure to handle the “investor issue” tactfully and diplomatically.

Is it possible to sell your business to a buyer who is not a U.S. citizen? 

Selling your business to a non-U.S. citizen is both possible and common. But there are caveats. 

The United States is a talent magnet for innovative entrepreneurs from around the world, and U.S. immigration laws are designed to attract skilled entrepreneurs from other countries, which ultimately boosts our economy in the long run. This benefits the U.S. by increasing the pool of skilled labor and attracting those who have a demonstrated track record of successful entrepreneurship in other countries. This results in a broad and diverse array of entrepreneurs and a constant influx of new ideas, products, services, and other technological innovations. It’s a win-win for both the U.S. economy and the buyer.

One of the most common pathways to gain U.S. citizenship is through the purchase of a business. A non-U.S. citizen buyer also has the option of obtaining U.S. citizenship by starting a business, though the majority feel that acquiring an existing business is a safer bet. Passive investments, such as real estate or businesses in which the owner is not required to play an active role, do not meet the requirements for obtaining a long-term visa to the U.S.

Here are the pertinent questions when it comes to dealing with buyers who are non-U.S. citizens:

• Do non-U.S. citizens make good buyers?
• What types of businesses do non-U.S. citizens like to buy?
• Is the process of selling a business different if you are selling to a non-U.S. citizen?
• What countries offer the E-2 visa?
• What are the requirements for an E-2 visa?
• How should you negotiate with a non-U.S. citizen buyer? Is the negotiating strategy different from negotiating with another buyer?
• Is selling to a non-U.S. citizen worth the hassle?

Each of these topics is addressed in the section that follows. 

Why Non-U.S. Citizens Make Good Buyers

Non-U.S. citizens make good buyers for two primary reasons, both of which mitigate risk to you, the seller:

• U.S. immigration laws require a high degree of capitalization, or down payment, normally at least 50% to 60% of the price of the business.
• The visa status of a buyer who is a non-U.S. citizen is contingent on the ongoing success of the business. As a result, they are more apt to persevere during difficult times to avoid losing their visa and having to return home. This is beneficial to you if you are financing a portion of the sale.

Due to the requirement that the business remains operational to ensure their visa remains active, non-U.S. citizen buyers are more risk-averse than domestic buyers. Imagine you move to South Korea – would you feel confident assessing demographic, socioeconomic, and other factors and creating a new strategy for the business? Most likely not, unless you’re already familiar with the industry and the local marketplace. Buyers who are non-U.S. citizens feel the same aversion to risk when assessing a business in the United States.

Every marketplace has subtle nuances that can only be understood by developing a thorough understanding of the various elements that make up the marketplace and the industry. These elements include demographics, psychographics, consumer preferences, competitive landscape, political landscape, and dozens of other factors. These factors are difficult for any outsider to fully understand. 

As a result of this lack of knowledge, non-U.S. citizen buyers purchasing a business are more risk-averse than their domestic counterparts. Most buyers are looking for a low-risk business that has a high chance of survival.

The exception to this rule is if no change in strategy is necessary for the business and the business only needs an investment in new capital for equipment, inventory, or working capital. In this case, a non-U.S. citizen buyer might not view this investment in capital as risky.

To some intermediaries, this aversion to risk may be misinterpreted as if the individual is looking for a guarantee. But, keep in mind that if the buyer fails in their new business, they can lose their visa status and their entire investment. Because their visa status depends on the continued operation of the business, they have a stronger motivation to succeed and persevere during difficult times. As a result, buyers who are non-U.S. citizens are much more cautious, and you should consider their need to maintain a conservative strategy when communicating and negotiating during the sales process.

The investment required to obtain a visa is significant, and the chances are high that the individual is astute and experienced, and therefore in a position to gauge the riskiness of an investment. At the same time, point out to the buyer that there are no guarantees and risk is present in any investment. The buyer should be able to develop a healthy perspective toward risk and seek to mitigate risk, but should also possess the strength to ultimately take the plunge. The ideal non-U.S. citizen buyer is a serial entrepreneur who has owned multiple businesses before. Such an individual will be comfortable with managing risk and will be capable of taking the plunge.

Selling your business to a non-U.S. citizen buyer is both possible and common. But there are special considerations you will need to keep in mind.

The E-2 Visa

The primary visa obtained in connection with the acquisition of a business is the E-2 visa. The United States has signed a reciprocal treaty of friendship, commerce, and navigation with dozens of countries. It’s possible for the buyer from such a country to become a U.S. citizen through several pathways. 

For further information about the E-2 visa, including a list of the U.S. Department of State’s Treaty Countries, go to the U.S. Citizenship and Immigration Services website for details. www.uscis.gov/working-in-the-united-states/temporary-workers/e-2-treaty-investors

Here is how the U.S. Citizenship and Immigration Services summarizes the description of the definition and requirements for an E-2 Visa from the U.S. Citizenship and Immigration Services:

“The E-2 nonimmigrant classification allows a national of a treaty country to be admitted to the United States when investing a substantial amount of capital in a U.S. business. Treaty investors (E-2) must invest a substantial amount of money and direct the operations of an enterprise they have invested in, or are actively investing in.

“To qualify for E-2 classification, you must:

• Be a national of a country the United States maintains a treaty of commerce and navigation with;
• Have invested, or are actively in the process of investing, a substantial amount of capital in a bona fide enterprise in the United States; and
• Be seeking to enter the United States solely to develop and direct the investment enterprise.”

E-2 Visa Requirements

There is no fixed formula that determines how much capital is required to qualify for an E-2 visa. Rather, a test of proportionality, or a relative test, is used. The amount of capital invested is considered relative to the value of the business as a percentage of the down payment. Required down payments might range from 50% to 90% for small businesses to as low as 10% to 20% for larger businesses. For example, a $5 million investment might suffice, regardless of the value of the business. The absolute minimum amount of cash that will generally suffice starts at $100,000. 

Exceptions may be made if the business is highly specialized and the investor possesses unique skills.

• Non-U.S. Citizen Buyers Must Invest Their Own Funds: Loans suffice as long as the assets of the business being acquired aren’t collateralized by the loan.
• Develop and Direct: The non-U.S. citizen buyer must own at least 50% of the equity in the business being acquired, and must have an active role in the management and operation of the business. Passive investments do not meet the criteria for an E-2 visa.

It is also understood that the business must have a history of generating a large-enough profit to provide the investor with a means of living. The business must also provide employment for other U.S. citizens. If the business will employ only the non-U.S. citizen and a few additional employees, it’s unlikely to qualify. The more people the business employs, the less weight may be given to the other factors. In other words, if the business employs 100 people, then a lower down payment may be required.

The purpose of the requirements above is to ensure that the non-U.S. citizen buyer is committed to the continued operation of the business. The factors are considered collectively, and there are no hard and fast rules.

Key Points

Here are some tips when dealing with a buyer whose purchase is contingent on them obtaining a visa:

• If you’re negotiating with multiple parties, don’t entertain offers from non-U.S. citizen buyers unless the offer is significantly more attractive than other offers. This is due to the extended time frames and potential risk of the foreign buyer not being granted a visa.
• The U.S. immigration process is time-consuming and difficult, and the buyer will likely have the help of an attorney to navigate the process. You can discuss questions regarding the time frame and other factors you should consider with both the buyer and their immigration attorney. 
• Non-U.S. citizen buyers share the same characteristics as domestic buyers – the desire to earn a living and a return on their investment. Bear in mind the buyer’s dual objectives of maximizing opportunity and minimizing risk when positioning your business to them. Focus especially on why your business is more stable than other businesses and specific methods that can be taken to reduce risk, such as eliminating fixed costs or reducing working capital requirements.
• Be prepared for delays and the requirement to use escrow. Your funds will be released once the visa is issued, but be prepared for numerous delays for the foreign buyer to obtain their visa.
• The liquidity requirements usually outweigh the disadvantages, inconvenience, and extended time frame involved with selling to a foreign buyer. This may not be the case though if you are negotiating with multiple buyers and the foreign buyer’s offer is no more attractive than other offers.

Selling a business is a complicated matter, and the balance of power is critical throughout the transaction. 

Consider this scenario:

Yesterday, an employee asked if you were interested in selling your business. He said his two brothers would like to go into business with him. Here’s the problem: he asked if you would sell and for how much. When you turned it around and asked how much he would pay, he simply answered, “Well, how much do you want?”

He doesn’t know you’re selling your business. It is important that information stays confidential since you don’t want your employees or customers to find out. You’ve known him for a long time, but don’t know if he could ever come up with the money. What do you do? 

You have two options:

1. Treat him as any other buyer and acknowledge that your business is for sale. Ask him to sign a non-disclosure agreement and other qualifying documents.
2. Don’t disclose that your business is currently for sale. Ensure the buyer is qualified before you discuss the sale with him.

In this situation, I recommend option 2, which I discuss in more detail in the section that follows. But let’s first take a look at option 1 in case you determine this is more suitable for your scenario.

Discussing the sale with your employees can be one of the most difficult and sensitive issues you will face during the sale process.

Option 1: Treat Them as Any Other Buyer

Even though you already know this potential buyer, you should treat them the same as any other buyer. But keep in mind that this option may alert your other employees that your business is for sale. 

Here are the steps:

• Ask the buyer to sign a non-disclosure agreement.
• Ask the buyer to complete a personal financial statement, which discloses how much liquid cash they have to invest and a summary of their net worth. Note: If the buyer claims they have an investor, the investor should complete these documents as well.
• If the buyer isn’t qualified, discuss their lack of qualifications directly with the buyer. Tell them you can’t release information until you verify they’re qualified.
• If the buyer is qualified, release a copy of your confidential information memorandum (CIM) to the buyer.

Keep in mind, the process for handling this buyer is no different than handling any other type of buyer. The buyer shouldn’t receive special treatment because of their relationship with you. It may be best to handle this process through a third party, such as a business broker or an M&A advisor. 

Your advisor or broker may be in a better position to verify the buyer is qualified. Additionally, because the buyer is your employee, the buyer may feel more comfortable discussing their personal finances with someone other than you.

Option 2: Don’t Disclose Your Business Is for Sale 

Ensure the buyer is qualified before you discuss the sale with them. You have every right to qualify the buyer before disclosing the sale of your business with them. 

In this case, you must handle this yourself if you wish to keep the fact that your business is for sale confidential. If you refer the buyer to your broker, this will clearly signal to the buyer that your business is for sale. 

Rather than handling it yourself, you can have one of your professional advisors, such as your accountant or attorney, verify that the buyer is qualified. Attorneys and accountants are held to high standards, and the buyer may feel more comfortable disclosing their personal finances to them.

The difficult aspect of this process is qualifying the buyer without offending them, which could motivate them to cause damage to your business. 

The key is to approach the process diplomatically. Explain to the buyer that you might consider selling, but not without a significant down payment. You may tell the buyer something to the effect of:

“Let me discuss this with my spouse.”

Come back a few days later and say …

“I have discussed this with my spouse, and we have determined that we would require a minimum cash down payment of $xxx,xxx before we would consider selling our business. If you can demonstrate that you have $xxx,xxx cash to put down, then we would be more than happy to discuss the sale with you.”

Taking this approach allows you to qualify the buyer financially without disclosing your asking price, or without having to commit to a specific number regarding the value of your business.

In most of these situations, an employee looking to purchase your business is not financially qualified, so only consider this if you have no other options.

If the buyer claims they have an investor, talk with the investor directly to verify they’re also qualified. If the buyer claims they will obtain financing from a third party, retain a professional to determine if your business can get pre-approved for SBA financing. If the professional can’t pre-approve your business for SBA financing, it’s unlikely the buyer will be able to obtain financing.

Key Points

• Discussing the sale with your employees can be one of the most difficult and sensitive issues you will face during the sale process. In most cases, employees don’t have the financial wherewithal to purchase your business, and it may be best to avoid these conversations. 
• If questions do come up, it is best to have a prepared, canned response to, “Is your business for sale?”
• Most employees dream of business ownership and may make exaggerated claims regarding their financial resources in order to complete a transaction. Many believe they can find an investor to put up the money. In most cases, these deals don’t happen. 
• In some cases, employees feel they have few other options for going into business for themselves, so they become pushy and demanding. If this happens, don’t cave in to their demands. You have invested years, or perhaps even decades, building your business, and you have every right to protect your investment. 
• Handle this situation with care and diplomacy – it’s possible to ensure your sale remains confidential and that you achieve a successful exit from your business.

Just as buyers perform due diligence on you and your business, performing due diligence on buyers is paramount. In fact, one of the most time-consuming yet critical first steps in the sale process is screening potential buyers. Its importance cannot be overstated.

A major mistake entrepreneurs make in the early phases of a transaction is wasting energy on buyers who aren’t qualified and judging the attractiveness of an offer without first obtaining background information on the buyer. 

Before you invest time and energy in negotiating with prospective buyers, you first want to establish that they’re motivated and financially capable of purchasing your business. Doing so will help ensure you’re negotiating with a qualified buyer and motivate you to invest more energy into the process.

