Ownership Transition — Survey Results

Mass Mutual Life Insurance Company provided the following survey results based on family-owned businesses. Although the survey was conducted several years ago, the results are still quite revealing, and still applicable.

• Four out of five companies are still controlled by the founders.
• 30% of family-owned companies will change leadership within the next five years.
• 55% of companies fail to conduct regular valuations of the company.
• 55% of CEOs who are 61 or older have not chosen a successor.
• 13% of CEOs will never retire.
• 90% of businesses will continue as family owned.
• 85% of successor CEOs will be a family member.
• 20% of family owners have not completed any estate planning.
• 55% of family owners do not have a formal company valuation for estate tax estimates.
• 60% of businesses do not have a written strategic plan.
• 48% of companies rely on life insurance to cover estate taxes.

The above survey indicates that many family businesses are not optimizing their opportunities. Their insular approach to succession, leadership, planning, etc., indicates their vulnerability for the long term. These vulnerabilities suggest that many business owners should work with professional advisors to resolve these issues. A professional intermediary is an essential member of this advisor group.

An Update on Earnouts

New accounting rules may require that acquirers and acquiring companies report earnout agreements as liabilities.

Joel Johnson, president of Orchard Partners Inc., in his article, “Earnouts,” published by Valuation Strategies, states: “In a given year, 2% – 3% of announced mergers and acquisition agreements involve earnouts.  These figures probably understate their prevalence.  Earnouts tend to be a characteristic of smaller deals; and in many small deals, terms are not announced.  Earnouts are rare when public companies are acquired and more common when ownership is concentrated among a few shareholders.”

This would mean, if implemented, that earnout agreements must have a value placed on them for accounting purposes. As Joel Johnson points out, “The higher the earnout, the greater the liability.”

Why the Earnout?

Johnson further states that earnouts are used for various reasons:

1. to bridge the pricing gap between the seller who places a heavy emphasis on the company’s projections, and the buyer who places most of the company’s value on its present and past performance.
2. to tie the acquisition payout to future performance.
3. to create a form of seller financing in that some of the buyer’s purchase price is delayed into the future. 4. to establish a form of escrow account in that the money is paid on condition of meeting certain thresholds.
5. to act as a type of employment agreement in that the CEO has to stick around in order to collect.

Remember: It Is Not Always the Price

The following are situations where the price was not the deciding issue in the successful sell of a business. The ultimate buyer may be the only one who really understands the situation. A business intermediary really understands the issues and can lead the buyer and seller to a successful resolution.

• One seller had 60 shareholders who needed to walk away from the deal.  The losing buyer wanted all selling shareholders to be accountable for the “reps and warranties.”  The winning buyer waived the reps and warranties at closing.

• A seller’s management team wanted some future upside in the deal.  The losing buyer offered all cash and normal compensation.  The winning buyer offered 80% cash, 20% stock plus 3-year earnout on revenues — including acquisitions.

• Time was of the essence.  The losing buyer needed 30 day due diligence and negotiations plus a 60-day window to close the deal.  The winning buyer offered to close within 40 days of the Letter of Intent and agreed to have limited due diligence.

The Three Ways to Negotiate

Basically, there are three major negotiation methods.

1. Take it or leave it. A buyer makes an offer or a seller makes a counter-offer – both sides can let the “chips fall where they may.”

2. Split the difference. The buyer and seller, one or the other, or both, decide to split the difference between what the buyer is willing to offer and what the seller is willing to accept. A real oversimplification, but often used.

3. This for that. Both buyer and seller have to find out what is important to each.  So many of these important areas are non-monetary and involve personal things such as allowing the owner’s son to continue employment with the firm.  The buyer may want to move the business.

There is an old adage that advises, “Never negotiate your own deal!”

The first thing both sides have to decide on is who will represent them.  Will they have their attorney, their intermediary or will they go it alone?  Intermediaries are a good choice for a seller.  They have done it before, are good advocates for their side and they understand the company and the seller.

How do the parties get together in a win-win negotiation?  The first step is for both sides to work with their advisors to settle on the price and deal structure positions.  Both sides should be able to present their side of these issues.  Which is more important – price or terms, or non-monetary items?

Information is vital to a buyer.  Buyers should keep in mind that the seller knows more about the business than he or she does.  Both buyer and seller need to anticipate what is important to the other and keep that in mind when discussing the deal.  Buyer and seller should do due diligence on each other. Both buyer and seller must be able to walk away from a deal that is just not going to work.

Bob Woolf, the famous sports agent said in his book, Friendly Persuasion: My Life as a Negotiator, “I never think of negotiating against anyone.  I work with people to come to an agreement.  Deals are put together.”

Due Diligence — Do It Now!

Due diligence is generally considered an activity that takes place as part of the selling process. It might be wise to take a look at the business from a buyer’s perspective in performing due diligence as part of an annual review of the business.  Performing due diligence does two things: (1) It provides a valuable assessment of the business by company management, and (2) It offers the company an accurate profile of itself, just in case the decision is made to sell, or an acquirer suddenly appears at the door.

This process, when performed by a serious acquirer, is generally broken down into five basic areas:

• Marketing due diligence
• Financial due diligence
• Legal due diligence
• Environmental due diligence
• Management/Employee due diligence

Marketing Issues
It has been said that many company officers/CEOs have never taken a look at the broad picture of their industry; in other words, they know their customers, but not their industry.  For example, here are just a few questions concerning the market that due diligence will help answer:

• What is the size of the market?
• Who are the industry leaders?
• Does the product or service have a life cycle?
• Who are the customers/clients, and what is the relationship?
• What’s the downside and the upside of the product/service?  What is the risk and potential?

Financial Issues
Two important questions have to be answered before getting down to the basics of the financials: (1) Do the numbers really work? and (2) Are the seller’s claims supported by the figures?  If the answer to both is yes, the following should be carefully reviewed:

• The accounts receivables
• The accounts payable
• The inventory

Legal Issues
Are contracts and agreements current? Are products patented, if necessary?  How about copyrights and trademarks?  What is the current status of any litigation?  Are there any possible law suits on the horizon? What would an astute attorney representing a buyer want to see and would it be acceptable?

