In the first part of this two-part series, we discussed the strategic planning a small business might undertake to identify potential buyers, build relationships with relevant professional service providers and manage the company to maximize enterprise value. This article overviews the mechanics of the transaction.
Begin Preparing the Company for Sale
Selling a business is undoubtedly complex, but most issues can be reduced to the buyer’s desire to acquire an asset that has a reasonably certain probability of growing profits, while eliminating as much risk to those profits as possible. The buyer also wants a transaction that will close quickly to minimize professional expenses and time invested. Sellers seek a combination of the best possible price paid in cash at closing, as opposed to an earn-out or a promissory note from the buyer, with the ability to close quickly and the least amount of post-closing liability. Although parties bring their own needs and desires to each transaction, having a general sense of each party’s goals helps frame exit planning.
Diligence: Identifying and Fixing “Deal Killers”
Potential buyers will have access to company documents, key employees and large customers to evaluate the potential acquisition. Frequently, potential buyers will review these diligence materials in connection with or immediately following the negotiation of a letter of intent. The letter of intent contains the purchase price and a summary of the terms of the transaction. After signing the letter of intent, the parties will have an exclusive period to negotiate a definitive purchase agreement during which time the buyer will scrutinize the diligence materials.
The buyer will review the business’s: (1) standing with government entities; (2) governing documents; (3) pending or threatened litigation or governmental investigations; (4) compliance with applicable laws, including environmental and employment laws; (5) licenses and permits; (6) insurance coverage; (7) budgets, debt, accounts receivable, accounts payable, financial records and tax returns; (8) material agreements, such as customer and supplier contracts, executive employment agreements and settlement agreements; (9) ownership and use of intellectual property; (10) collective bargaining agreements and labor matters; (11) physical assets, equipment and real estate; (12) policies and procedures; and (13) key vendors and customers.
This list isn’t comprehensive, and each item warrants its own lengthy discussion. However, a buyer will generally attempt to identify any liability that would jeopardize the business’s profits. The buyer will also seek to identify contractual or regulatory limits on the company’s ability to operate.
As risks are identified, the buyer may request additional information, demand the seller to fix the issue or seek various concessions from the seller. For example, buyers frequently request that the seller place a portion of the purchase price proceeds in an escrow account, which money will be returned to the buyer if certain liabilities result in losses to the buyer as set forth in the final purchase agreement. The buyer may also request a reduction in the purchase price, a specific indemnification right or simply refuse to proceed.
Often, buyers and their lenders will walk away from a deal when there are significant unresolved tax issues, including improper payments to, or use of company assets by, family members, environmental issues, significant litigation and labor and employment issues, such as worker misclassification, unfunded pension liabilities or systemic wage and hour violations.
Exit planning requires management to begin identifying and addressing a potential buyer’s concerns in advance of a planned sale. Many common issues, such as resolving environmental matters, concluding a regulatory investigation or producing audited financial statements, have significant lead times and the savvy seller won’t allow these items to become roadblocks during the sale process. Working with clients in connection with exit planning will allow them to identify and efficiently mitigate potential issues before a buyer demands a purchase price reduction or large escrow fund.
Such advance preparations can also help clients avoid being among the majority of small businesses that fail to document an exit plan and subsequently fail to sell.
Once diligence is concluded, post-closing obligations are negotiated and financing is secured, the parties close the transaction in accordance with the definitive purchase agreement. As a condition of closing, the selling party may execute a consulting or employment agreement for a transition period. The buyer may also require that the seller agree not to compete with the business.