Most buyers who aren’t serious won’t go to the trouble of completing a detailed buyer profile and personal financial statement, so the fact that the screening process takes time will itself help weed out tire kickers. Once the buyer submits an offer, they should submit source documents to verify their financial ability to complete the transaction, which will allow you to screen the buyer more thoroughly.

Don’t waste your time and energy on buyers who aren’t qualified. 

Part of your initial due diligence is to assess the buyer’s motivation. When dealing with potential buyers, ask yourself: 

• How motivated does the buyer appear? 
• Do they quickly return your calls and emails? 
• Are they eager to move forward, or do they seem overly critical? Overly critical buyers usually don’t have serious intentions of buying a business.

The process may change slightly depending on whether the buyer is an individual, a company, or a private equity group. It is worth noting the process for screening an individual is different from screening a company.

The sale of a business can be compared to a sales funnel. There are major steps along the way, and buyers drop off at each step.

How the Numbers Break Down

Here is how the numbers might break down on a typical transaction:

• Interested buyers: 100 
• Buyers who will sign a non-disclosure agreement and receive your CIM: 20 to 25
• Buyers who will respond with questions or interest: 15
• Buyer meetings: 5 to 8
• Second meetings with buyers: 3 to 5
• LOIs received from buyers: 1 to 3

As you can see, the sale of a business can be compared to a sales funnel. There are major steps along the way, and buyers drop off at each. 

By examining the major stages of selling a business and preparing for each one, you can dramatically improve the chances of a successful sale. Let’s take a more detailed look at why you should perform due diligence on prospective buyers.

Reasons for Screening Buyers

Looking into buyers is not only a good business practice, but will save you time in the long run. Let’s look at some reasons why:

• If you’re financing a portion of the sales price, you should screen the buyer just as any bank would.
• You want to ensure they will qualify for the lease and don’t want to waste their time. You may also have to remain on the lease as a guarantor, in which case you will want to ensure the buyer is qualified and is unlikely to default on the lease.
• Make sure they meet any requirements for a franchise, license, or any other qualifications required by third parties.
• Verify that the buyer has the cash down payment before investing significant time or money in performing due diligence. Due diligence is a serious commitment for you and can cost you thousands or tens of thousands of dollars in professional advisor fees paid to attorneys, accountants, and other third parties. Any prudent seller will want assurance that the buyer has enough cash to complete the transaction before they make this investment.
• Even if the buyer is paying all cash and no third-party approvals are required, fraud and theft are still a risk for any seller. You will be giving the buyer access to highly sensitive information such as bank statements and tax returns. Screening the buyer gives you confidence you’re dealing with a legitimate party.

Use a Phased Screening Process

A phased screening process involves screening buyers in phases or stages. This is necessary because most buyers will refuse to be thoroughly screened at the initial stages, particularly before seeing information on your business and deciding they’d like to take a closer look.

For example, if you were to ask a buyer for a financial statement, bank statements, tax returns, and other documents early in the process, most would refuse. The solution is to ask the buyer for this and other qualifying information in stages as the buyer progresses through the steps in buying your business.

Releasing information in phases saves time, preserves confidentiality, and ensures that unqualified buyers aren’t provided sensitive information about your business.

The first step in determining if they’re serious is to ask the buyer to sign a non-disclosure agreement (NDA), buyer profile, financial statement, and disclosure statement. Once buyers have completed these documents, they will then have access to your CIM with more details on your business.

If the buyer is interested once they review your CIM, they may:

• Ask to meet you personally. 
• Request additional information, such as financial statements, prior to meeting you. 
• Should the buyer decide to make an offer, they may also have to disclose more detailed information about themselves, including a detailed financial statement, buyer disclosure agreement, bank statements, tax returns, and more. 
• Most of this information is provided after an offer has been accepted, but some is provided before if you are financing a portion of the purchase price. Doing so allows you to evaluate the buyer’s creditworthiness before committing to a seller note.

When selling a business, the process looks like this: 

• The buyer signs a non-disclosure agreement (NDA), buyer profile, financial statement, and disclosure statement.
• The buyer receives your CIM.
• The buyer requests additional documents, such as financial statements on the business or requests a meeting with the seller.
• The buyer submits a letter of intent (LOI).
• You review the buyer’s information and accept, reject, or counter the offer.

If the offer is accepted, due diligence begins, and a further mutual exchange of information ensues. For example, the seller may perform a background check on the buyer, hire a professional to investigate the buyer, if the seller is carrying a note, or request other financial documents, sometimes required if the seller or bank is carrying a note.

In the beginning of the sales process, you’re making claims that aren’t verified until an offer is accepted and the buyer moves into due diligence. 

Releasing information in phases saves time, preserves confidentiality, and ensures that unqualified buyers aren’t provided information about your business.

Know What To Release and When

Information about your business should be released to the buyer in phases, in a specific order, as the buyer expresses their interest and provides documentation to confirm their financial and operational qualifications to purchase your business. 

Let’s clarify what information is regularly shared with buyers.

Information regularly shared with buyers before an LOI is accepted:

• Teaser profile
• CIM
• Profit and loss statements 
• Balance sheets
• Asset list

Information regularly shared with buyers after an LOI is accepted:

• Financial and tax
• Cash flow statements
• Bank statements
• Federal income tax returns
• Payroll and sales tax reports
• Merchant account statements
• Accounts receivable and payable schedule
• Legal
• Copy of lease for premises
• Copies of supplier and vendor contracts
• Advertising contracts
• Copies of equipment leases
• Copies of material contracts
• Copies of any other third-party contracts
• Franchise-related documents
• Insurance-related documents, such as policies, workers’ compensation, health insurance, and liability insurance
• Environmental documents and inspections
• Operations manual
• Inventory list
• Marketing material and collateral
• Copies of licenses, permits, certificates, and registrations
• Details on staffing and payroll-related documents, such as job descriptions and employment contracts

Information that is sometimes shared with buyers:

• Pricing with specific customers or clients
• Customer contracts – names are redacted
• Employee names, agreements, and other information
• List of suppliers

Information that is not regularly shared with buyers:

• Software code
• Customer names – current and prospective
• Trade secrets

Uncooperative Buyers

The sales process is long and arduous. Finding a flexible and realistic buyer who is easy to work with is just as important as finding someone who will pay your price. Let’s go through some examples of problematic buyers and how you should respond to them:

Buyers Who Refuse To Be Screened

Most deals with buyers who refuse to be screened, uncooperative buyers, or worse yet a “buyer from hell” end up falling apart. These types of buyers will try to bargain for much more than they initially agreed on, threaten lawsuits, threaten to leak word of the sale to competitors, and more. Don’t waste your time with them, plain and simple. Find someone who is easier to work with and who is cooperative enough to get a deal done. Remember, all transactions require cooperation from both the buyer and seller. If you encounter a buyer who seems exceptionally rigid in their strategy, you should move on.

Refusing to provide information is a red flag. Don’t waste your time with buyers that refuse to provide financial information on themselves. The majority of the time, it isn’t advisable to provide information to any buyer who refuses to provide any information about themselves. Even if they are qualified, refusing to complete a simple form makes them uncooperative, and it’s difficult to progress with the transaction with uncooperative buyers.

Buyers Who Don’t Respond 

How many times should you follow up? You shouldn’t have to chase down a buyer. I recommend following up a maximum of two or three times. A buyer must be sufficiently motivated to go through the process and has plenty of opportunities to change their mind, so don’t go running after them. If you have to chase a buyer or “push” them through the sales process, it’s unlikely they will follow through to closing the sale.

Verifying Information on the NDA

Should you verify the information on the NDA? No. Based on my experience, a small number of buyers provide inaccurate information, so verifying each buyer’s information is impractical and will likely scare buyers away this early in the process. Few buyers lie on their financial statement, especially when you ask them to sign the document. When an offer is made, you may ask to see source documents such as bank statements. Buyers know that their representations are verified in the process, and few will falsify this information.

The screening process involves releasing information to the buyer in phases. This means that as you release more information to the buyer about your business, you will also request information from the buyer, which will provide you with an opportunity to verify their information.

If the buyer claims to have an investor, ensure the investor is also pre-screened since they will have access to confidential information on your business. The investor should sign the NDA and also fill out the qualification forms.

What Happens After the NDA is Signed

The sequencing of events in any deal is important. Here are some common questions and my tips for what to do after an NDA has been signed.

Should you send the CIM after they sign the NDA? 

I recommend sending the CIM to buyers as soon as they sign the NDA. Buyers expect to see this immediately after signing the NDA and will often ignore your emails if they don’t immediately receive a professionally prepared package about your company right off the bat. 

How long does it take to close once a buyer is found? 

It takes two to four months to close, on average, once an LOI is accepted. I have closed some transactions in as little as one month, yet others have taken more than six months. It generally takes one to two months for due diligence and another one to two months to close once due diligence has been completed. The process can take longer if third-party financing is involved or if complications arise during the process.

What’s your number one rule for dealing with buyers? 

Run your business as if you’re never going to sell it. Never get hung up on one buyer. It’s easy to get wrapped up with one buyer so much that you lose focus on the business, and revenue begins to slide. Invest your time in a buyer, but not on your emotions. Spend time with the buyer, give them what they need, treat them with respect while staying focused on running your business until the closing.

Individuals

There’s an adage in journalism that holds, “If your mother says she loves you, check it out.” The idea behind this dictum is to caution reporters to always confirm the facts. 

The same principle holds true when it comes to dealing with prospective buyers of your business. A buyer might tell you they’re financially qualified to take over your company, but are they really? A buyer might try to convince you they have the necessary tolerance for risk to take on your business, but how do you know for sure? 

This section will address in detail the questions that are central to determining your suitor’s financial wherewithal, their sincerity, their motivations, and more, to wit:

• When to screen individual buyers
• How to screen an individual buyer’s financial qualifications
• How to screen a buyer’s motivation level
• Screening first-time business owners versus previous business owners
• Screening a buyer’s tolerance for risk
• Understanding a buyer’s expectations to make sure they are realistic
• Does it matter how long the buyer has been in the market

Here’s the scoop on getting the scoop on your buyer … 

Screen Individual Buyers Before Evaluating an Offer

Is a $2 million offer good or bad? 

If it’s from a buyer with a net worth of only $100,000 who has been convicted of multiple felonies and has just recently declared bankruptcy, it’s likely a waste of time negotiating with this buyer. On the other hand, if you have an all-cash offer from a serial entrepreneur who has an 800 FICO score and a related background, perhaps it’s worth pursuing.

It’s critical to screen individual buyers financially to ensure they have the wherewithal to complete the transaction before commiting your energy and time to negotiations.

Financially Screen Individual Buyers 

Many buyers are unrealistic regarding how much money is required to buy a business. Most are undercapitalized. As a result, many stay in the market for a long time because they don’t have enough liquid cash to buy a business. 

Also, many of these undercapitalized buyers make offers on businesses that are contingent on bank financing, and most of these deals are turned down by banks, often months later. As a result, it’s critical to screen individual buyers financially to ensure they have the wherewithal to complete the transaction before you commit your energy and time to negotiate with these buyers.

Screen Individual Buyers’ Motivation Levels

Some buyers are working at their day jobs and are secretly looking for a business during their work hours. They have no choice but to correspond through email. Other buyers prefer talking to someone on the phone about the business.

If the buyer is local, then politely request they meet you at your business, so you can give them a tour and answer their questions. This process weeds out buyers who sit at home and dream about buying a business. It is a give-and-take process, so give the buyer detailed information, then request that they spend time to meet you.

Treat First-Time Buyers and Serial Entrepreneurs Differently

First-time buyers are great buyers if and when they decide to pull the trigger. However, assessing their tolerance for risk is difficult. 

Buyers who have previously owned a business are accustomed to making decisions based on incomplete information and are more likely to make an offer on a business. Previous business owners are also aware that there is no perfect business. 

On the other hand, those who haven’t owned a business often don’t understand what it means to be a business owner and are not accustomed to making decisions based on a “gut feeling” or a lack of complete information. They also may be more averse to risk than those who have owned a business.

Screen First-Time Buyers’ Tolerance for Risk

Screening a first-time buyer’s tolerance for risk is difficult, but not impossible. A highly motivated buyer has the strength and commitment to overcome their fears and will develop the courage to make an offer. Buying any business is accompanied by some degree of risk and therefore fear, and it’s critical that a buyer is able to face their fears. 

Have you met with a buyer five or six times and they are requesting even more information about your business? The most effective method to assess this buyer’s tolerance for risk and ability to face their fears is to ask the buyer to make an offer. Those willing to take the plunge will make the offer. Risk-averse buyers will be overcome by fear and disappear. A buyer must face this fear directly if they are ever going to buy a business.

Avoid Buyers Looking for the Perfect Business

Beware of the buyer whose goal is to buy the “perfect” business and eliminate all forms of risk. This buyer will never buy a business. 