Environmental Issues
Not too long ago this area would have been a non-issue.  Not any more!   Current governmental guidelines can levy responsibility regarding environmental issues that existed prior to the current occupancy or ownership of the real estate.  Possible acquirers – and lenders – are really “gun-shy” about these types of problems.

Management/Employee Issues
What employment agreements are in force?  What family members are on the payroll? Who are the key people?  In other words, who does what, why, and how much are they paid?

Operational Issues
The company should have a clear program covering how their products are handled from raw material to “out the door.” Service companies should also have a program covering how services are delivered from initial customer contact through delivery of the services.

The question is, do you give your company a “physical” now, or do you wait until someone else does it for you – with a lot riding on the line?

The Offering Memorandum

A solid, factual and compelling offering memorandum maximizes the chances of not only selling a business, but obtaining the highest possible price.  An offering memorandum is also referred to as the selling memorandum, a confidential descriptive memorandum, or simply as “the book.” The memorandum, regardless of the terminology used, must be as factual as possible, but the Executive Summary portion of it allows for a bit of “selling the sizzle.”  Most potential buyers want to know the basics of the company and of the deal right at the beginning.  What is the proposed transaction and what are some of the company highlights?  The executive summary should also contain an outline of the ownership and management structure, a description of the business, some financial highlights, a quick review of the company’s products and/or services, its markets, reason for sale and any other major items of importance.

The executive summary, then, is a quick synopsis of the items covered in the offering memorandum that should entice a prospective buyer to study the offering memorandum itself.  Here are some critical elements of the offering memorandum:

• Executive Summary
• The Company
• History of the Company
• The Markets
• The Products
• Distribution
• Customers and/or Clients
• The Competition
• Management
• Real Estate
• Financials
• Growth Strategies
• Competitive Advantages
• Conclusion
• Exhibits

“The offering memorandum should not only be a compelling document in order to capture the reader’s attention, but it should be so thorough that one should expect the potential acquirer to submit a fairly tight price range for his or her initial offer.  In short, the best offering memorandums are complete but not too long, easy to read, believably professional and show that the company has an opportunity for growth.”
    Source: The Best of the M&A Today Newsletter

Considerations When Selling…Or Buying

Important questions to ask when looking at a business…or preparing to have your business looked at by prospective buyers.

• What’s for sale?  What’s not for sale?  Does it include real estate? Are some of the machines leased instead of owned?

• What assets are not earning money? Perhaps these assets should be sold off.

• What is proprietary? Formulations, patents, software, etc.?

• What is their competitive advantage? A certain niche, superior marketing or better manufacturing.

• What is the barrier of entry? Capital, low labor, tight relationships.

• What about employment agreements/non-competes? Has the seller failed to secure these agreements from key employees?

• How does one grow the business? Maybe it can’t be grown.

• How much working capital does one need to run the business?

• What is the depth of management and how dependent is the business on the owner/manager?

• How is the financial reporting undertaken and recorded and how does management adjust the business accordingly?

Reasons to Sell / Reasons to Acquire

A January 2004 survey conducted by the DAK Group/Rutgers found the following breakdown of why businesses are for sale:

Reasons To Sell

  • Risk reduction      44%
  • Competition or market changes   41%
  • External pressures     27%
  • Lifestyle factors (age, health, etc.)   14%
  • Lack of capital      9%
  • Ownership/management issues  07%

Note: Multiple responses allowed;  Source: DAK Group/Rutgers

It is interesting to note that the top, by far, three reasons to sell are financial as is the fifth reason. The information furnished by much of the media suggests that the big reason to sell is generational – in other words, all of yesterday’s owners are now ready to retire.  According to the survey above, that motivation (included in “Lifestyle factors”) represents only 14 percent, and it  includes health and other personal issues.  The last reason, at 7 percent, might also include retirement since ownership/management could be involved with retirement issues.  Twenty-one percent of the respondents mentioned either lifestyle or ownership/management issues.  Placing these reasons at the top of the list does not justify the hype of the “baby-boomers” retiring over the next few years.

Shown, below, the reasons for considering an acquisition seem to be more obvious.  Although growth leads the list by a hefty margin, all of the other reasons could also be considered growth issues.

Reasons for Considering an Acquisition

  • Growth   72%
  • Acquire competitor  38%
  • Product diversification 37%
  • Geographic diversification 29%
  • Technology   09%

Note: Multiple responses allowed;   Source: DAK Group/Rutger

Keys to a Successful Closing

The closing is the formal transfer of a business. It usually also represents the successful culmination of many months of hard work, extensive negotiations, lots of give and take, and ultimately a satisfactory meeting of the minds.  The document governing the closing is the Purchase and Sale Agreement.  It generally covers the following:

• A description of the transaction – Is it a stock or asset sale?

• Terms of the agreement – This covers the price and terms and how it is to be paid.  It should also include the status of any management that will remain with the business.

• Representations and Warranties – These are usually negotiated after the Letter of Intent is agreed upon.  Both buyer and seller want protection from any misrepresentations.  The warranties provide assurances that everything is as represented.

•  Conditions and Covenants – These include non-competes and agreements to do or not to do certain things.

There are four key steps that must be undertaken before the sale of a business can close:

1. The seller must show satisfactory evidence that he or she has the legal right to act on behalf of the selling company and the legal authority to sell the business.

2. The buyer’s representatives must have completed the due diligence process, and claims and representations made by the seller must have been substantiated.

3. The necessary financing must have been secured, and the proper paperwork and appropriate liens must be in place so funds can be released.

4. All representations and warranties must be in place, with remedies made available to the buyer in case of seller’s breech.

There are two major elements of the closing that take place simultaneously:

• Corporate Closing: The actual transfer of the corporate stock or assets based on the provisions of the Purchase and Sale Agreement.  Stockholder approvals are in, litigation and environmental issues satisfied, representations and warranties signed, leases transferred, employee and board member resignations, etc. completed, and necessary covenants and conditions performed.  In other words, all of the paperwork outlined in the Purchase and Sale Agreement has been completed.

• Financial Closing: The paperwork and legal documentation necessary to provide funding has been executed. Once all of the conditions of funding have been met, titles and assets are transferred to the purchaser, and the funds delivered to the seller.

