June 24, 2015Client Alert

A Primer on Preparing to Sell Your Business

Selling your business should be a planned event, consummated only following careful preparation. Although many businesses are sold with just a modicum of advance planning, the best results will be obtained—and the risk of a disappointing sale process avoided—if the following steps are taken.

1. Expectations

A typical sale process, involving the engagement of an investment banker or broker, can span six to twelve months, not counting some of the preliminary actions described below. The process is expensive in terms of management time, diminished focus on the business's ordinary course operations and professional fees. Owners, therefore, ought not undertake the process on a less-than-committed basis; "testing the water" oftentimes is a not a good choice.

2. Assembling the Team

The "team" includes key management personnel, professional legal and accounting advisors and an investment banker or broker. 

Careful consideration should be given to the selection of those key managers who need to become part of the team at the outset. Concerns about "loose lips" can be real and even fatal; however, certain managers—those who will eventually be part of the management presentations with final bidders—are almost always brought into the circle of trust at an early date.

Most businesses already have existing relationships with key legal and accounting advisors. However, given the fact that a business sale is oftentimes the financial culmination of the owner's career, it is prudent to candidly assess the M&A experience of the historic advisors: how will they fare when matched against their counterparts on the buyer's side?

Equally, if not more important, is the selection of an investment banker or broker. The recommended procedure is to identify perhaps three to four firms; determine both their experience with the relevant industry segment and the personality "match" (after all, you will be spending a considerable portion of your time with the related broker); and, ask each to make its formal "presentation" of capabilities, business valuation assessment, process and proposed fees in the proverbial "bake-off" held over a period of a few days. Challenge the bankers on topics such as perceived value drivers, deal risks and opportunities. By requiring formal presentations and compressing all presentations into the course of a few days, the owner will have an enhanced basis on which to compare and contrast the proposals. Specifically, the formal presentation process will engender valuable give-and-take, helping the owner determine which banker's insights and strategies will be most conducive to the successful sale process.

3. Aligning the Management's Interests and Motivations

In some situations, the key management team requires no additional incentives in order to align their personal efforts with the economic interest of the selling owner. They are loyal, personally committed to achieving the owner's goal, and there is little risk of their departure pending a sale. In many other instances, however, it is beneficial and (perhaps necessary) to create alignment. For example, management may be mobile and nervous about the prospects of a new owner, or management may either be resentful of the owner's impending riches, or confident of their own ability to strike out on their own. In these instances, the owner may decide to obtain appropriate restrictive covenants (or non-solicitation covenants, confidentiality agreements or IP assignment agreements) from the key executives. If these have not previously been obtained, it is not unusual to offer the executives a sale bonus or severance arrangement, with "stay" features included, in exchange for their covenants. We have found that a sale bonus pool, tied to a percentage of the sale proceeds helps assure that the self-interest of the management team aligns with the owner's desire to obtain the best price for the business.

Additionally, it is imperative that the owner communicates with the key executive group concerning their inclusion (or non-inclusion) as potential buyers. Ambiguity on this basic question will fester and can seriously diminish the prospects of a successful sale process.

4. Reviewing and Assessing Target Company's Financial Statements; Shaping Earnings

Three points should be kept in mind. First, most buyers draw comfort in a target company's audited, accrual-based financial statements, because that is the accounting norm by which buyers analyze a target company's performance. This is a problem for companies historically using cash basis or modified-cash basis, or those which have utilized mere compiled or reviewed financial statements. Accordingly, unless reconstructing the target's historic account statements to an accrual basis is simple and can be accomplished at the early stage of a sale process, owners may choose to convert to accrual-based statements, including an audit or at least a review, a year or two in advance of the intended sale date.

Second, owners should have forward vision. If a sale is in the not-too-distant future, efforts can be undertaken to identify the value proposition and key economic drivers; maximize Earnings Before Interest, Depreciation and Amortization (EBITDA) and cash flows, and eliminate or document "discretionary" spending which otherwise may have to be explained as an "add back" to a potential buyer. Many a target has embarked upon long-term business planning – including unnecessary cap-ex and operating costs—only to realize in a sale process that the winning bidder does not value those efforts.