This type of buyer is easy to spot but difficult to describe. You’ll know ‘em when you see ‘em. They have been in the market for a business for three years and have looked at over 100 companies for sale and will bring a clipboard to your meeting with them. They will initially seem extremely interested in your business and will request meeting after meeting only to find out, at the eleventh hour, that your business isn’t “perfect.”

Challenge the buyer and educate them that there is no perfect business. Explain to the buyer that you thought the exact same thing before you started or bought your business. 

Talk openly about the buyer’s fear. Empathize with the buyer and challenge them to pull the trigger. Don’t meet with the buyer more than three or four times unless they make an offer on your business, which is the ultimate test.

Avoid Buyers Who Have Been Looking Too Long

Buyers should be able to identify a business and make an offer within 6 to 12 months. They should be able to close on a business within 12 months of starting the process. If the buyer has been in the market for over a year, you may have problems. Occasionally, we see buyers who have been in the market for one to two years. One to two years is a coin toss. A buyer who has been in the market for over two years is a red flag and should be avoided.

Handling an Unqualified Buyer

You have a buyer who is interested in your business but doesn’t seem to have enough cash. What should you do? Someone has approached you, and they are interested in your business, but the deal looks a little skinny. It doesn’t appear as if the buyer has enough liquidity to purchase your company. What are your options?

Let’s discuss the three general options you have:

1. SBA Financing: I recommend getting your business pre-approved for an SBA loan. Yes, that means “your business” – and not the buyer – is pre-approved for a loan. The most popular loan for purchasing a business is the 7(a) loan. This loan requires a 20% down payment. However, if you structure the sale properly, you can reduce this requirement to 10%. This requires that you take action. Once your business has been pre-approved, you may also have the buyer pre-approved as well. However, don’t reverse these steps.
2. Net Worth: Alternatively, the buyer may be able to access the equity in their other assets, such as equity in their home or their retirement account. I recommend going back to the buyer and simply asking them if they can liquidate any assets and provide a larger down payment.
3. Investors: Friends, family, and fools. A last resort for the buyer is to seek money from investors. Note that this is commonly used by foreign investors, but this approach is not commonly used by U.S.-born citizens. If the buyer claims to have potential investors, I recommend communicating with them directly. Investors will not make an investment without seeing information on your business, so they should also sign your non-disclosure agreement.

There is also a fourth option: Offer more seller financing. I assume, however, that you would explore the three options above before offering additional seller financing. 

Preparing your business for sale will help you respond to the issues that will come up with interested buyers. Knowing your options for financing can keep the lines of communication open between you and a potential buyer.

Competitors

Keeping the details of your business secure and confidential is critical at any time, especially when a competitor approaches you. 

This section explores the following strategies you can employ to protect yourself when selling your business to a competitor:

• Contact buyers based on increasing stages of risk
• Thoroughly screen buyers
• Know what to release and when
• Release information in phases
• Mark or stamp documents “confidential”
• Appoint a neutral third party to facilitate due diligence
• Prepare a custom or buyer-specific non-disclosure agreement (NDA)

Contact Buyers Based on Increasing Stages of Risk

First, contact buyers that represent the lowest risk to you and your company. Typically, this involves initially contacting private equity firms and indirect competitors. 

Dealing with these buyers represents the lowest level of risk to your business. This is the de facto standard in most private auctions if you hire an M&A advisor to represent you.

This strategy of first contacting low-risk buyers lets you polish your presentation and positioning before contacting higher priority or higher-risk buyers, such as competitors. The first buyers you contact will inevitably point out potential drawbacks, deal-breakers, or other weaknesses they may see in your business. No matter how much prep work you do, there will always be small details you miss in getting your company ready for sale. 

Your experience with first contacting the low-risk, low-priority group of buyers will help you hone your first impressions with the high-priority buyers. Such a strategy always yields useful feedback that can be used to tighten up future buyer presentations and increases the chance of a smoother transaction.

At Morgan & Westfield, we recently sold a large commercial cleaning company, and this is the strategy we used. We initially contacted a few dozen out-of-state competitors who could benefit from expanding their geographic reach. We considered these competitors low-risk since they weren’t directly engaged in the business’s geographic market. In another instance, we employed a similar strategy to sell a large landscaping company, but in this scenario, we contacted indirect competitors in the geographic market. We considered this lower risk as the companies were ideal acquisition candidates, but they were not direct competitors. Our strategy was to contact direct competitors only as a last resort. In both of these cases, we started with low-risk potential buyers and were able to sharpen our approach until we found the right buyers for each business.

Keeping the details of your business secure and confidential is critical at every stage.

Thoroughly Screen Buyers

Thoroughly qualify the buyer before releasing information. It’s important to ensure the buyer is qualified before you share confidential information. You can get more detailed in your requests as due diligence progresses. 

We ask interested parties, including competitors, to complete a “Buyer Package” that asks dozens of questions relating to their financial position and any past acquisitions they made. We do this before we release any information to them regarding a business. If the buyer refuses to answer these questions, we don’t provide them any additional information about the business.

If the buyer demands to talk to customers in the latter stages of due diligence, you can respond that you would like to talk to some of their key employees, owners of past companies they have acquired, or other contacts.

Consider hiring a private investigator to perform a few searches on the buyer or the company, depending on the sensitivity of the information you are sharing. An experienced P.I. is resourceful, with access to databases and other resources, and may be able to quickly identify someone with a less-than-pristine reputation. 

Ask your attorney to search public records to discover how many times they have been involved in litigation, if at all. 

Checking a potential buyer’s credit – either business or personal – may also be wise. 

Obtaining detailed financial information to verify the buyer’s ability to complete the transaction is a good idea if you have any doubts regarding the buyer’s financial ability. Go with your gut. If you have doubts regarding specific areas, dig into these areas. For example, if the buyer makes questionable claims regarding several of their past acquisitions, ask to speak with the owner of a company they acquired. This request is certainly within your rights, especially if the buyer is asking for highly sensitive information.

Know What to Release and When

Only release general information in the early stages of any conversation with a potential buyer. Withhold sensitive information – or any other form of information that a competitor could use against you – until the latter stages of the transaction.

Release Information in Phases

Release information to the buyer in phases, as the buyer demonstrates continued interest in your business. In this manner, you release more sensitive information as you gain the knowledge and trust of the buyer. 

For example, you should release highly confidential information, such as customer contracts, only at the later stages of due diligence. Only release sensitive information later in the process, or not at all.

Impose deadlines on the buyer. In some cases, you can break due diligence into stages and ask that the buyer sign off on the completion of each stage. 

For example, you can allow the buyer to perform financial due diligence first. Once they have done so, you can request that they sign off on the satisfactory completion of that stage before moving to the next phase of due diligence. 

While this strategy might be possible for some businesses, it’s impractical in most acquisitions due to the iterative nature of due diligence. A more straightforward solution is to simply withhold sensitive information until the later stages of due diligence.

Release highly confidential information only at the later stages of due diligence.

Mark or Stamp Documents ‘Confidential’

Stamp or watermark all documents “Confidential” before releasing them to the buyer. While this is not a requirement of most NDAs, it is a good practice and clearly communicates to the buyer the confidential nature of any information you share with them.

Appoint a Third Party to Facilitate Due Diligence

Appoint a neutral third party to perform due diligence on behalf of the buyer. In these cases, the third party would only serve to perform due diligence – they would not pass on any of the confidential information to the buyer.

For example, if you own a software company, you and the buyer could jointly hire a third party to perform a code audit. The third party would be the only contact to have access to your software code. After they complete their code audit, they would prepare a report and present it to the buyer for analysis, limiting the number of contacts with access to your confidential software code.

A second scenario may be one in which your business has high customer concentration, and the buyer is concerned about retaining your top three customers, who account for 70% of your revenue. In this case, a third party could be hired to perform customer surveys to ensure your top clients are satisfied. A transaction could also be structured to obscure the fact that the company was acquired. I recently employed this strategy to sell a large service firm in Chicago.

Jointly retain a third-party CPA firm to perform financial due diligence if you must share sensitive financial information with a buyer. 

There are always risks involved with sharing your sensitive business information during the sales process. But there are steps you can take to minimize that risk and still share the necessary information about your business with potential buyers.

Prepare a Custom or Buyer-Specific NDA

NDAs are more than a tool to keep your information confidential. While that is usually the explicit goal of an NDA, it isn’t the only one. A non-disclosure agreement has two primary goals beyond that.

Goal 1: Control Behavior

The primary goal of the NDA is to prevent confidentiality breaches from occurring in the first place. If the terms of the NDA are clear, this objective is likely to be achieved. Considering this objective, it’s often helpful in smaller transactions to reiterate the confidential nature of the transaction to the buyer during the initial phone conversation or meeting. 

It may be counter-effective to draft an NDA that is overly complex. Unfortunately, some buyers don’t thoroughly read the terms of the NDA and inappropriately assume that the language is all boilerplate. With this being the case, it helps to reiterate the key terms of the NDA if you believe the competitor has not completed many acquisitions before and may not possess this knowledge. 

If the buyer attempts to negotiate the language of the NDA, this can be a good sign. It can be a sign that the buyer closely monitors their commitments and intends to abide by them. Also, if the goal of the NDA is to control behavior, then it goes without saying that the language should be clear, concise, and devoid of legalese.

Goal 2: Offer a Mechanism for Litigation

If an NDA is violated, your primary option in most cases is to litigate. While you can deliberate for hours regarding the definition of confidential information, this won’t matter if the buyer doesn’t understand the nuances of the language contained within the NDA. With that being said, we believe the primary goal of an NDA is to control and prevent undesirable behavior. If the first objective to “control behavior” is achieved, litigation isn’t necessary. If controlling behavior is the goal, then the language of the NDA should be clear and understandable. 

Now that I have explained the purpose of the NDA, let me offer several tips on how to strengthen the NDA when dealing with direct competitors.

Prepare a Buyer-Specific NDA

Have your attorney prepare an NDA that is specific to the buyer you are negotiating with. A standard NDA is normally sufficient during the preliminary stages. But, if you’re dealing with a direct competitor and are releasing highly sensitive information, your attorney should prepare an NDA for that specific buyer. 

Prepare a Separate NDA for Different Information

Separate NDAs can be prepared for different categories of confidential information, with different language necessary for different scenarios. 

For example, each of these scenarios may require a different set of legal strategies and language to protect you – the buyer meets with key employees vs. if the buyer meets with key customers vs. if you share proprietary pricing with the buyer.

Customize the NDA

An NDA often has to be customized for certain types of buyers. 

For example, we handle a wealthy private individual differently than we handle a direct competitor. We also manage private equity groups differently from competitors. 

Our process is more stringent with competitors since these transactions represent more risk to the seller. The protection a non-disclosure agreement offers varies based on the language contained within the NDA. In middle-market transactions, the NDA is negotiated with many buyers, especially if the buyer is a potential competitor.

To determine which topics to handle differently in an NDA with a competitor, consider the following questions:

• Is information that is communicated orally included? 
• Is “derived information” included?
• Is the fact that your business is for sale considered confidential information?
• What is the definition of “representatives”?
• What is the definition of “confidential information”?

You can also consider addressing the following in your NDA when dealing with a competitor:

• Non-Solicitation: Include language in which the buyer agrees to not actively solicit your customers, suppliers, or employees. See tips below for when to introduce this language.
• No-Hire: The buyer agrees not to hire your employees, as opposed to not soliciting them.

Ask the Buyer’s Representatives to Sign an NDA

Always ask the buyer to obtain a signed NDA from their representatives before releasing your information to them. If the representatives don’t sign your NDA directly, then the buyer should be held liable for any breaches made by their representatives. The buyer should also disclose their representatives’ names and contact information if they receive information on your business. 

Have the Buyer Sign Multiple NDAs

Ask the buyer to sign a different NDA at different points in the transaction as the negotiations advance. Each NDA can contain progressively more restrictive language and terms as you release more sensitive information. 

For example, a buyer may not be interested in signing an NDA that contains a non-solicitation or a no-hire clause early in the process. But, the buyer may agree to this language in an NDA later in the process if you agree to let the buyer meet with your employees during due diligence. 

It may be necessary for your attorney to draft an NDA before you allow the buyer to meet with key customers. This is rare in most transactions, but there may be cases where customer concentration is an issue, and the buyer may want to talk with key customers before they agree to the closing. If this is the case, it may be necessary to negotiate an NDA with the buyer before allowing such conversations to take place.

Clauses to Consider Modifying

Now that I’ve offered several tips, let’s discuss the specific language contained within the NDA.

Definition of Confidential Information: This is a commonly negotiated section. Many agreements broadly define confidential information and then make specific exclusions. This section should specifically address any confidential information you are particularly concerned about.

Definition of Representatives: Many NDAs allow the buyer to share sensitive information with their “representatives” without your explicit consent, but some agreements don’t define what a representative is. I don’t recommend this. The NDA should require that the buyer obtain the seller’s consent before releasing the confidential information to third parties, including their representatives. The agreement should also define what a representative is.