It is best if a pre-closing is held a week or so prior to the actual closing.  Documents can be reviewed and agreed upon, loose ends tied up, and any open matters closed.  By doing a pre-closing, the actual closing becomes a mere formality, rather than requiring more negotiation and discussion.

The closing is not a time to cut costs – or corners.  Since mistakes can be very expensive, both sides require expert advice.  Hopefully, both sides are in complete agreement and any disagreements were resolved at the pre-closing meeting.  A closing should be a time for celebration!

Seller Financing — How a Broker Can Help

Another important factor relating to the asking price is the amount of cash involved in the sale. There is an old saying that the higher the full-price, the lower the down payment – and vice-versa. The sale of almost any business involves some seller financing. The smaller the down payment, the higher likelihood of a quick sale. No seller wants to take back his or her business because the buyer wasn’t successful. On the other hand, a buyer wants to make sure that the business will not only pay for itself, but also provide sufficient income for his or her family’s needs.

What it all boils down to is that the seller wants the buyer to be successful and the buyer wants to buy a successful business. With the amount of capital required in today’s market to buy a business, sellers should feel optimistic that they are dealing with successful buyers.

A Valuable Service

Screening and qualifying buyer prospects is perhaps the business broker’s most valuable service. Business brokerage industry statistics indicate that over 90 percent of buyer prospects who call on business-for-sale ads are unqualified for some reason. The successful business broker survives by mastering qualifying and screening techniques!

Maintaining Confidentiality

Confidentiality is always a major concern. Sellers feel that maintaining confidentiality is important in safeguarding the current business. They don’t want the word to leak out to customers, suppliers, competitors – and especially the employees. This is an area where a business broker professional can be especially helpful. They use non-specific descriptions, screen and qualify buyers and require buyers to sign confidentiality agreements before showing businesses or providing specific information.

However, even under the best of circumstances, rumors can fly. There are basically two ways sellers can muffle the business-for-sale problem. The first is to explain that over the years there have been people who have inquired about whether the business might be for sale. These inquiries are unavoidable and they do happen.

The other way is to handle the matter directly and to explain that you have been considering retiring and now may be the right time. The employees, especially the key ones, should be told prior to putting the business on the market so they don’t hear the rumors second-hand. They should be told that they are very important to the business’s success and that a new owner would most likely be happy to retain them. When the sale is complete, they can be offered a bonus for helping in the process. Sellers should do whatever it takes to keep the employees from deserting the ship and keep them on deck to maintain business as usual. Once employees have been dealt with openly and fairly, they will understand that discretion will help protect their future.

The Future of the Business

Sellers may feel that they have built the platform for the future growth of the business. It is only natural for them to want to share in any extraordinary profits in what they feel they have helped create. Sometimes, if the price is low enough and it allows a buyer to purchase the business, he or she may be willing to provide some type of earn-out or royalty based on any substantial increase in sales. The professional business broker can offer advice on how to make this work for everyone. However, everyone has to agree that no one can predict the future. As mentioned earlier, the buyer is hoping to buy the future, but is not willing to pay for it.

What Buyers Think

Many buyers think that the business they buy should be able to pay for itself. They are wary of sellers who demand all cash. Is the seller really saying that the business can’t support any debt, or is he or she saying that the business isn’t any good and I want my cash out of it now, just in case?

Why Seller Financing?

Many business owners would like to receive all-cash for their business when selling. And yet they are often told that this is really not possible. Why? Most people are accustomed to financing just about everything – home, car, vacation home, even college for their children. The first question business brokers are often asked is, “How much money will I have to invest to buy that business?”

Seller financing is usually necessary because of the lack of outside financing available. Certainly, some is available, but less than 90 percent of small business sales receive outside financing when selling. If you are selling, you may be one of the few lucky ones, but the business better be absolutely perfect.

If a seller is not willing to finance the sale, many buyers suspect a problem. After all, a business should be able to pay for itself and provide a reasonable income for a buyer. A buyer then wants to know what is wrong with the business that the seller wants all cash?

Aside from this, even if a buyer has all of the necessary funds, he or she may want to spend their money on improving the business, adding equipment, building inventory, or just keep it for working capital.

Another similar issue that is raised by sellers is that, if they are willing to finance the sale, they want some outside collateral to secure the loan on their business. They want to make sure that they get all of their money – with no risk. Buyers are very sensitive about this issue. Again, they raise the point about the business being able to pay for itself. They may feel that the seller wants additional security because of concerns about the business’s ability to generate a reasonable profit. This is not a reassuring signal to the buyer. Most buyers are already using most of their capital for the down payment, and they generally are very reluctant about using their home or retirement funds for additional collateral.

The services of a business broker professional can usually provide guidance in the overall financing process. And financing is often the key to the successful selling of a business.

Financing the Business Sale — Some Questions to Answer!

Structuring the purchase of a business is an issue that should be faced early in the selling decision. Ultimately, the final structure of the sale will be determined by actual negotiations between buyer and seller, but the seller must still answer the following questions:

  • What is the lowest amount of cash acceptable from the sale?
  • Has consideration been given to paying off all unsecured creditors and a portion of the closing costs? (Both are, in most cases, the seller’s responsibility.)
  • Is there any long-term or secured debt that can be assumed by the buyer? (This may make more cash available to the seller.)
  • What is an acceptable interest rate for the seller-financed sale?
  • Will the business be able to service the debt and still provide a return acceptable to a buyer in relation to the down payment required? (This is a particularly important question for the seller to address.)
  • What are the tax consequences of the sale?

Recent studies indicate that the more favorable the terms, the higher the price. In fact, one study found that offering favorable terms might increase the total selling price by 30 percent. A business broker professional can advise you on the all-important issue of seller financing.

The professional business broker is a good source for assistance in structuring the sale of a business. Although they are not able to provide legal advice, business brokers are the experts of preference when the arena is the business marketplace. Brokers will use their knowledge of previous sales, current market conditions, and outside financing strategies, if applicable or available.

A business generally represents a seller’s largest financial asset. How the sale is structured may mean the difference between the success or failure of the transaction. The best sale structuring will result in the best deal possible for both buyer and seller. A business broker can be the key player in accomplishing this goal.