Third, it is always a good practice to review and self-assess the entire key accounting principles, estimates, practices and policies employed by the target company. Not only will such self-assessment assist in the due diligence process, but it will allow the target and potential bidders to identify at an early stage any differences of opinion as to the appropriateness of the practices employed by the target company. Deals have been impacted, if not cratered, because a target's accounting policies—even though having received the imprimatur of the target's accountants—are different than those of a particular bidder or the industry within which the bidder views the target as engaging.

5. "Unwanted" Assets

Preparing for sale should also involve a review of all the non-operating assets of the target and of real estate used by the target, particularly if leased by the target's owner or her related parties. Though closely-held target companies and their owners have numerous rationalizations why non-operating assets have been acquired by the target (e.g., condos, vehicles, aircraft, excess real estate, boats, etc.), professional buyers generally abhor such baggage. They may need to be distributed to the owner pre-sale or concurrently with the sale. Such a distribution, while normally simple, can trigger tax consequences and, if there are multiple owners, can lead to inter-owner squabbles. As for operating real estate, particularly if leased to the target company by a related party, the owner should decide early on whether she wishes to remain a lessor (in which case, the lease should be reviewed and rewritten on arms-length terms) or if the real estate should be sold. If operating real estate previously leased to the buyer by a related party is to become part of the sale, it is important to restate the accounting consequences on a pro-forma basis as the accounting conversion of a lease expense to a capitalized asset with depreciation may affect the target's historic and future EBITDA.

6. Impact of Sale of Customers and Suppliers

No sale process should be seriously considered without an assessment of the impact of a sale on the target by customers and suppliers. This self-analysis is critical to properly posturing the business to bidders. Sometimes, if done sufficiently in advance, there may be a possibility of putting long-term contractual arrangements in place, which may help assure a buyer's concern about the consequence of a sale. Or, if a key customer's or supplier's reason for doing business with the target is "personal" and tied to the owner's own relationship to the customer/supplier, pre-planning might help transition some of that personal relationship to another executive who is expected to remain fully employed by the target following the sale.

7. Due Diligence; Self-Assessment

A necessary step in preparing your business for sale is conducting preliminary due diligence. This includes review of the target company's stock ledger, option grants, minute book, basic permits and licenses, among other items. Also, on a more granual level, due diligence includes review of all important contracts, leases, licenses and other agreements to ascertain the existence of anti-assignment clauses, change-in-control provision or other matters that could either require procural of third-party consents or create an economic consequence (such as, the existence of prepayment penalties in loan agreements or a provision in a key contract allowing the counter-party to change or re-price a material pricing or other term). Basic sell-side M&A due diligence also will highlight those terms in the target company's standard contracts that are likely to draw the attention of buyers who may consider such terms to be other than market.

As an owner of the target company, it will be invaluable to put yourself in the shoes of a prospective bidder to assess the "problems" your business confronts. Some of these problems may be readily apparent to the owner; others are probably unknown and unsuspected. Examples of some of these typical problems are: tax compliance issues (such as multi-state "nexus" problems); regulatory compliance deficiencies (after all, few closely-held companies have invested adequate resources to fully comply with the increasingly bewildering regulatory requirements confronting certain industries); environmental issues; employment law compliance (such as wage and hour problems, or characterization of employees as independent contractors); inadequate growth plans or inability to have delineated specific growth opportunities; management succession weaknesses; or, under-energized management teams. Buyer's due diligence will usually uncover these problems, and a credible and thoughtful response can mean the difference between a "deal killer" and a routine matter that is capable of being handled in the give-and-take of negotiations. It is far better to have self-identified these weaknesses and commenced remedial efforts, than to be caught unaware and have to justify inaction.

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