Permitted Uses: The NDA should state that the confidential information can be used only for purposes of evaluating the transaction and for no other purpose.

Disclosures Required by Law: Most NDAs allow the buyer to release confidential information if compelled to do so by law. NDAs with strongly worded language on behalf of the seller allow the seller to mediate these claims and otherwise offer the seller several protective mechanisms before the information is released.

Return or Destruction of Information: The NDA should require the buyer to return or destroy the information if they decide not to pursue the transaction, although this clause is often irrelevant given the current state of technology.

Access to Employees: This is a hotly debated topic. All NDAs should restrict access to employees in the early phases of the transaction. If you wish to grant access to your employees, I highly recommend having your attorney draft a non-disclosure that addresses non-solicitation of your employees before you allow the buyer to meet with your employees.

Non-Solicitation of Customers, Employees, and Suppliers: This is also a hotly debated section and some buyers may refuse to sign an NDA that contains this language in the earlier stages of the transaction. You can soften this by stating that the buyer agrees to not actively pursue your employees, but that your employees can be hired if they apply through general employment advertisements.

No Obligation to Proceed: The NDA should state that the parties have no obligation to proceed and that the parties do not intend to create a binding commitment.

Disclaimer Regarding Accuracy: To protect the seller, the NDA should state that you aren’t making any warranties regarding the accuracy of the information.

Term: All NDAs should include a term. Most NDAs contain a term of two to three years. Go for the longest term you can get away with.

Choice of Law: I recommend choosing your home state.

Injunctive Relief: The NDA should specifically allow you to obtain an injunction in the event of immediate damage.

Assignment: Most NDAs are not assignable, and the NDA should clearly state whether or not it is assignable.

Key Points

If you’re contacted by a competitor, I recommend the following:

• Contact buyers based on increasing stages of risk.
• Ask your attorney to prepare a custom or buyer-specific NDA.
• Thoroughly screen the buyer.
• Release information to the competitor in stages or phases.
• Stamp documents “confidential.”
• Appoint a neutral third party to facilitate due diligence.
• Ask your attorney to prepare a specific non-disclosure agreement for your competitor.
• Ensure the buyer’s representatives also sign a non-disclosure agreement.
• Ask the buyer to sign additional non-disclosure agreements as the transaction progresses.

You have marketed your business for sale and several buyers have contacted you and expressed interest in your business. The next step after the buyer has signed a confidentiality agreement is to send the buyer an offering memorandum on your company, usually called a confidential information memorandum, or CIM for short.

A CIM is a professionally prepared summary of your business that is presented to prescreened buyers who are interested in purchasing your company. The CIM addresses the buyer’s questions quickly and efficiently, saving countless hours. It includes information regarding your company’s history, products, services, licensing, and competition. It also includes a financial summary, information about operations, lease terms, the value of assets and inventory, an employee summary, and terms of the sale. 

The purpose of the CIM is to help the buyer decide if they would like to take the next steps and learn more about your business. The CIM will not address every question the buyer may have about your business. It’s not supposed to. Rather, it allows the buyer to move to the next step in the transaction, which is a site visit or request for more information.

Here are the major topics typically covered in a CIM:

• Assets
• Competition
• Customers
• Deal structure and financing
• Equipment
• Facilities
• Financials
• History
• Improvement potential
• Intellectual property
• Inventory
• Litigation
• Operations
• Pricing
• Product or service
• Staff

Advantages of Preparing a CIM

Taking the time to prepare a CIM will provide you with several key advantages.

Saves Time

When selling a business, you will quickly learn that all buyers ask the same questions. You’ll answer the same 50 to 100 questions from every potential buyer. This becomes tiring if you aren’t prepared. A CIM replaces what might be a one- to two-hour discussion by efficiently and consistently answering the questions virtually every buyer will have about your business. CIMs minimize distractions and allow you to focus on running your business.

Many buyers are tire kickers. If you waste your time talking to dozens of uninterested buyers, you may lose patience by the time you have a real buyer on the hook. An efficient process will save you time and grief, and ensure you’re fresh when you’re in front of a serious buyer. 

Helps You Prepare

When a business broker, M&A advisor, or investment banker assists you in preparing the CIM, you have the opportunity to discuss your operations in-depth, and it prepares you for the dozens of questions a sophisticated buyer may ask. 

An experienced business broker or M&A intermediary will have crafted hundreds of CIMs and will be adept at presenting the business in the best light possible. You will also have the chance to rehearse your answers to common questions buyers will ask you, such as:

• Why are you selling your business?
• If the business has such incredible potential, then why don’t you keep it?
• Who are your competitors, and how do you stack up against them?
• Why should I buy your business? Why don’t I just start one?

Communicates the Value of Your Business

Often, a buyer consults with third-parties who assist in decision making, such as accountants, attorneys, or investors. In the absence of a CIM, the buyer must sell the business to third parties on their own. With a professionally prepared CIM, the buyer can simply present this document to their advisors, then have an intelligent discussion based on the contents of the document.

Provides You With Perspective

Reviewing your CIM gives you a unique opportunity to view your company from a fresh, realistic, objective perspective, as if you were a buyer. Doing so prepares you for negotiations and gives you the opportunity to position your business in the best light possible.

Communicates That You are Serious

Preparing a CIM also communicates to the buyer that you are serious about selling your business, and the buyer is more likely to take you seriously and treat you with respect as a result.

When selling a business, you will quickly learn that all buyers ask the same questions.

Tips for Preparing a CIM

Include the Right Amount of Information 

The story of your business should be presented in a coherent, professional package. Your CIM should include most of the information a buyer needs to know when deciding if they would like to pursue your business. But the CIM shouldn’t contain everything the buyer needs to know. It should contain just enough information for the buyer to decide if they would like to invest time in meeting with you – it doesn’t need to answer every imaginable question about your business.

Present the Highlights in a Persuasive Format 

The CIM should present the key selling points of your business in a persuasive story. It should also position the negative points of your business in the best light possible. For example, if you haven’t invested heavily in marketing your business in recent years, this presents a tremendous opportunity to the buyer to increase revenues.

Differentiate Between Your CIM and Teaser 

The teaser profile is an abstracted version of the CIM and is often three to five pages in length. The teaser profile contains the highlights of the business and is sent to prospective buyers on a confidential basis – that is, without divulging the identity of your business. It is helpful to ascertain whether a buyer is seriously interested before allowing them access to more sensitive information, including your company’s name. The teaser profile can be shared with buyers before they view the CIM if you are not comfortable sharing more detailed information with a potential buyer.

Patience is Key When Buyers Don’t Respond 

Don’t chase buyers down. Buying and selling a business requires a lot of patience. A buyer needs to be proactive if they’re serious about buying your company. Not hearing from a buyer happens all the time, and I suggest that you just keep moving forward. Don’t chase down any buyer. 

The first step when a buyer expresses interest in your business is to request that they sign a confidentiality agreement. Many critical issues are addressed in a properly drafted non-disclosure agreement (NDA), including non-solicitation and other “sales process” issues. It’s tempting to assume that all NDAs are boilerplate, but a mistake at the stages of negotiating and signing an NDA can close off critical options later in the process. In extreme cases, leaks can destroy your business. 

A properly drafted confidentiality agreement also sets expectations and signals buyers that you are well-represented. This means buyers will be less likely to use negotiating tactics that are unlikely to work on a sophisticated seller who is properly represented.

In nearly every M&A transaction, a confidentiality agreement (CA) is executed, but a CA is only one of many tools in your arsenal you can use to maintain confidentiality during the sale process. This section explains strategies you can use in combination with a properly drafted CA before and during the sale to offer a high level of control over your sensitive information.

Topics Covered in an NDA

At a minimum, an NDA will usually cover the following topics:

• Definition of confidential information
• Restrictions on use of the confidential information
• Obligations of the recipient
• Standards of care
• Term
• Remedies
• Permitted disclosures
• Return of confidential information
• Disclosure period
• No obligation to proceed
• No grant of IP rights
• Enforcement
• Law and jurisdiction
• Dispute resolution

With regard to the confidential information, the NDA should obligate the buyer to:

• Use the information only for purposes described in the agreement.
• Disclose the information only to persons with a need to know the information for purposes of evaluating the transaction.
• Use appropriate or reasonable efforts to keep the information secure.
• Ensure that anyone to whom the information is disclosed further abides by obligations restricting use, restricting disclosure, and ensuring security at least as protective as the agreement.
• Not share the information with third parties, unless required to by law, for a minimum period of time, typically one to five years.
• Safeguard the information they receive with reasonable precautions that are at least as stringent as the safeguards they use to protect their own information.
• Not reverse engineer or decompile the information.
• Notify the disclosing party of any leaks of the disclosed information.
• Comply with all government rules and regulations, including export and import laws.
• Cease use of the information and return it to the disclosing party upon termination of the NDA.

The first step when a buyer expresses interest in your business is to request that they sign a confidentiality agreement.

The Importance of a Properly Drafted NDA

The language in M&A confidentiality agreements has evolved over the years and is no longer restricted to language that only addresses confidentiality. Despite the implication of the name “confidentiality agreement,” many additional critical issues are addressed, such as intellectual property rights.

If an investment banker or M&A advisor represents you, expect your advisor to have a template. Because most M&A advisors represent sellers, their template should be seller-friendly. 

If your situation is unique, consult with your attorney to draft a custom NDA. In most cases, buyers will make few requests to the language contained in your NDA, but be prepared to negotiate the terms of the agreement as requests are highly varied based on who the buyer is.

In practice, most NDAs are drafted by the disclosing party, which is usually the seller in M&A transactions. Sellers negotiate with multiple buyers, and maintaining consistent language across the agreements simplifies the process for the seller. Most NDAs never make it past the first stage of selling a business, which is signing an NDA and reviewing the offering memorandum. You will likely end up executing dozens of non-disclosure agreements with potential buyers during the sale process, 99% of which you will never look at again.

The Process

For transactions in the middle market, most intermediaries first provide a teaser profile to the prospective buyer before requesting that the buyer sign a non-disclosure agreement. Most buyers in the middle market prefer to see if the business is a good fit before committing to the terms of an NDA. The teaser profile allows the buyer the opportunity to determine if the company may be a good fit before they execute an NDA. 

The teaser profile and NDA are often contained in the same document, and the buyer is asked to sign the NDA if they would like to access the confidential information memorandum (CIM) on the business. 

Timing the Execution of a Confidentiality Agreement or NDA

The non-disclosure agreement is the first document to be signed in a transaction and sets the tone for the negotiations, making it a critical component of the sale process. Depending on the type of business being sold, the name and location of the business can be highly sensitive. A seller may want to protect that information until they know the buyer is genuine and sincere.

The goal of the intermediary representing the seller is to protect their client’s sensitive and confidential information while providing enough information to a potential buyer so the buyer can decide whether to pursue the business. Needless to say, this is a delicate balancing act. 

If the business is being sold through a broker or M&A intermediary, the NDA will usually be executed before the business’s name is disclosed. If the owner has been approached by a competitor directly, then an NDA is often signed before substantive discussions take place or before the seller shares confidential information with the buyer.

Buyer’s Benefits for Signing an NDA

Many buyers view an NDA as one-sided for the sole benefit of the seller. This is initially true, though the buyer will also benefit from the protections afforded in the NDA. Potential buyers who did not end up purchasing the business but who may be the business’s competitors will still have signed an NDA before accessing confidential company information, thus protecting the future of the business.

The fact that a business is for sale may, for example, cause a significant customer to reconsider their relationship with the company. A non-disclosure agreement helps prevent this and therefore benefits the future owner of the business.

By signing the NDA, the buyer is letting the seller know they’re serious about buying a business. A seller is unlikely to share highly sensitive and critical information about their company without a signed NDA. Most sellers refuse to have further discussions with a buyer who is unwilling to sign a confidentiality agreement. Sellers become more cooperative in relation to the degree to which the buyer is cooperative. 

Differences in Buyer Groups

How commonly are confidentiality agreements negotiated? 

It’s rare for parties to refuse to negotiate the terms of an NDA. The first draft is always negotiable, but the degree to which the parties negotiate depends on their individual bargaining strength. Every buyer, whether a corporate or financial buyer, has their own idiosyncrasies in terms of the language they look for in a confidentiality agreement, based on the history of their past transactions and what may have gone wrong. In practice, a minority of buyers request changes to a confidentiality agreement. But, the later you request an NDA from a buyer, the more prone a buyer is to attempt to negotiate the terms of a CA or NDA.

What is the role of my attorney and M&A advisor? 

Every M&A advisor will have a template they use. Your attorney should become involved if you have unique needs to be addressed, such as trade secrets that need to be protected or non-solicitation of key employees, or if your marketing strategy includes approaching competitors.

Do advisors sign NDAs? 