Seller Financing: It Makes Dollars and Sense

When contemplating the sale of a business, an important option to consider is seller financing. Many potential buyers don’t have the necessary capital or lender resources to pay cash. Even if they do, they are often reluctant to put such a hefty sum of cash into what, for them, is a new and untried venture.

Why the hesitation? The typical buyer feels that, if the business is really all that it’s “advertised” to be, it should pay for itself. Buyers often interpret the seller’s insistence on all cash as a lack of confidence–in the business, in the buyer’s chances to succeed, or both.

The buyer’s interpretation has some basis in fact. The primary reason sellers shy away from offering terms is their fear that the buyer will be unsuccessful. If the buyer should cease payments–for any reason–the seller would be forced either to take back the business or forfeit the balance of the note.

The seller who operates under the influence of this fear should take a hard look at the upside of seller financing. Statistics show that sellers receive a significantly higher purchase price if they decide to accept terms. On average, a seller who sells for all cash receives approximately 70 percent of the asking price. This adds up to approximately 16 percent difference on a business listed for $150,000, meaning that the seller who is willing to accept terms will receive approximately $24,000 more than the seller who is asking for all cash.

Even with these compelling reasons to accept terms, sellers may still be reluctant. Selling a business can be perceived as a once-in-a-lifetime opportunity to hit the cash jackpot. Therefore, it is important to note that seller financing has advantages that, in many instances, far outweigh the immediate satisfaction of cash-in-hand.

  •  Seller financing greatly increases the chances that the business will sell.
  • The seller offering terms will command a much higher price.
  • The interest on a seller-financed deal will add significantly to the actual selling price. (For example, a seller carry-back note at eight percent carried over nine years will double the amount carried. Over a nine-year period, $100,000 at eight percent will result in the seller receiving $200,000.)
  • With interest rates currently the lowest in years, sellers can get a much higher rate from a buyer than they can get from any financial institution.
  • The tax consequences of accepting terms can be much more advantageous than those of an all-cash sale.
  • Financing the sale helps assure the success of both the sale and the business, since the buyer will perceive the offer of terms as a vote of confidence.

Obviously, there are no guarantees that the buyer will be sucessful in operating the business. However, it is well to note that, in most transactions, buyers are putting a substantial amount of personal cash on the line–in many cases, their entire capital. Although this investment doesn’t insure success, it does mean that the buyer will work hard to support such a commitment.

There are many ways to structure the seller-financed sale that make sense for both buyer and seller. Creative financing is an area where your business broker professional can be of help. He or she can recommend a variety of payment plans that, in many cases, can mean the difference between a successful transaction and one that is not. Serious sellers owe it to themselves to consider financing the sale. By lending a helping hand to buyers, they will, in most cases, be helping themselves as well.

What Is Goodwill?

In the practical sense, when selling a business, goodwill is all the hard work and effort the seller has put into the business over the years. When acquiring a business, goodwill is the difference between the tangible assets and the purchase price.

Goodwill value should not be confused with going-concern value. There is a big difference. One leading business appraiser has defined going-concern value as, “The premise that a business will continue to operate consistent with its intended purpose as opposed to being liquidated.” In other words, the value of a business for just being in business is the going-concern value. It has nothing to do with whether the business is profitable, “on its last legs,” or merely breaking even. Essentially, if the doors are open, a business is a going concern.

Most business owners view goodwill as good service, products and reputation. One dictionary defines Goodwill as, “A desire for the well-being of others; the pleasant feeling or relationship between a business and its customers.”

The M&A Dictionary defines goodwill as: “An intangible fixed asset that is carried as an asset on the balance sheet, such as a recognizable company or product name or strong reputation. When one company pays more than the net book value for another, the former is typically paying for goodwill. Goodwill is often viewed as an approximation of the value of a company’s brand names, reputation, or long-term relationships that cannot otherwise be represented financially.”

Some Examples of Goodwill Items

  • Phantom Assets
  • Local Economy
  • Industry Ratios
  • Custom-Built Factory
  • Management
  • Loyal Customer Base
  • Supplier List
  • Reputation
  • Delivery Systems
  • Location
  • Experienced Design Staff
  • Growing Industry
  • Recession Resistant Industry
  • Low Employee Turnover
  • Skilled Employees
  • Trade Secrets
  • Licenses
  • Mailing List
  • Royalty Agreements
  • Tooling
  • Technologically Advanced Equipment
  • Advertising Campaigns
  • Advertising Materials
  • Backlog
  • Computer Databases
  • Computer Designs
  • Contracts
  • Copyrights
  • Credit Files
  • Distributorships
  • Engineering Drawings
  • Favorable Financing
  • Franchises
  • Government Programs
  • Know-How
  • Training Procedures
  • Proprietary Designs
  • Systems and Procedures
  • Trademarks
  • Employee Manual
  • Location
  • Name Recognition

What goodwill is and how it is represented on a company’s financial statements are two different issues. For example: until recently, if a company sold for $5 million, but only had $1 million in tangible assets, the balance of $4 million was considered goodwill. Under previous accounting standards, this goodwill had to be amortized by the acquirer over a 15-year period. This especially affected public companies, since an acquisition could negatively impact earnings, thus reducing the price of its stock. One result of this was that public companies were reluctant to acquire firms in which goodwill was a large part of the purchase price. On the other hand, purchasers of non-public firms received a tax break because of the amortization.

The accounting profession recently took another look at goodwill and changed the way goodwill is handled. The reason for this was to bring accounting into today’s business world. For years, companies were built around hard assets such as heavy equipment and machinery. Many of today’s industrial giants are not really industrial at all. They are built around intangible assets such as patents, brand names, intellectual property, etc. – basically what are considered goodwill items. These businesses don’t have huge factories full of workers on assembly lines.

Some new rules or standards were created by the Federal Accounting Standards Board (FASB) and implemented on July 1, 2001. Under this change, goodwill may not have to be written off (unless it is carried at a value in excess of its real value). However, the standards now require that companies, both private and public, have their intangible assets, including goodwill, valued by an outside expert on an annual basis. The rules basically define the difference between goodwill and other intangible assets and how they are to be treated from an accounting and tax reporting standpoint. How they are treated can impact the bottom line and have tax consequences. Also, completely identifying the items that may have been combined into goodwill and establishing separate values may increase the true intangible asset basis.

