Source: MSCA Connection
Featuring Richard Jahnke, Sunbelt Business Broker
Small businesses drive the American economy. Of the estimated 27 million business in the United States, 99% fall under the U.S. Small Business Administration’s definition of small businesses (businesses with fewer than 500 employees). Most small businesses will experience a change of ownership through either a transfer of its assets or stock at some point during the life of the business. Ownership changes may be brought about by changes in market conditions, retirement, health issues, or succession to a family member or employee(s) and are often accompanied by a number of sub-issues within the overarching transaction, which sub-issues may include the disposition of real estate in some form. For many real estate professionals, it’s easy to focus in on the real estate elements of the deal and lose sight of the big picture. An understanding of the overall transaction can help you assess the issues so that you can successfully close the deal.
When you are involved in the sale and purchase of a small business, it is good practice to understand the emotions and motives that may underlie the transaction. Ownership changes for publicly traded companies on Wall Street are funded by stock trades and investment banking firms and ownership of the company is maintained by the shareholders as “absentee owners,” often without any emotional ties to the company except for motive to achieve a profit. This is not the case with small business owners, where the owners may have invested years (in some family-owned companies, generations) into building the business from the ground up. When they sell the business, it is a life-changing event. By keeping in mind, the often personal nature of the transaction, you can better understand the priorities and goals of the parties involved. In any sale and purchase, the parties have to arrive at a meeting of the minds on the value of the asset being conveyed. This can be challenging, as valuation is an art, not a science. In the real estate industry, property’s market values are often formulated by appraisers using recent sales of comparable properties to arrive at the estimated market value. This method of valuation is not easily applied to small businesses, as these transactions do not have as many comparative sales to analyze. The value of a small business is commonly based on a multiple of two to four times the “Seller’s Discretionary Cash Flow” (SDCF). The SDCF is calculated by taking the business’s pre-tax earnings and adding back those expenses not directly related to generating revenue and sales for the company, such as depreciation, interest, owner’s salary and pension, owner’s auto expense and insurance, owner’s travel and entertainment expenses. Naturally, the seller’s valuation of the business and the buyer’s valuation of the business are often quite different. In addition, small business transactions that include the disposition of real property—whether it’s the negotiation of the purchase and sale of company real estate, negotiating a new lease or an assignment of an existing lease, or some other configuration of real estate issues—may include multiple methods of valuation to account for not only the business interest but the property interest as well, which can complicate the overall valuation for the transaction and related negotiations.
Part of the challenge in selling a small business is getting the word out to the right people. Much like a real estate broker, a business broker is hired by the seller and paid a commission to market the business to the right prospects and secure a buyer. A good broker will make every prospect sign a confidentiality agreement before divulging sensitive information about the seller’s business, as the seller does not want to tip off employees, customers and competitors that the business is for sale. When a buyer wants to make an offer to purchase they will submit a letter of intent, which outlines the basic terms of the offer and buyer’s contingencies. Additional business terms that may not be addressed in the letter of intent, but will have to be negotiated by the parties, are: the scope of the assets included in the sale; the allocation of the purchase price among the assets being conveyed; the representations and warranties of the parties; indemnification and the parties’ remedies for post-closing breaches of representations, warranties, and covenants; non-compete and consultation agreements; and real estate matters.
In most deals there are multiple moving parts, many of which have their own timing structure. Real estate professionals involved in small business transactions can be surprised to discover that, unlike real estate purchase and sale agreements which are typically negotiated and executed by the buyer and seller in advance of the closing, asset purchase agreements and stock purchase agreements are often negotiated by the parties in advance of the closing but actually signed by the buyer and the seller at the closing table. In this scenario, the buyercompany’s due diligence has already been done by the time the agreement is signed and the buyer will need to coordinate the time and expense invested in the transaction to prevent incurring substantial cost on a deal that does not come to fruition.
During the due diligence period, the buyer and the seller will each evaluate the deal using their attorneys and accountants to advise them. The buyer will want his or her accountant to review the seller’s financial information, which typically includes the company’s tax returns, P&L statements, accounts receivable, collections, cost of sales, operating expenses and profitability. In addition to the buyer’s due diligence with respect to the business, if real property is involved, there will be additional due diligence with respect to the real property being conveyed or leased, as well. If bank financing cannot be procured by the buyer at the time of the purchase of the business, the seller may agree to finance the transaction. In this case, typically the buyer will make a substantial down payment and the buyer will give the seller a note for balance of the purchase price, which will be amortized over a short period with a balloon payment at the end of the term of the note. Once the buyer has had three to five years of operating history, the buyer can usually obtain bank financing and pay off the note to the seller. In these situations, the seller has a vested interest in the success of the new owner and is often paid a salary to stay on and train the new owner in the operation of the business and introduce the new owner to the company’s clients and customers.
The parties all benefit from a well-planned and executed transaction. By understanding the basic components of the sale of a small business we become better aware of potential issues and can provide thoughtful advice to our clients and customers to support them in getting the deal done.
Blog Adapted from MSCA Connection Newsletter