Private equity firms nearly always sign an NDA when scouting for acquisitions, though few venture capitalists will sign an NDA. Most M&A advisors and investment bankers will sign a non-disclosure agreement, but some will view the request as naive due to their implied duty of confidentiality. Professionals such as PE firms, venture capitalists, M&A advisors, and investment bankers wouldn’t be in business for long if they were in the business of stealing ideas. Attorneys and accountants will sometimes sign an NDA if the situation is unique, such as if they are part-owners in a competitive firm. However, they are bound by an implied duty of confidentiality, so requesting them to sign an NDA is considered unnecessary in most situations.

There is no such thing as a “standard” NDA. Always have the NDA reviewed by your attorney before signing.

What if the buyer offers a “standard” NDA? 

If a buyer approaches you to potentially buy your company and asks you to sign their “standard” NDA, there are a few things you need to keep in mind. There is no such thing as a “standard” NDA. Always have the NDA reviewed by your attorney before signing. Any company with a legitimate interest will be willing to negotiate the terms of their NDA.

What’s signed after the NDA? 

A “letter of interest” or “letter of intent” (LOI) is customarily signed after the parties have exchanged information and the buyer has expressed an interest in moving forward into due diligence. After due diligence is completed, the parties then replace the LOI with a purchase agreement, which is signed at closing to consummate the transaction.

Can the buyer disclose the transaction terms after the CA expires? 

Yes, unless the NDA specifically prohibits this. An alternative is to remove the expiration date altogether, though a majority of buyers will argue that it may be difficult to monitor compliance with the agreement long-term if it lacks an expiration date. Some jurisdictions may also not allow a perpetual term. Therefore, an expiration date is recommended in most situations.

Key Points

• Understanding a few basic points concerning confidentiality agreements ensures that the critical purpose they serve won’t be defeated by ambiguities or ignorance of the meaning of terms used in the agreement.
• As with any agreement, there is no “one size fits all” approach, and you should consider professional advice before taking action. To best assure the NDA is enforceable, careful consideration should be given to the above factors – especially since the protection of ideas and trade secrets is inherently difficult.

Controlling the flow of information is critical to ensuring confidentiality. Knowing when to address issues in your business, when to leverage other offers, and most importantly, when to keep your mouth shut have made and broken countless deals. Therefore, being able to maintain confidentiality is vital. 

Strategy 1: Control What and When Information is Released

Controlling the content and timing of when information is released is foundational to maintaining confidentiality. Here are several strategies for controlling what and when information is furnished to potential buyers:

• Redact or Aggregate Information: Consider sharing highly sensitive information in summary form in which key information – such as customer or employee names – is redacted.
• Release Information in Phases: Release information to buyers in phases as the sale progresses and as transaction milestones are achieved, such as completion of financial due diligence. At each milestone, request that the buyer sign off on its completion. For example, names of key customers or employees should be released only at the tail end of due diligence, or after a purchase agreement is negotiated and executed.
• Develop Separate Strategies for Different Information: Highly sensitive information subject to misappropriation by the buyer could be summarized, shared with neutral third parties, or shared only in summary form with the buyer. Always exercise extreme caution in areas of unprotected trade secrets and other non-registered IP.
• Set Up an Electronic Deal Room: If you are negotiating and conducting due diligence with multiple parties simultaneously, it may be wise to release all information through an electronic data room. This allows you to track who accesses information and exercise some control, such as limiting the ability of buyers to download or print information.
• Email Information to Create a Document Trail: Email as much information as possible to create a document trail in the event litigation needs to be pursued. This documentation can provide you with enormous leverage in the event of threatened litigation, such as when the opposing parties weigh the potential merits of a case before initiating a lawsuit. Since the evidentiary burden is on the seller in most confidentiality agreements, the more documentation you have, the more leverage you have to reach a quick resolution in the event of a breach.

Controlling the content and timing of when information is released is foundational to maintaining confidentiality.

Strategy 2: Control Who Receives Information 

If you are releasing highly sensitive information, you can often limit who this information is released to. Here are several strategies for doing just that:

• Screen Buyers: Thoroughly screen all buyers before releasing any information. All buyers should be screened financially, and direct competitors should be screened with extra diligence. Due diligence is a two-way street – you should verify your buyer’s financial position during due diligence before releasing sensitive information. Verify how many acquisitions they have previously made and request to talk to several CEOs of their past acquisitions. If you encounter warning signs, immediately slow down and dig deeper. In the case of private, supposedly “wealthy” individuals, request a credit report or hire a private investigator to perform a background check if suspicions are raised. In one case, I sold a staffing firm to a private, wealthy individual who stole the funds he used to purchase the business from a trust, of which he was the trustee. While such cases are rare, if doubts are raised, trust your gut and dig deeper.
• Release Highly Sensitive Information to Neutral Third Parties: In the case of extremely sensitive information, it’s possible to appoint third parties to review the information and prepare a summary report to present to the seller. In one large transaction I handled, representing the seller, two customers accounted for 40% of the annual revenue. The buyer was concerned due to the risk associated with the high concentration of revenue, but the seller was unwilling to let the buyer talk directly with the customer. We hired a third-party firm to perform customer surveys and prepared a summary report to present to the buyer.
• Limit Information to Select Parties: Alternatively, you can limit information to specific people or departments within the buyer’s organization, such as the buyer’s CPA, attorney, or CFO. When doing so, we recommend that the third party also sign a non-disclosure agreement. 
• Use the Attorney-Client Privilege: Omit documents from the data room that are subject to the attorney-client privilege, such as those that might be relevant to recent litigation. In other words, if you’re in the process of litigation, be sure to disclose any documents pertinent to the litigation exclusively through your attorney. Note that in the event of a successful transaction, the buyer may share a common interest with the seller if the buyer becomes a “successor defendant.” But this privilege isn’t guaranteed, especially if the transaction is unsuccessful. Therefore, it’s wise to limit disclosure of any litigation-sensitive information exclusively through your attorney to retain the attorney-client privilege.

Strategy 3: Handle Breaches Immediately 

Leaks in confidentiality rarely cause permanent damage. In most cases, unintentionally loose lips cause a leak, and a quick phone call to the offending party quickly reverses the damage, if any.

In the event of a breach, immediately call the offending party. Assess their reaction to the news and their tone – listen to their story before taking any dramatic action. In most cases, the other side will apologize and immediately take steps to correct the action, such as firing the employee who initiated the breach or calling the customer to reconstruct the narrative of the story. 

When a breach isn’t clear, a phone call may serve to raise the other party’s awareness of the issue, and in most cases, the story will quickly disappear. Send an email to confirm your conversation and any actions they have agreed to take. This creates a paper trail in the event you need to pursue litigation in the future.

The steps that follow are necessary to consider only if your initial marketing campaign to sell your business isn’t generating adequate results.

So, if they’re not coming to you, you may need to go to them. 

Some of the tried-and-true approaches outlined below have risks. Chief among them is the risk of jeopardizing confidentiality. Many people assume that when a company is for sale, it’s on shaky financial ground. You don’t want to lose valuable clients, vendors, or employees because of negative assumptions that people make when they learn that your business is for sale.

But for those of you who want to branch out further with your marketing strategy, I have some additional suggestions you may want to explore, starting with an obvious but often overlooked one … 

Consider People You Know

Sometimes, you don’t have to go far to find the perfect buyer. Does anyone you know seem to be a possible candidate? Has anyone expressed interest in purchasing your company in the past?

• For Small Businesses: There are people in your life who dream of owning a business like yours. You’ll never know who they are until you start trying to connect with them. Once you begin talking to the people you know for ideas, potential interests, and references, you may find that you have a world of opportunities at your feet.
• Word of Mouth: You can do a lot of marketing via your personal network. People love to share compelling stories. If your business is well known, then word of mouth may be enough to spread the news that your business is for sale. Cast a wide net. Spread the word about your intent to sell among your friends, acquaintances, and business contacts. Inquire with people you know, but remember: if you do so, you must be prepared for the public to learn of your plans quickly.
• Print, Direct Mail Marketing, and Advertising: There are a number of areas where you can look to place a classified ad, such as trade publications or periodicals geared specifically to your industry. 

Selling to an Employee or Management Team

Often, employees or your management team may have aspirations to become business owners. Your own team may be a source of potential leads to buyers, or it may be the cause of conflicts and hold-ups if not handled properly.

What are the benefits of selling to an employee?

Employees are familiar with your business operations, strengths, customers, competition, and unique advantages in the market. Your current managers, or people in their networks, may have distinct insider knowledge that allows them to quickly make a decision, which can be one of the most efficient sales experiences any seller can hope for.

What are the drawbacks of selling to an employee?

An employee may not have the financial resources necessary to buy your business and invest in the future growth of the business. It can be an adjustment to go from being an employee to being an owner, even for the most aspiring entrepreneur. 

To sell to an employee, be prepared to finance all or part of the sale or arrange for a bank to finance the transaction. 

Disclosing to your team members that your business is for sale may cause some disruptions. Employees may fear the upcoming change and leave their positions, or may even attempt to undermine the sale. 

If you begin serious discussions with the wrong person, the dynamic shifts from an employer-employee relationship to a business owner’s relationship with a business owner. This can cause tension in the work environment throughout negotiations and ownership transfer, especially if discretion is not maintained and confidentiality is not respected. 

Employee Stock Ownership Plans (ESOP)

Employee stock ownership plans are plans in which employees can buy shares of a company under specific terms. 

Not often seen in businesses with less than $5 million in annual revenue, ESOPs are complex and expensive to establish. They often require the specialized knowledge of accountants, tax advisers, and lawyers for ongoing re-examination and re-certification to keep the plan compliant with all regulations.

Employee stock ownership plans are one way to integrate employee ownership in a company, often positively affecting the employees’ commitment, dedication, and productivity. In some cases, selling to one or more employees may also have tax advantages.

Although the process varies, typically, the ESOP plan purchases stock at its inception, using a bank loan. Employees can receive shares as compensation, like a 401(k), with the potential for the ESOP shares to vest immediately or over time, as with a pension plan. As employees reach retirement age, they will have options to diversify their ESOP holdings away from company stock or cash out. 

An ESOP structure may make sense for your business, but these normally yield the lowest sales price and are often used only as a last resort.

Professional Contacts

There are many other contacts you can reach out to in order to broaden your marketing strategy. 

These professionals are in contact with potential buyers every day. Keep in mind that if you establish a relationship with any of these professionals, and it results in a successful sale, it’s best to compensate them for their facilitation.

• Accounting and Legal Professionals: Close advisers, such as lawyers and accountants, get to know the business owners they work with and may be able to connect you with their clients or someone in their network. Most firms have specialized groups in focused industries; you want the information for the group that specializes in your industry. 
• Consulting Professionals: These people are in close contact with senior executives and can be in a terrific position to connect you with buyers. When you’re contacting a professional at a consulting firm, attempt to reach the most senior-level contact possible. Research their portfolio and industry specialties, and approach them with a professional introduction that clearly indicates why you’re contacting them. 
• Industry Associations: In your local community, in your state, and nationally, there are likely multiple associations for professionals in your industry. These organizations connect people in the same and overlapping businesses and bring them together through online forums, trade shows, events, and industry-specific publications. Learn the names of the major associations and gain membership if necessary. Reaching out to other members, advertising within the organization itself, or participating in an event could introduce you to a range of potential buyers. 
• Active and Retired Senior Executives: Current or retired executives in your industry often have extensive networks and may be less conflicted about recommending potential buyers. Using your knowledge of your industry, both local and widespread, consider executives who may be able to refer you to others in their network or who may be potential buyers themselves.

Other Potential Buyers

There are a few other areas to consider where you may find potential buyers.

• Employees of Competitors: A competitor’s employees or management team may be interested in buying your company. Of course, it can be hard to find the right employees to approach. There is no magic formula to finding competitors’ employees. It’s generally done by word of mouth, through local classified advertising, or trade press advertising. In some cases, more aggressive buyers will contact business owners directly or through a third party.
• Customers: Often, your best customers are those who are your biggest fans. They promote your business within their circle because they love what you offer. They may make large purchases on a regular basis, or they may have approached you about business deals, offers, or opportunities in the past. Don’t overlook this important group of potential buyers.
• Suppliers: It’s common for businesses to acquire other businesses with which they are already connected. Sometimes referred to as “vertical integration,” this type of acquisition can complete the value chain for a company expanding into new industries or areas.

Is your business likely to be sold to a financial buyer, strategic buyer, or industry buyer? A key consideration for developing a marketing campaign and deciding which groups of buyers to target is the size of your business. 

• For small businesses most likely to be sold to an individual, confidentially marketing your company on specialized portals is the most effective strategy. 
• For mid-sized businesses or those most likely to be sold to a financial buyer, strategic buyer, or industry buyer, a targeted campaign is the most effective.

With a targeted campaign, your broker will reach out directly to potential corporate buyers – many M&A advisors call this a private auction. This involves compiling a list of potential corporate buyers and then contacting them directly through emails, letters, and phone calls. Corporate buyers can also be targeted through select trade publications.

There are advantages and disadvantages to selling your company to a corporate buyer or competitor, so it’s important to proceed carefully. But targeted campaigns are not recommended for every company. 

In certain industries, a competitor or corporate buyer may pay significantly more for your business than an individual buyer.