The upshot of all this is that the meaning of goodwill just got more complicated. Here’s a simplification: prior to acquiring a company or placing your business on the market, you should definitely consult your accounting professional. Goodwill may still represent the hard work and effort the seller has put into his or her business over the years — it just has to be accounted for differently and in more detail.

Confidentiality Agreements

“Confidentiality Agreement – A pact that forbids buyers, sellers, and their agents in a given business deal from disclosing information about the transaction to others.”

The M&A Dictionary

It is common practice for the seller, or his or her intermediary, to require a prospective buyer to sign a confidentiality agreement, sometimes referred to as a non-disclosure agreement. This is almost always done prior to the seller providing any important or proprietary information to a prospective buyer. The purpose is to protect the seller and his or her business from the buyer disclosing or using any of the information provided by the seller and restricted by the confidentiality agreement.

These agreements, most likely, were originally used so that a prospective buyer wouldn’t tell the world that the business was for sale. Their purpose now covers a multitude of items to protect the seller. A seller’s primary concerns are to insure that a potential buyer doesn’t capitalize on trade secrets, proprietary data, or any other information that could essentially harm the selling company. A concern of the prospective buyer may be that similar information or data is already known or is being developed by his or her company. This can mean that both parties have to enter into some discussion of what the confidentiality agreement will cover, unless it is general in nature and non-threatening to the prospective buyer.

A general confidentiality agreement will normally cover the following items:

  • The purpose of the agreement – it is assumed that in this case it is to provide information to a prospective acquirer.
  • What is confidential and what is not. Obviously, any information that is common knowledge or is in the public realm is not confidential.
  • What information is going to be disclosed? And what information is going to be excluded under the disclosure requirements?
  • How will confidential information be handled? For example, will it be marked “confidential,” etc?
  • What will be the term of the agreement? Obviously, the seller would like it to be “for life” while the buyer will want a set number of years – for example, two or three years.
  • The return of the information will be specified. For example, if the sale were terminated, then all documentation would be returned.
  • Remedy for breach, or determination of what will be the seller’s remedies if the prospective acquirer discloses, or threatens to disclose any information covered by the confidentiality agreement.
  • Obviously, the agreement would contain the legal jargon necessary to make it legally enforceable.

One important item that should be included in the confidentiality agreement is a proviso that the prospective acquirer will not hire any key people from the selling firm. This prohibition works both ways: the prospective acquirer agrees not to solicit key people from the seller and will not hire any even if the key people do the approaching. This provision can have a termination date; for example, two years post-closing.

The sale of a company involves the disclosure of important and confidential company information. The selling company is entitled to protection from a potential acquirer using such information to its own advantage.

The confidentiality agreement may need to be more specific and detailed prior to commencing due diligence than a generic one that is used initially to provide general information to a prospective buyer.

Tips on Maintaining Confidentiality

  • Use a code word or name for the proposed merger or acquisition.
  • Don’t refer to any principal’s names in outside discussions.
  • Conversations concerning the merger or acquisition should be held in private.
  • Paperwork should be facedown unless being used.
  • All documents should be kept under lock and key.
  • Important data maintained on the computer should be protected by a password.
  • Faxing documents should be done guardedly.

The Anatomy of a Deal

The following might be a subtitle for this true account of how one deal was put together: “In spite of everything, you need only one buyer – the right one!” (Although the details are factual, names and financial data are fictional.)

The company (let’s call it ElectroCo) has carved a niche in a billion dollar industry. It manufactures proprietary electronic products and is owned by a private equity firm that wants to sell it for liquidity reasons. At the beginning of 2001, the private equity group retained an intermediary firm (fictional name — United Associates) to take the company to market. The goal was to have it sold by the end of the year.

ElectroCo had annual sales of about $12 million, gross margins of 50 percent, an EBITDA of $1.8 million (15 percent) and a reconstructed EBITDA of $2 million. It also had been growing over the past ten years at a 10 percent rate and had always been profitable. It had a diverse customer base split about equally between end-users and OEM accounts. However, the seller wanted to set a very aggressive full price, with all-cash in a not-so-vibrant M&A market.

On the plus side, however, the seller was cooperative and provided any information that United needed. It also had audited statements, conservative accounting and instant monthly statements. ElectroCo was, in addition to these factors, on the verge of getting a substantial amount of new business.

In preparing to take the business to market, United Associates came up with a basic game plan. For confidentiality reasons, direct competitors were eliminated from the buyer search. Synergistic buyers were targeted-either because they served similar markets or utilized similar manufacturing methods. United also elected to contact selected private equity groups and other intermediary firms.

More specifically, United planned on creating a list of 100 potential buyers. A buyer was defined as an entity that had signed a Confidentiality Agreement, had been pre-approved by the seller, and therefore, had been sent an Offering Memorandum. United anticipated 15 written Term Sheets leading to five Letters of Intent which, hopefully, would lead to the best deal. United was not sure that they could sell the business at the multiples asked by the seller. However, they succeeded, and that success was to be based on the following:

Preparing a thorough and compelling Offering Memorandum and pointing out the positive future prospects. This required the complete cooperation of ElectroCo’s management team.

  • Developing a complete list of possible buyers both in the U.S. and abroad.
  • Contacting the buyers to see if they would be interested in the company, but still maintaining confidentiality.
  • Administering all of the potential buyer activity and sending the Offering Memorandum to the appropriate parties.
  • Following up with all of the prospects who received the Offering memorandum and arranging tours of the facilities with the serious prospects.
  • Setting time frames for expressions of interest and term sheets, and fielding questions from the serious prospects.
  • Holding the deal together in spite of the tragic events of September 11th, which resulted in a two-month delay that could have been much longer.
  • Making sure that complete confidentiality was maintained and making sure that any future confidentiality leaks did not occur.
  • Constantly reminding ElectroCo’s management to stay focused on maintaining sales and profit goals.
  • Maintaining communications with both the buyers and ElectroCo’s lawyers and other outside advisors.

United was able to develop a list of 85 possible acquirers; however, five would not sign the Confidentiality Agreement. Here is a breakdown of the 85 possible buyers:

Buyer Type                  Number of Buyers
Strategic                      45
Some Synergy              20
Private Equity Groups     20

Of the 85 possible buyers, 15 were companies or divisions of firms with annual revenues of $1 billion or more. 12 of these 15 were foreign or owned by foreign companies. ElectroCo chose not to deal with four of the buyer firms due to negative industry knowledge. Two of the buyers were individuals that had financial backers. Four buyers were just “bottom fishing.” Three of the 85 decided not to move forward due to the events of September 11. One buyer only wanted to acquire assets, not the stock, of ElectroCo. Interestingly, eight of the 85 firms had previously talked to ElectroCo about a possible merger or acquisition.

Of the buyers who elected not to proceed or move forward, the majority felt that acquiring ElectroCo was just not a good fit. Some of the other reasons why other buyers decided not to continue were:

  • Management was too thin
  • Since ElectroCo was a good company, the price would most likely be too high
  • Buyer purchased another firm
  • One potential acquirer was acquired itself
  • Buying company was having its own internal problems
  • Buyer wanted to move company – this was unacceptable to the seller

After all of this, United Associates arranged five visits for acceptable buyers – the target number. Overall, United received:

  • Term Sheets 4
  • Verbal Offers 2
  • Letters of Intent 4

Of the five buyers who visited the business and met with ElectroCo’s management, two wanted to acquire the company. These were the best prospects. There were also two other firms, held in abeyance, in case one of the other two didn’t work out. One of the original two and ElectroCo’s preferred acquirer offered the desired price and terms. The buyer was:

  • A public company that wanted to grow through acquisition.
  • One with a synergistic product line.
  • Unlike some of the private equity groups, not totally focused on the financial aspects.
  • One with an appreciation of ElectroCo’s product lines, its technology and the company’s potential.

United Associates started with 85 possible buyers. The final list came down to just a few and the September 11 tragedy certainly did not help in the sales efforts. ElectroCo was not a company for just anyone. Despite all of this, United got the deal done – proving once again, that you need only one buyer – the right one!

Representations and Warranties

From the buyer’s point of view, “the critical aspect of negotiations is what is stated in the representations and warranties such that the document reflects the following:

Everything you know, you told us.
Everything you told us is true.
Everything you didn’t know, you should have known.”

Nelson Gifford, former CEO of Dennison Manufacturing Company

Both parties and their advisors must understand that Representations and Warranties are not a measure of anyone’s honesty, sincerity or integrity, but a method of allocating some of the risks inherent in any transaction. After all, buyers and sellers are entitled to all the benefits of their bargain – nothing more and nothing less.

In almost any sale of a business, the seller makes certain representations. Their purpose is to insure that the seller, and the buyer, are truthfully and accurately representing themselves and their business. These representations and warranties may focus on various legal, financial or environmental aspects of the sale such as: undisclosed liabilities, pending litigation and tax issues. Their purpose is that the seller is warranting that none of these issues will impede the closing or impact the new ownership. The purchasing entity also represents and warrants, for example, that it has the financial capability to purchase the business. These are usually included in the final agreement between the buyer and the seller. They can be as simple as the seller warranting to the buyer that there is a clear and marketable title to the business being sold. Representations and warranties can also be a lot more complicated. For example, they may not only contain a warranty or representation, but also provide for a remedy if things aren’t as stated or certain future events happen. These are much more important in a stock sale than one of just assets. In the stock sale, the buyer is assuming all of the outstanding issues, risks and, if any, future problems. The seller might warrant that there is no pending litigation and then a disgruntled customer files a post-closing lawsuit. The final agreement might state that an agreed-upon dollar amount would be set aside to cover such contingencies. This remedy is known as an indemnification. The purpose of an indemnification is to provide a solution to a breach of the representations and warranties.

Representations and warranties should be discussed and agreed upon in the early negotiations of the sale. These early discussions can clear up future misunderstandings and provide a safety net for both parties. There is probably little point in continuing negotiations if the representations and warranties can’t be mutually agreed upon at the outset. Intermediaries generally prefer to get agreement on them prior to a Letter of Intent being prepared. From a seller’s standpoint, the company should not be taken off the market prior to a general understanding of the Representations and Warranties.

They are one of the most important aspects of any final agreement. The buyer obviously wants to have as many of them, and as broad in scope, as possible. They create a sort of built-in insurance policy. The seller, on the other hand, would like there to be none, or as few, and as restricted, as possible.

Problems can develop when the buyer, for example, inserts among the representations and warranties an item that is open-ended or beyond the seller’s control. For example, the seller warrants that there are no equipment leases or equipment rental agreements other than described in Schedule F. The buyer doesn’t want to be responsible for any equipment agreements that have not been mentioned. However, the seller wants to limit the company’s exposure. Keep in mind that in privately held companies, the owner is usually responsible for any indemnification of the representations and warranties, so he or she is very concerned with them. The seller’s lawyer might limit the exposure to a dollar amount along with a time period – say three years. Or, as is most common, the buyer agrees to absorb any of the leases up to a dollar amount, anything over which the seller must cover. This means that if some equipment leases do turn-up after the closing, assuming that there has not been any fraud or deception, the method of handling them has already been covered in the agreement.

This time period on the Representations and Warranties is a big concern for sellers. The time periods for the Representations and Warranties surviving the closing can be a deal-killer in the seller’s eyes. How long should a seller be responsible for them? Obviously, this is a critical area and has to be carefully negotiated between the parties. Some that might survive the closing would be matters of litigation, insurance and employee issues. Today, an important post-closing issue can be the intellectual property that may be included in the sale. The buyer entity wants to protect itself from any attack on the ownership of the intellectual property, as it may be a key ingredient of the acquisition. By placing a cap on the dollar amount that the seller and/or his or her company is responsible for and placing reasonable time frames on this section of the agreement can usually resolve this sensitive area.