Advantages and Disadvantages of Targeted Campaigns

Consider these points before proceeding with a targeted campaign:

Advantages of Targeted Campaigns

• Experience: A corporate buyer may already be familiar with the industry and marketplace and will likely be motivated to purchase your business as a means of expanding their market share. 
• Knowledge of Industry: A corporate buyer may be more knowledgeable about what it takes to purchase a business. This means the transaction may go more smoothly than would be the case with an individual buyer who has never owned or purchased a business. 
• Price: In certain industries, a competitor or corporate buyer may pay significantly more for your business than an individual buyer.

Disadvantages of Targeted Campaigns

• Confidentiality: It can be risky letting your competition know that you want to sell your business. 
• Low Probabilities: In some industries, the probability of selling to a competitor or corporate buyer may be lower.
• Price: In certain industries, a competitor or corporate buyer may pay significantly less for your business than an individual buyer. This situation is especially true if it’s easy for the buyer to replicate your business at a lower cost than your asking price.

Determine if a Targeted Campaign Is the Right Approach

The size of your company and the likely buyer are also considerations to keep in mind.

Size: Selling Small vs. Mid-Sized Businesses

• Selling a Small Business: Small businesses – those with less than $5 million in annual revenue or less than $1 million in EBITDA – are purchased by individuals 90% of the time. Companies account for the other 10% of such transactions. Targeted campaigns are suitable only for a select number of smaller businesses.
• Selling a Mid-Sized Business: Targeted campaigns are almost always suitable for middle-market businesses with EBITDA greater than $1 million per year.

Negotiating with competitors also tends to be a much more rigorous process than selling your company through ad portals. Competitors are often more difficult to deal with than industry outsiders. For example, they are much more particular about the language in a non-disclosure agreement and may attempt to learn the identity of the company without signing an NDA. You should also have your attorney on standby to manage revisions to the non-disclosure agreement, letter of intent, and purchase agreement, if necessary. 

Buyers: Individuals vs. Corporate Buyers 

• Individuals: Individuals are more likely to purchase small businesses. The most efficient and cost-effective method of contacting individual buyers is through targeted forms of media such as web portals and trade journals in which individuals have identified themselves as potential buyers. In other words, this group of people has already been corralled for you, thus making the process more efficient and cost-effective. 
• Corporate Buyers: Companies are more likely to purchase mid-sized businesses. Most corporate buyers are looking for businesses that generate at least $10 million in annual revenue. There are always exceptions. For example, in mature industries where growth is a zero-sum game, such as landscaping, competitors regularly acquire small businesses.

Types of Corporate Buyers

Here are the different types of corporate buyers:

• Direct Competitor, Different Geography: The business is in the same industry, and may be looking to expand into your area. 
• Direct Competitor, Same Geography: The business is in the same industry and same geographical area as your business. This is common in “zero-sum” industries where the industry is no longer gaining market share, or growing, and competitors are fiercely competing for market share, such as commercial cleaning or lawn care. In these industries, it’s often more cost-effective to acquire a competitor than attempt to steal market share from a competitor through advertising.
• Indirect Competitor: In this instance, the buyer may be interested in expanding into a new market or selling their products or services to your existing client base. For example, a food distributor may be interested in purchasing a food manufacturer. Rather than build a business from scratch, they may be interested in simply acquiring your company. If you choose to approach a company you think may have this synergistic potential, be prepared to clearly and concisely demonstrate the potential and competitive advantages of your business.
• Customers: Often, your best customers are your biggest fans. They promote your business within their circle because they like what you offer. They may make large purchases regularly, or they may have approached you about business deals, offers, or opportunities in the past. Don’t overlook this critical group of potential buyers.
• Suppliers: Businesses will commonly acquire other companies they are already connected with in some fashion. Rather than outsourcing their product or service to you, it can be more profitable and part of their acquisition strategy to bring your services under their corporate umbrella. This type of acquisition can complete the value chain for a company expanding into new industries or areas.

The Ideal Corporate Buyer

Here are the characteristics of the ideal corporate buyer:

• Experience: The ideal corporate buyer has made previous acquisitions. Approach only those targets that are ready, willing, and able to take action. You will know this by researching the company and determining how many acquisitions it has made in the past one to five years. The more acquisitions or companies the corporate buyer has made recently, the more likely it will buy another company.
• Size: The corporate buyer should generate at least $10 million in annual revenue and be at least three times the size of your company. An overwhelming majority of smaller companies are not ready, willing, or able to spend millions of dollars to purchase a competitor. There are exceptions, but in general, only mid-sized and larger companies grow through acquisitions. Be particularly wary of smaller companies with revenue of less than $10 million per year that contact you. Why? Smaller companies tend to be busy putting out fires and chasing the next big customer rather than proactively creating a team focused on developing and executing an acquisition strategy. While these deals do sometimes happen, the ideal corporate buyer will generate at least $10 million per year in revenue and be at least three times your size. If your company generates $5 million per year in revenue, for example, the ideal buyer should generate at least $15 million annually in revenue.

Process for Targeted Campaigns

When Morgan & Westfield conducts a targeted campaign, we first work with the seller to prepare a list of potential buyers, including corporations and competitors. It’s helpful if you prepare a preliminary list of companies you believe may be suitable candidates. You know your industry best and are in the most suitable position to compile the initial list. Your broker can then expand the list and research contact information for any companies you have provided or that they have discovered. I recommend first researching direct competitors, then any indirect competitors, and finally any companies in related industries.

The preferred size of the list depends on the type of business and your industry. An ideal roster should include at least 50 to 100 names. Smaller lists may sometimes be sufficient if the interest level of the names on the list is high or if the companies have aggressively pursued you in the past.

Your broker will then send the buyers a “teaser” profile on your company to pique their interest. The teaser usually contains a non-disclosure agreement to sign if the buyer would like to receive more information on your company. The confidentiality of your business is maintained throughout the process as the teaser profile doesn’t disclose your company’s identity. 

Targeted Marketing in Publications 

An alternative to approaching buyers directly is marketing in publications such as trade magazines.

Here are the types of publications that might be suitable for marketing your business:

• Trade publications
• Other publications that target potential buyers for your business, such as medical journals for a medical-related business
• Online blogs or forums
• Any other publication whose readership consists of your target market

How much do most publications charge? 

This varies considerably depending on the industry and the publication. Rates can range from as low as $50 to as much as thousands of dollars for highly targeted national publications.

Can this be combined with other marketing methods? 

Yes, I recommend marketing some businesses using multiple methods.

Do you always recommend this approach? 

No, this strategy is generally only required for highly specialized businesses.

What kind of responses are expected? 

This varies greatly depending on the publication and its readership, so this is difficult, if not impossible, to predict.

If they’re not coming to you, you may need to go to them.

If Google is within reach, search for “businesses for sale.” What you’ll get in return in a fraction of a second is a myriad of web portals that exclusively list opportunities for prospective owners of small and mid-sized businesses.

These sites are the most effective means of marketing smaller firms for sale. And because these portals are frequented by your competitors and private equity firms, they also attract qualified buyers of medium-sized businesses. 

Never has it been so easy and efficient to reach potential buyers. But online business-for-sale web portals are a double-edged sword. While they make the process of selling a business easier and more convenient for sellers, they also open up opportunities for buyers. Because buyers have more options and access to more information, they are now more selective and educated. 

The success rate is impacted by two things: 

1. The attractiveness of your business.
2. The proper use of the web portal tool, including writing effective ad copy. 

On average, most of the businesses we sell through Morgan & Westfield receive 3 to 5 qualified responses per month. The most effective ads receive more than 10 to 20 responses per month. A slow ad receives 1 to 2 responses per month. 

Variables That Impact the Response Rate

You can tinker with several variables in your marketing strategy that can dramatically change the quantity and quality of buyers that show interest. Here is a description of the most critical variables.

Variable 1: SDE or EBITDA

Higher EBITDA or SDE equals more responses. Cash flow is critical to buyers. More than all other factors combined, cash flow determines how many responses you receive. My observations have shown that ads for businesses with lower cash flow multiples receive up to 10 times more responses than those with higher multiples. 

Variable 2: Asking Price

• Most portals require a specific price, so listing a range is not an option.
• At specific price points, buyers will have different levels of experience or sophistication. 
• A higher price point indicates a larger, more established business, and the buyers tend to be more sophisticated. 
• For businesses with lower asking prices, be prepared to deal with a more unsophisticated buyer pool. 

The asking price can significantly impact the number of responses because of the supply-and-demand principle. There are more businesses for sale in lower price ranges than in higher ones. Additionally, there are more buyers with $1 million cash than $10 million cash. 

Sophisticated buyers tend to conduct extensive research before deciding which business to buy. A sophisticated buyer may look at 100 to 300 or more companies for every acquisition they make. For example, a buyer of a $500,000 business may look at 20 other businesses for sale, whereas a buyer of a $10 million company may research and contact more than a hundred companies.

Businesses priced below $1 million tend to receive a fair number of financially qualified buyers. For businesses priced above $5 million, the higher the price, the more financially qualified and sophisticated the buyers tend to be.

Variable 3: Ad Title

The ad title is critical. The title of your ad should catch buyers’ interest and pull them in. I recommend tweaking and updating the ad title every 30 to 90 days. A revised ad title can double or triple the number of responses. Using a new or different ad title makes your business appear as a new listing on the portals and pushes it back to the top again. A revised title may spark interest from a buyer who merely glanced over it the first time around. 

For certain businesses, a simple title may work best. For other unique or esoteric businesses, a catchy title might be the most effective. 

An effective title can increase the number of responses by 100% to 500%. I recommend using a catchy, yet descriptive ad title. The idea is to catch the interest of qualified buyers. While the title shouldn’t be misleading, its primary goal is to induce qualified buyers to read your ad. Think about the unique aspects of your business and include them in the ad. This may take some consideration, but every business has something unique or special worth mentioning. 

The most effective ads receive more than 10 to 20 responses per month. A slow ad receives 1 to 2 responses per month.

Some successful ad titles I have used in the past include:

• Profitable B2B Marketing Company With 90% Repeat Clients
• High-Margin Service Company With Repeat Customers
• Profitable Coupon Business With Recurring Revenue
• Profitable B2B Niche Service With 70% Repeat Clients
• Rapidly Growing Home-Care Business
• Coastal Lifestyle Business
• Highly Profitable Non-Medical Home Care
• High-Growth Niche Metallizing Company
• Half-Century Old Niche B2B Service Business

Variable 4: Location

A business advertised for sale in Los Angeles County or Chicago will receive more activity than one for sale in a remote town in South Dakota. If it makes sense, market your business for sale in the nearest large metropolitan area. I suggest considering different markets when advertising your business for sale. For example, if your business is in a small city located two hours outside of Chicago, I suggest marketing it directly in Chicago. Businesses advertised in or near larger cities or metropolitan areas receive more traffic, and therefore more inquiries. 

Variable 5: Ad Copy

Confidentially marketing your business for sale is best done using nondescript copy to ensure your sale remains confidential. Ad copy that is intentionally vague will describe your business in generic terms and not disclose its identity. It wants to be descriptive enough to generate interest, but lacks the specifics for anyone to be able to identify your business. 

Most web portals display a limited portion of the ad copy, perhaps only two to three lines, before you click on the ad to view the full details. If you have a story, tell it in as few words as possible because space is limited here.

Passion + interesting + exciting = increased buyer response. Describe your business with passion. Don’t just list its mundane features. Your ad should highlight the benefits and interesting aspects of your business. It should sound exciting and point out the compelling features of your business, such as location or how the products and services you offer are unique. 

Use the ad to briefly describe what your business does and why it’s an attractive investment. Put yourself in the buyer’s shoes – what would catch your attention? What do you like the most about your business?

I recommend experimenting with different text in the ad copy. The ad copy needs to be crisp, concise, and on point to increase responses to your ad. While longer ads receive fewer responses, they tend to attract a more qualified buyer in terms of interest. The key is balance – there should be a balance between quantity and quality.

Describe your business with passion.

Variable 6: Financing

Financing will be an important consideration for most buyers, so how you address this topic in your description can impact how many potential buyers consider your business.

• Seller Financing: Buyers love sellers who are willing to finance a portion of the sale. I’ve consistently found that ads for businesses for sale that offer seller financing receive significantly higher responses.
• Small Business Administration (SBA)/Bank Financing: Businesses that have been pre-approved for SBA financing also receive more responses because they require a lower down payment and therefore generate a higher cash-on-cash return for the buyer.

Variable 7: Industry

On most portals, you can decide what category or industry to position your business in, such as health care, tech, retail, service, or manufacturing. The categories are usually broken down by industry type. 

The category should be carefully selected. For highly specialized businesses that can be sold to an industry outsider, it may make sense to position the business in broader categories outside of your industry that are more popular than your niche. I also recommend positioning your ad in multiple categories if it’s allowed, which exposes your business to a wider range of buyers. 

Variable 8: Annual Revenue

Buyers assign more importance to a business’s EBITDA or SDE than to its revenue, as margins vary widely from industry to industry. In fact, some business-for-sale portals no longer display the gross revenue on the search results. Gross revenue, however, still appears in the text, but is visible only after a potential buyer clicks on the ad to view the details. 

Increasing the Number of Responses

Consider the following:

• Include your SDE or EBITDA in the ad.
• Price your business reasonably.
• Develop a short, catchy title.
• Market your business in a nearby sizable metropolitan area, if possible.
• Write a concise ad with a bulleted list of the highlights.
• Offer seller financing or have your business pre-approved for SBA financing.
• Reposition your business in multiple categories, or occasionally switch categories.

You should also consider updating your ads to increase the response rate. A fresh ad and revised marketing tactics often lead to more successful results for the following reasons:

• Reposting the ad with a new ad title and image makes your business appear as a brand-new listing. This leads to responses from people with whom you have not yet connected.
• Repositioning the ad under new categories will also expose your business to a new subset of buyers who have not yet seen your company.
• Removing your original ad and posting a new one will push it to the top of the list again.

You have determined the group of buyers most likely to buy your company and most likely to pay the highest price. Now, which is the right tool to use to target those buyers – a fishing rod or a rifle?

A fishing rod involves casting a line, dropping the bait, and waiting for a nibble. In the world of selling a business, the “fishing rod” approach entails confidentially marketing your business for sale using various media, including online media, trade publications, newspapers, and others. This is a passive approach in which you patiently wait like a fisherman for a fish to take the bait.

Selling a business with a rifle, on the other hand, involves knowing exactly who your target is, tracking them down, confronting them directly, and firing an accurate shot right at the bullseye. Selling a business with a rifle is an active, involved process that requires planning, discipline, accuracy, stealth, and confidentiality. These factors also make it costlier and more time-consuming.

In some cases, you can use both. But keep in mind that you usually fish for small creatures such as bass, salmon, tuna, crappie, and trout, while you hunt for larger beasts, such as deer, elk, bison, and moose. It’s no different in the M&A world.

Let’s go hunting! Or fishing. Or both!

Small businesses – those with annual revenue of less than $1 million to $5 million – are almost exclusively purchased by individuals and are not usually acquired by companies. This is why fishing is the more suitable tactic for attracting these buyers. And because companies and private equity firms are more likely to be buyers of mid-sized businesses, hunting is the preferred approach in these instances. 

Next, you must figure out the most efficient way to contact your targeted market. Do you hunt them down directly? Or, is it more effective to advertise your business for sale in a form of targeted media that reaches those who are actively looking for businesses to buy?

In this section, I walk you through how to design a marketing strategy to best reach the buyers most likely to purchase your business.

Ready? Let’s go hunting! Or fishing. Or both!

What’s the most efficient method for contacting buyers?

• Small Businesses: Because the target market for small businesses is primarily individuals, the most efficient and cost-effective method of contacting those buyers is through targeted forms of media, in which those individuals have identified themselves as potential buyers of businesses. In other words, fishing. This group of people has already been corralled for you, thus making the process more efficient and therefore cost-effective.
• Mid-Sized Businesses: On the other hand, the most effective method for selling a mid-sized business – and for contacting companies and private equity firms – is through a mix of hunting and fishing. 

When to Fish vs. Hunt

When to Fish

The most cost-effective method for selling a small business is by confidentially marketing the business on specialized business-for-sale portals or other targeted media. 

Individuals can only be cost-effectively targeted through advertisements. It wouldn’t be realistic to directly contact – or hunt – individuals to purchase your business.

When to Hunt

Hunting for buyers is only practical for selling a business that is likely to be purchased by a financial buyer, strategic buyer, or industry buyer.

When hunting, you should only approach those targets that are ready, willing, and able to take action. You will know this by researching the company and determining how many acquisitions it has made in the past. The more companies it has purchased recently, the more likely it will buy another company.

An overwhelming majority of smaller companies aren’t ready, willing, and able to spend hundreds of thousands or millions of dollars to purchase a competitor. There are exceptions, of course, but in general only mid-sized and larger companies grow through acquisitions.

Importance of Size

When hunting, does company size matter?

Be particularly wary of smaller companies with revenue of less than $5 million to $10 million per year that contact you to purchase your company. Smaller companies don’t regularly acquire other companies. Why? Because they are too busy putting out fires and chasing the next big customer to be proactive enough to create a team focused on developing and executing an acquisition strategy.

Smaller companies typically grow organically by slowly increasing their marketing and advertising budgets. Most of them are in a state of disorganized chaos, as noted above. They don’t have large enough cash reserves to pursue acquisitions as a growth strategy. Attempting to sell your business to smaller companies is, therefore, an ineffective strategy that can waste an enormous amount of time and risk a leak in confidentiality. 

Larger Companies and Business Deals: Size Does Matter

The primary criteria larger companies use to determine if an acquisition makes sense is EBITDA. These companies are usually looking for a minimum EBITDA of $1 million.

Why? The answer is simple – it takes just as much time to do a $1 million deal as it does to do a $25 million deal. Also, the professional fees involved in the acquisitions are similar, regardless of the size of the transaction. As a result, the percentage of fees decreases as the deal size increases, so it’s more cost-effective to complete larger acquisitions.

For example, a $1 million deal may command fees and expenses of $50,000, or 5% of the total transaction size, while a $25 million transaction may command fees of $150,000 to $300,000, or 0.6% to 1.2% of the total transaction size. This means that the percentage of fees and expenses decreases as the size of the transaction increases. Doing larger deals is, therefore, more cost-effective.

A company must invest in 25 businesses – each having an EBITDA of at least $1 million per year – to have the same impact as buying a single company with an EBITDA of $25 million. So, buying larger companies is more efficient, both from a cost and time perspective.

Key Points

• When selling your business, first determine the type of buyer most likely to buy your business.
• If your target buyer is an individual, then fishing will be the most practical strategy for selling your business.
• If your target buyer is a company, then hunting will be the most practical strategy for selling your business.

It takes just as much time to do a $1 million deal as it does to do a $25 million deal.

The reasons companies make acquisitions vary widely and can be difficult to discern. Nonetheless, common patterns do emerge, and it’s possible to draw generalizations that assist in prioritizing your value drivers.

Why does that matter?

Knowing the reasons behind an acquisition will help you develop the most suitable marketing strategy for selling your company.

Larger companies acquire smaller companies because smaller companies are more innovative.

Why Companies Make Acquisitions

Spurs Innovation

Small businesses are more innovative than big businesses. Most innovation occurs in small start-ups as they are more agile and willing to take greater risks. Larger companies acquire smaller companies because smaller companies are more innovative – most innovations are created in small companies and then brought into the mainstream by larger companies. 

Examples include Uber and Lyft unseating much larger competitors in the $40 billion taxi industry, Airbnb making a significant dent in the $570 billion global hotel industry, or Netflix dominating the $100+ billion TV industry. 

Increases the Odds of Success

Companies make acquisitions because it’s difficult, if not impossible, for companies to predict winners in product launches, partnerships, strategic alliances, or acquisitions. By completing a large number of acquisitions, a company can increase its odds of success. To counter the low odds, competitors establish corporate investment funds to make either majority or minority stakes in a large number of upcoming start-ups. The majority of well-established tech companies have large, dedicated teams who are exclusively devoted to making acquisitions. Note that I said acquisitions, not an acquisition. Companies attempt to defy the odds by completing a series of acquisitions, as opposed to relying on a single acquisition.

Reduces the Chance of Failure

In 2018, Jeff Bezos told his employees, “One day, Amazon will fail.” To think that the founder and CEO of a nearly $2 trillion company expects to fail highlights the dynamic changes that have taken place in business since the tech revolution began less than one generation ago. Large companies have high failure rates. They often have too many resources. Losses are huge when an innovation at a large company fails. By acquiring other companies, large businesses reduce their long-term chances of failure.

Specific Reasons a Company May Acquire Your Business

Access to Technology

With superior distribution networks, a large company can scale a solution out to the masses at a much faster clip than a small start-up with a limited marketing budget and sales team. By widening the acquirer’s product suite, the company provides a broader range of solutions to its customer base and will likely lower customer attrition and improve retention. 

But, it isn’t just access to technology – rather, it’s access to technology that has been validated by the market. Companies look to the ultimate decision-maker – the customer – to determine the potential success of a product. 

Access to Markets

Other companies acquire a business as a fast entryway into a different geographic or customer market segment. For example, a software company in the restoration construction space could acquire a software company in the industrial construction sector. One of the objectives of the acquisition would be to gain quick access to the customer base, and gain immediate reputation and credibility in the industrial sector. Such a move could allow it to roll out its existing suite of products or services to the customer base of the company it purchased in the industrial segment. Without the acquisition, the company may have a difficult time making the leap from one industry to another, so the acquisition shortcuts the leap and mitigates the risk associated with doing so.

Access to Customers

A major objective for some companies is access to strategic customers. Perhaps a company has made countless futile attempts to gain access to blue-chip customers in their industry, and their attempts have been in vain. An acquisition would be a guaranteed method of gaining those customers if a competitor they purchase has existing relationships with those customers.

Roll-Ups and Multiple Expansion

Finally, a large, well-capitalized competitor may go on an acquisition frenzy, acquiring multiple small competitors and rolling them up into one large entity with the goal of consolidation and expanding the multiple of their company. This plan of multiple expansion is important because the larger the EBITDA, the higher the multiple will be when the business is sold. 

If the buyer is a financial buyer, they start by purchasing a platform company, which is typically a company generating a minimum of $20 million in annual revenue. They will then complete a series of small, tuck-in acquisitions to round out the capabilities of the platform company by adding customers, technology, and other products to their lineup. 

In roll-ups, consolidation is rapid, and premium pricing is temporary. If you don’t sell, you will be left to compete with the consolidated entity, which will have much more resources than you – including a larger sales force, stronger brand awareness, and premium pricing. Roll-ups are a great time to sell if this is occurring in your industry.

Diversity of Acquisition Strategies and Corporate Development

Acquisition Strategies Are Diverse

Even though the reasons for making an acquisition may be similar from company to company, acquisition strategies vary significantly from company to company. 

Some companies, such as 3M, acquire hundreds of small companies at early stages and therefore lower valuations. Other companies wait for significant customer validation before considering an acquisition and end up paying higher premiums. 

Corporate Development Strategies Are Diverse

Acquisitions are one of many corporate development strategies for companies. Well-funded companies establish strategic corporate development plans to supplement their strengths and mitigate their weaknesses. Corporate development plans include many strategies, such as:

• Internal research and development 
• New product development
• Partnerships
• Joint ventures
• Licensing
• Strategic alliances
• Mergers and acquisitions
• Divestitures and carve-outs to offload unprofitable business segments

In business, where there are no guarantees of success, a strategic corporate development plan is designed to maximize a company’s possibility of long-term success. M&A is one of many strategies in a company’s corporate development plan. 

How Reasons for Acquisitions Relate to Business Value

While reasons for acquisitions vary, focus on detecting common patterns in your industry that will help you prioritize which buyers to focus on. M&A is only one weapon used within corporate development, but the aim of corporate development is universal – to maximize company value. By understanding your competitor’s strategy and objectives, you can take concrete steps to target buyers most likely to pay maximum value for your company.

Conclusion

This chapter has covered a lot of ground about buyers and how to reach them. Keep in mind the four types of buyers:

• Individual
• Financial
• Strategic
• Industry and competitors

Once you have identified your most likely type of buyer, narrow down your approach to reach them directly. Consider the goals each type of buyer is likely to have. Understanding their goals, and identifying how you can help them achieve their goals, will help you ultimately sell your business. This leads us to the next area to focus on – marketing your company for sale.

In some industries, selling to a financial or strategic buyer may not be an option, so your best bet may be to sell to a direct competitor. Or, your business may be so specialized that only a competitor would purchase it.

There is a fine line between industry buyers and strategic buyers. Strategic buyers realize synergies from acquiring your company, whereas industry buyers can easily replicate what your company has to offer and realize no synergy as a result of the acquisition.

Goals

Industry buyers are often seen as the buyer of last resort because they usually pay the lowest price. These buyers know the industry well and are not willing to pay for goodwill. The value of your company lies in what the buyer can’t easily recreate. 

For example, if you want $10 million for your business and the buyer could achieve the same level of revenue by investing $3 million into marketing, they will not buy your company if it costs more than $3 million.

Considerations

Selling to industry buyers carries an additional risk – a potential leak in confidentiality. Approaching direct competitors is risky, and the word will inevitably get out. Once it does, competitors are likely to use this against you and may attempt to poach your customers or employees. This can further undermine the value of your company and may also kill a deal you are currently negotiating.