Sellers often want to couch their Representations and Warranties by using the term material in them. In other words the defect must be material to be considered for any type of remedy. Some sellers even want to limit their exposure by stating that the representation is to the sellers’ best knowledge. Experts feel that the buyer is buying the business and anything that makes the deal riskier threatens the sale. The seller’s claim that to the best of his knowledge there is no other litigation, except that stated on Schedule K, doesn’t provide the buyer the protection that he or she needs. Since the words material or sellers’ best knowledge might be considered vague or ambiguous, placing dollar limits can usually resolve them.

What all this means is that the Representations and Warranties are a big part of the deal. They should not be left to the last. Many sales have fallen apart because a Representation or Warranty and Indemnification were just not acceptable to the seller, or to the firm’s board of directors. The buyer’s due diligence should uncover many of the issues that will be subsequently incorporated in the agreement as Representations and Warranties, and be addressed prior to the drafting of the agreement. The drafting of them should be left to the pros.

Too many deals have fallen apart, or been delayed, because the buyer or his advisors decided, at the last minute, to insert a “surprise” representation or warranty, that the seller not only did not agree to, but had not even seen – causing the seller to become disillusioned with the buyer. Representations and Warranties should be discussed early in a transaction, perhaps be part of the deal structure items, and any changes after the due diligence period disclosed (or proposed) well before the final draft of documents is circulated.

Note: The above article is not intended to provide legal advice. It is designed merely to offer some insight into the subject of Representations and Warranties. For more information, the reader is advised to consult an attorney, intermediary or other competent advisor.

“Red Flags” in the Sunset

Unlike that poetic title of an old-time standard song, Red Sails in the Sunset, red flags are not a pretty sight. They can cause a deal to crater. Sellers have to learn to recognize situations indicating there might be a problem in their attempt to sell their business. Very, very seldom does a white knight in shining armor riding a white horse gallop up, write a large check and take over the business – no questions asked. And, if he did, it probably should raise the red flag – because that only happens in fairy tales. Now, if the check clears – then fairy tales can come true.

Sellers need to step back and examine every element of the transaction to make sure something isn’t happening that might sink the deal. For example, if a company appears interested in your business, and you can’t get through to the CEO, President, or, even the CFO, there most likely is a problem. Perhaps the interest level is not what you have been led to believe. A seller does not want to waste time on buyers that really aren’t buyers. In the example cited, the red flag should certainly be raised.

A red flag should be raised if an individual buyer shows a great deal of interest in the company, but has no experience in acquisitions and has no prior experience in the same industry. Even if this buyer appears very interested, the chances are that as the deal progresses, he or she will be tentative, cautious and will probably have a problem overcoming any of the business’s shortcomings. Retaining an intermediary generally eliminates this problem, since every buyer is screened and only those that are really qualified are even introduced to the business.

Both of the above examples are early-stage red flags. Sellers have to be focused so they don’t waste their time on buyers that are undesirable. If a buyer appears to be weak, does not have a good reason to need the deal, or is otherwise unqualified, the red flag should be raised because the chances of a successful transaction are diminished. The seller might seriously consider moving on to other prospects.

Red flags do not necessarily mean the end of the deal or that it should be aborted immediately. It simply means that the seller should pay close attention to what is happening. Sellers should keep their antenna up during the entire transaction. Problems can develop right up to closing. Here is an example of a middle-stage red flag: The seller has received a term sheet from a prospective buyer and is then denied access to the buyer’s financial statements in order to verify their ability to make the acquisition. As a reminder, a term sheet is a written range of value for the purchase price plus an indication of how the transaction would be structured. It is normally prepared by the would-be purchaser and presented to the seller and is non-binding. A buyer who is not willing to divulge financial information about his or her company, or, himself, in the case of an individual, may have something to hide. Due diligence on the buyer is equally as important as due diligence on the business.

If a proposed deal has entered the final stages, it doesn’t mean that there won’t be any red flags, or any additional ones, if there have been some along the way. If there have been several red flags, perhaps the transaction shouldn’t have gone on any further. It is these latter stages where the red flags become more serious. However, at this point, it makes sense to try to work through them since problems or issues early-on apparently have been resolved.

One red flag at this juncture might be an apparent loss of momentum. This might mean a problem at the buyer’s end. Don’t let it linger. As mentioned earlier, at this juncture all stops should be pulled out to try to overcome any problems. If a seller, or a buyer, for that matter, suspects a problem, there might very well be one. Ignoring it will not rectify the situation. When a red flag is recognized, it is best that it be confronted head-on. It is only by acting proactively that red flags in the deal can become red sails in the sunset – a harbinger of smooth sailing ahead.

The Confidentiality Myth

When it comes time to sell the company, a seller’s prime concern is one of confidentiality. Owners are afraid that “if the word gets out” they will lose employees, customers and suppliers. Not to downplay confidentiality, but these incidents seldom happen if the process is properly managed. There is always the chance that a “leak” will occur, but when handled correctly, serious damage is unlikely. Nevertheless, a seller should still be very careful about maintaining confidentiality since avoiding problems is always better than dealing with them. Here are some suggestions:

  • Understand that there is a “Catch 22” involved. The seller wants the highest price and the best deal, and this usually means contacting numerous potential buyers. Obviously, the more prospective buyers that are contacted, the greater the opportunity for a breach of confidentiality to occur. Business intermediaries understand that buyers have to be contacted, but they also realize the importance of confidentiality and have the procedures in place to reduce the risk of a breach. Another alternative is to work with just a few buyers. This, however, does reduce the chances of obtaining the best price.
  • Another way to avoid this breach is to try to keep a short timetable between going to market and a closing. The shorter the timetable, the less the chance for the word to get out. One way to keep a short timetable is to gather all of the information necessary for the buyer’s due diligence ahead of time. Create a place where all of this material can be consolidated. This can be as simple as a set of secured file drawers. Such documentation as: customer and vendor contracts, leases and real estate records, financial statements and supporting schedules (assets, receivables, payables), conditions of employment agreements, organization charts and pay schedules, summary of benefit programs, patents, etc. should be gathered. It is not unusual for due diligence examinations to look back 3 to 5 years, so there could be a lot of records.
  • The above means that the seller has to get organized. Selling one’s business is fraught with paperwork. Set up some three-ring binders so all of the relevant paperwork and resulting documentation has a place. These binders should be kept in a secure location.
  • The seller’s employees should be conditioned to having strange people (potential buyers) walk through the facility. One way to avoid suspicion is to arrange to have unrelated people, for example – customers, suppliers, advisors – tour the company facilities prior to placing the business on the market.
  • If sellers have not prepared their employees for strangers walking through the facilities as suggested above, awkward situations can develop. A valued employee may question why tours are being conducted. The seller is then placed in the position of explaining what is happening or covering the question with a “smokescreen.” A seller could reply by saying that the strangers are possible investors in the company. If asked directly if the business is for sale, the seller could respond by saying that if General Electric wants to pay a bundle for it – anything is for sale. Once in the selling process, it is also important to minimize traffic by only allowing serious, qualified prospects to tour the operation.
  • Keep in mind that confidentiality leaks can emanate from many sources. For example, an errant email ends up on someone else’s email. A fax gets sent to the wrong fax machine or UPS or FedEx deliveries go to the wrong people. Establish methods ahead of time on how to communicate with potential buyers or an intermediary.
  • The key to handling confidentiality may be for the seller to retain a third party intermediary. They will insist that all potential buyers sign a confidentiality agreement. They will also be able to advise the seller on how to handle the “company tours” and can insure that only qualified buyers are shown the facilities.
  • The “myth” is that confidentiality issues can make or break a deal, or cause serious damage to the seller’s business. The reality is that breaches seldom occur when an intermediary is involved, and if they do occur and are handled properly, there is little damage to the business or a potential transaction.

Does the Deal Fit?

“The most successful integrations were directed by people who placed the common good of the combined organization and its customers before all else.”

From: The Mergers & Acquisitions Handbook.

By now, most business owners are familiar with the problems created by the merger of Daimler, the German automobile company, and Chrysler, the American car maker. Here is the classic case of cultural friction adversely impacting what was originally promoted as the merger of “equals.” If any deal can point out the importance of a cultural fit in a merger or acquisition – this is it. The officers of Daimler took complete control and the executives of Chrysler left in droves. Not only were the management styles completely different – centralized versus decentralized, quick decisions versus decisions by committee, supplier rivalries versus supplier partnerships — but, in addition, the American management team received huge compensation packages, while the Daimler people worked on small salaries, but huge “perks.”

Mergers and acquisitions are supposed to produce synergies that bring results.  If they don’t, the culture is too often the reason. John Chambers, the CEO of Cisco Systems, who has been involved in some seventy acquisitions, says that he will not do a deal unless there is a cultural fit. Culture according to one dictionary is defined as the “customary beliefs, social forms, and material traits of a … social group.” The word “compatible” may be a better choice defined by the same dictionary as: “able to exist or act together harmoniously.” Regardless of the semantics, if both companies can’t work well together, the deal is a bad one. The importance of this cultural fit may be influenced by the nature of the deal and the desires of the seller. Here are some examples:

  • The seller sells the company on an all-cash basis and doesn’t really care what happens to the employees, the customers or the new owners. In other words, the seller takes the money and runs.
  • The seller receives sufficient cash that he or she is secure about the transaction. Despite this almost all-cash deal, or the quality of the security for the balance, there is serious concern for the employees and their future with the new ownership.
  • The seller merges the company and/or receives stock in the acquiring firm. Further, the seller’s compensation, to say nothing of any increase in the equity, may be determined by the success or failure of the cultural fit of the merged companies.

Obviously, in the first example, the question of a cultural fit, or any fit, for that matter, is moot. Assuming, however, that the prospective seller fits into one of the two latter situations, how does one determine the compatibility of the two firms? It may be a non-issue if the seller’s company is going to remain autonomous. Or, the acquiring firm may have been through several similar situations and is experienced in the assimilation process. These two examples do not necessarily mean that the companies will mesh perfectly, but they do help. However, if a cultural fit is of concern, what can be done to help assure an orderly blending of the two firms?

It can be as simple as the seller having a casual dinner with the owner or CEO of the acquiring or merging company. Much can be learned one-on-one about how the other company is managed and about its owner’s business philosophy. Is it based on teamwork? Is it entrepreneurial or hierarchical? Is the company customer or policy driven? If the CEO of the acquiring company is reluctant to share a social occasion, then the seller may have already received the answer to the cultural fit question.

Other areas that should be considered: how are the employees of the other company compensated? Or, for example, something as mundane as the company’s product return policy may provide insight into the successful integration of the two businesses. How far apart are the companies’ mission statements?

Absorbing smaller companies can be a lot easier than two firms of approximately the same size merging. There are few companies whose cultural styles are so similar that integration is an easy matter. In many cases, where there may not be a perfect cultural fit, proper communication can resolve most of the issues. Unfortunately, there are some situations, like the Daimler Chrysler example, in which the two companies may never be integrated successfully.

Sellers who are concerned about the right cultural fit should investigate this before the deal gets too far along and, obviously, prior to closing. An intermediary has the knowledge and experience to work with both buyers and sellers on this all-important issue. The right culture may be a “soft” issue when it comes to mergers and acquisitions, but just may be one of the most important.

Selling Your Company — Some Key Points

  • Settle all litigation and environmental issues before putting the company on the market.
  • Hire a good transaction lawyer, because the buyer will also.
  • If company owners are totally inflexible, the buyer may walk away from the transaction.
  • Be prepared to accept a lower price for lack of management depth, dependence on a small number of customers or clients, and lack of geographical distribution.
  • When a buyer indicates he or she may be ready to submit a Letter of Intent, tell them up front what items you want included. For example, price and terms; what assets and liabilities are to assumed, if an asset purchase; what contracts and warranties are to be assumed; and time schedule for due diligence and closing.  (These are just some of the items a seller might want included.)
  • Be advised that many buyers will view the value of Sub Chapter S corporations to be worth less than if the company is a C Corporation.
  • Make the company more visible by attending trade shows.  Tie up patents, copyrights and trademarks.  Create a public relations program.  These areas all create perceived value.
  • Selling a company involves sometimes-inconsistent objectives: speed, confidentiality and value – pick the two that are the most important.
  • Keep in mind that companies get stale after sitting on the shelf for awhile.
  • Don’t expect your lawyer to win every point of contention – you want a dealmaker, not a dealbreaker.