Tips for Dealing With Industry Buyers

When dealing with industry buyers, I recommend the following:

• Hire a Professional: Having a professional negotiate on your behalf can help your bottom line. These buyers will often initially offer a low price. They will only increase their bid if they believe there may be competition to purchase your company. 
• Build Value: You want to build value in your company that can’t be easily replicated by a competitor. This includes intellectual property, such as patents, trademarks, trade secrets, recognized brand name, as well as long-term customer contracts.
• Maintain Confidentiality: Carefully track the release of your confidential materials. Serialize your confidential information memorandum (CIM) and other documents so a leak in confidentiality can be traced to its source.
• Stay Calm: Never show any signs of desperation. If you do, this will be used against you throughout the negotiations.

Key Points

• When selling your business, keep in mind who the most likely buyer will be. 
• Consider if it’s most likely you will be approached by an individual buyer, strategic buyer, financial buyer, or industry buyer, then market your business accordingly, based on its size and individual advantages. 
• Knowing who your buyer will most likely be will help you determine the steps you need to take to prepare your business for sale, as well as determine the best marketing strategy and overall sales approach to maximize your company’s value.

Strategic acquisitions occur in nascent industries, especially those dominated by venture-capital-backed companies or “winner take all” industries, such as technology platforms or industries in which research and development (R&D) is critical to the ongoing success of a company. 

Google, Salesforce, Microsoft, Apple, PayPal, and many other technology companies are perennial acquirers. Once nascent industries mature, companies make acquisitions to eliminate competition, such as Facebook’s acquisition of Instagram and WhatsApp, PayPal’s acquisition of Braintree, Google’s acquisition of Motorola, and HP’s acquisition of Compaq. In these industries, the pace of growth is so fast that companies furiously compete to become the dominant industry leader in a winner-take-all pot. 

Strategic buyers may pay a higher multiple than other buyers if they can’t easily replicate what your company has to offer. The replication aspect is a key distinction.

Goals

Strategic or synergistic buyers are often direct or indirect competitors that purchase a company as an alternative to organic growth. Strategic buyers can include competitors, customers, or suppliers who may be looking to enter new markets or acquire proprietary products, technology, or access to customers. 

These buyers have longer holding periods than financial buyers and often have no defined exit plan. They typically expect to fully integrate your company into theirs and hold it indefinitely. They may sometimes seek to acquire only your technology, intellectual property, or customer base and may plan to shut down your operations and lay off your staff after the closing. 

In an “acqui-hire,” a competitor purchases your company with the sole objective of acquiring your staff and ceases operations at closing. Acqui-hires are common in the technology sector and other sectors in which talent is scarce. 

It may make more financial sense for a strategic buyer to grow through acquisitions than to grow by creating new products and services or by acquiring new customers. 

This happens most often in mature industries. Some examples include the cellular industry with T-Mobile’s acquisition of Sprint and MetroPCS, growth in media companies such as AT&T’s acquisition of Time Warner or Walt Disney’s acquisition of Twenty-First Century Fox, and consumer products with Heinz’s acquisition of Kraft. These are examples of mature industry acquisitions in which organic growth has slowed, and the most suitable option for increasing revenues is to “buy growth.” 

Considerations

These buyers focus on the long-term fit with their companies and synergies, as well as the ability to integrate your company with theirs.

All strategic buyers will recreate whatever value you have to offer if they can do so at a lower price than it would cost to acquire your company. These companies also consider the amount of time it may take to recreate your value proposition. If the company must move quickly, it may make more sense for them to acquire your company due to the lost opportunity cost of building it from scratch. This is known as the “buy vs. build” decision.

Tips for Dealing With Strategic Buyers

When dealing with strategic buyers, I recommend focusing on these areas:

• Value Proposition: Focus on building a company whose value is difficult to replicate. If the buyer can easily replicate what your company has to offer, they are unlikely to buy it.
• Realistic Assessment: Be realistic in determining if your company is a suitable investment for a strategic buyer. Consider retaining a middle-market M&A advisor to perform an unbiased assessment of your business to determine if a synergistic buyer may be a likely candidate for your business. In my estimate, less than 5% to 10% of middle-market companies can be sold to a strategic buyer.
• Private Auction: Hire an M&A intermediary to conduct a private auction. Strategic buyers do not offer to pay for strategic value unless they are aware that other buyers are also competing to acquire your company.

Private equity is technically “equity that is private.” This is different from public equity, which is equity that is publicly held or traded. Private equity groups are the most common buyers of mid-sized companies in many industries. 

Financial buyers primarily consist of private equity firms and value a business based solely on its numbers without taking into account the impact of any synergies.

There are approximately 2,000 to 3,000 private equity firms in the United States. In addition, there are also family investment offices and other types of investors that function similarly to private equity firms.

Private equity groups raise money from institutional investors, or limited partners, and then invest these funds into private companies on behalf of the investors. The fund usually has a lifespan of 10 years, and the PE firm normally has a holding period of three to seven years for each business in which they invest. The PE firm makes a profit either from distributions it pays itself out of the company’s earnings or from selling the company at a higher price than it paid, or both.

Goals

ROI

Financial buyers are the most common buyers of middle-market companies. They focus on the return on investment, technically called the internal rate of return, or IRR, as opposed to any strategic benefits of the acquisition. 

PE firms are experts at scaling companies through creating strategic relationships, building strong management teams, and developing efficient sales and marketing programs. The end goal for many PE firms is to sell the business to a strategic buyer.

PE firms purchase a company as a stand-alone entity, and the changes they make to the business post-closing are designed to increase the value of the business. Any adjustments they make are to increase profitability and make the company more attractive to future investors. 

As a result, financial buyers analyze a company’s cash flow on a stand-alone basis, without taking into account any synergistic benefits, with the objective of enhancing the capacity to increase earnings and the value of the business over the next three to seven years. 

Price is an important consideration for these buyers because the business is typically run as a stand-alone company post-closing unless they own a similar company in their portfolio. 

PE firms don’t usually plan to integrate a newly purchased company with another company post-closing like strategic buyers do. As a result, PE firms are restricted as to the multiples they can pay, and these multiples are fairly easy to predict. The only exception to these rules is when a PE firm owns a company in their portfolio that may have some synergistic benefit for your company.

Integration

The only exception to the rules above is when a financial buyer owns a company in their portfolio that is a direct competitor of the target company. In these situations, the buyer can be thought of more as a strategic or industry buyer than a financial buyer.

Developing an exit plan is paramount if you wish to sell to a PE firm. If there is no defined exit, including a list of potential companies you can likely sell your business to in the future, it’s unlikely the PE firm will be interested in your business. The PE firm must be able to significantly increase the value of your business before they consider acquiring it. 

Most PE firms target an internal rate of return (IRR) of 20% to 30% per year, which means they must generate a return on invested capital of two to four times if they exit the investment, or re-sell your business in three to five years.

Considerations

Internal Rate of Return

PE firms use significant leverage when purchasing a company because the leverage increases their internal rate of return. 

IRR is also heavily dependent on the holding period, or the amount of time the investment is held, which is why a PE firm’s holding period is shorter than the holding period for other buyers. If leverage, or bank debt, is used to acquire your business, your business must generate enough cash flow to cover the debt service. As a result, a PE firm can’t pay more for your business than the numbers dictate.

Retaining the Management Team

Private equity firms almost always prefer to retain both you and your existing management team. After all, private equity firms are often not industry experts and will need someone to run the company post-closing. If you and your management team don’t stay to operate the business post-closing, the PE firm must bring in a team to operate it. This increases risk, and therefore lowers the value of your business.

Deciding To Sell to a Financial Buyer 

Selling to a PE firm allows you to sell a portion of your company now, thereby diversifying your risk. You can then sell the remaining portion in the future, potentially achieving a second, larger exit in three to seven years when the PE firm re-sells the business. The PE firm incentivizes you to stay involved by encouraging you to retain at least a 20% interest in the business post-closing. 

For example, you sell 80% of your shares now, which is usually enough to secure retirement, and you retain 20% of the company post-closing. The remaining 20% equity may lead to a larger exit for you than the initial 80% sale. 

Tips for Dealing With Financial Buyers

When dealing with financial buyers, I recommend the following:

• Build a Strong Management Team: Financial buyers typically require the existing management team to remain to operate the business after the closing.
• Increase EBITDA: This is the primary metric financial buyers use to value a business.

When selling your business, keep in mind who the most likely buyer will be.

High-net-worth individuals comprise a minority of the buyers of middle-market businesses, whereas corporate buyers purchase the majority of middle-market businesses. On the other hand, individuals are the primary buyers of small businesses.

Here are some statistics regarding the number of high-net-worth individuals in the world:

• There are over 14 million high-net-worth individuals with financial assets valued at more than $1 million.
• There are over 225,000 ultra-high-net-worth individuals with financial assets valued at more than $30 million. 

Goals

Income

Individuals are almost always looking to purchase an income stream. They may have recently resigned from their job or they may be unhappy in their career and want to pursue the American Dream. Many are also former entrepreneurs but their goal is the same – generate personal income.

Freedom

Studies show that people start or buy small businesses primarily so they can control their own destinies and achieve freedom. Surprisingly, the goal of getting rich falls lower on the list of reasons these individuals want to buy a business. While an individual’s primary objective for purchasing a business is income substitution, they often value freedom and the ability to control their own destinies more than getting rich.

Considerations

Risk 

For these buyers, the process of buying a business can be quite emotional. That’s because buying a business is a risky proposition that often requires parting with a substantial portion of their net worth. They may have never previously owned a business, which can make the decision even more difficult for them. 

For this reason, they often stick to less risky investments and prefer to buy businesses with proven track records. Most stick to industries with which they are familiar; however, some buyers may consider purchasing a business in an unfamiliar industry if the business can be quickly learned or if the seller is willing to stay on after the closing for an extended period to ensure a smooth transition. 

Some individuals may be former small business owners. If so, these buyers are more likely to pull the trigger than a buyer who has never owned a business because they are familiar with risks inherent in a business – especially if they have owned a business in the same or a similar industry.

Financing

Individual buyers finance the purchase of a business primarily through a combination of their own cash, seller financing, bank financing, SBA financing, or the use of their retirement funds. Most individuals acquire businesses valued at less than $10 million in transaction size. 

Tips for Dealing With Individuals

When dealing with an individual buyer, I recommend the following:

• Minimize Risk: You want to minimize any risk associated with your business. For individuals, the perception of risk kills more deals than the absence of opportunity. Retain a business broker or M&A advisor to objectively analyze your business and identify ways to make your business more attractive to these types of buyers. When I perform an assessment for a client, for example, I analyze the business as a potential investor would. I prepare a report that contains a determination of the business’s marketability, an analysis of the risks and opportunities, potential deal killers, methods of reducing risk, and a list of steps the owner can take to minimize risk in the business and maximize its value. 
• Avoid Information Overload: Don’t overwhelm the buyer with information, especially early in the process. Many individuals are nervous about making the leap into buying their own business – sending them more information or arranging too many meetings will only overwhelm them if they aren’t ready. Most serious buyers should be prepared to make an offer after the second or third meeting. If they don’t, move on.

When selling to a financial buyer, focus on building a strong management team and increasing EBITDA.

There are four broad categories of buyers of businesses:

1. Individual Buyers: These are buyers who tend to buy small businesses. Individual buyers have two primary goals – income and freedom. Their primary concerns are how risky the business is and whether financing can be obtained to purchase it. For these buyers, the process of purchasing a business can be quite emotional. For this reason, they often stick to less risky investments and prefer to buy a business with a proven track record. When selling your business to an individual, I recommend minimizing the perception of risk and avoid overwhelming them with information.
2. Financial Buyers: These buyers tend to buy small and mid-sized businesses. Financial buyers primarily consist of private equity (PE) firms and value a business based predominantly on its EBITDA, without taking into account the impact of any synergies. Financial buyers have two principal goals – generating a high return and achieving a successful exit. Their key considerations when evaluating the attractiveness of a business are the profitability, stability, and growth potential of the business and retaining the existing management team. When selling to a financial buyer, you should focus on building a strong management team and increasing EBITDA. 
3. Strategic Buyers: These are buyers who tend to buy small and medium-sized businesses. Strategic or synergistic buyers are considered to be the holy grail of buyers and may pay a higher multiple than others if they can’t easily replicate what you have to offer. Strategic buyers have longer holding periods than financial buyers and often have no defined exit plan. Most strategic, or synergistic, buyers look at the synergies your business has when they intend to fully integrate your company with theirs, so they focus on the long-term fit of your business with theirs. When selling to a strategic buyer, focus on building value that’s difficult to replicate and hire an M&A intermediary to manage negotiations and conduct a private auction.
4. Industry Buyers: These buyers tend to merge with or acquire direct competitors. If your business is asset-intensive with less-than-favorable margins, selling to an industry buyer may be the only suitable option. In some industries, selling to a financial or strategic buyer may not be an option. Industry buyers are often seen as the buyer of last resort because they usually pay the lowest price. These buyers know the industry well and may not be willing to pay for goodwill. Selling to industry buyers carries an additional risk – a potential leak in confidentiality. When selling to an industry buyer, hire a professional to negotiate on your behalf, build value that can’t be replicated, carefully track the release of confidential information, and never act desperate. 

Know your audience.