|Gary L. McGuirk is first vice president and private wealth advisor for Merrill Lynch Private Wealth Management in Boston.
Paul J. McCauley is first vice president and private wealth advisor for Merrill Lynch Private Wealth Management in Boston.
Paul D. Broude is corporate partner at Epstein Becker & Green, P.C. in Boston.
This is a two-part series about pre- and post-deal planning. This article deals primarily with helping a business owner think about the financial considerations of the sale. The second article will address helping a business owner manage the windfall.
As an attorney, you know that from the moment a client considers starting a business, there is a tremendous amount of planning involved. It comes with the territory if the business is to be successful. When building the business, there's an assumption that it will be successful. It's founded on solid plans, good ideas and a great team. Starting and growing a business is more than a full time job. Most business founders assume that they will someday be able to sell the business for a substantial profit. But it's easy to get so caught up in starting and growing the business that the owner often doesn't plan enough for the eventual sale of the business. Just as successful business growth requires plans, ideas and teamwork, so does the sale of a business.
There are many benefits to planning ahead, especially in this market environment. Business owners thinking about a future sale should make sure a transaction team (meaning attorney, financial advisor, accountant and investment banker), focused on the needs of the seller, is on board and communicating long before the event itself.
To demonstrate that point, consider the following cautionary tale:
A business owner was approached by a publicly traded company about selling his privately held business for 1.5 million shares of the buyer's stock, worth $50 million based on the current trading price. In addition, the seller asked for and was granted a seat on the buyer's board of directors after the sale to watch over his investment. Between the time of the handshake agreement and actually sitting down at the table to draft documents, the shares increased to almost $90 million. The business owner, concerned about the stock's volatility wanted the ability to "hedge" his new stock position, protecting it from falling below a predetermined price. The acquiring company originally refused, but eventually agreed to permit the seller to hedge his shares in exchange for a reduction in purchase price of $15 million of the seller's shares.
It turned out, however, that the seller's stock was relatively young and volatile - factors that made it difficult to borrow shares in the market, which is necessary to implement a hedge transaction. As a result, the seller actually paid $15 million in a reduced purchase price for the right to enter into a hedge transaction that could not, in the end, be implemented. In addition, by accepting a board seat, the seller subjected himself to securities law limitations on the sale of the buyer's stock by insiders, significantly limiting his ability to sell shares. In retrospect, a transaction team would have considered the liquidity issues far in advance of the sale of the business, advised the seller about the ability to hedge his shares and the consequences of serving as a director, and helped develop other ways to protect the seller's interests.
Let's look at this same scenario and see what could have been done if there had been a discussion between the seller and his transaction team about selling the company long before the actual transaction occurred.
In the scenario above, the first consideration would be the volatility of the stock. When would the seller be legally and contractually permitted to sell his shares? If the shares could not immediately be sold at the current market price, could the seller borrow other shares of the buyer's stock in the market? As it turned out, that was not possible in this case, which made hedging a poor strategy. Instead, the selling team could have negotiated with the buyer for other alternatives to dispose of the seller's shares in an organized way, and other options to protect the value of the shares.
In any possible sale situation, there should be a discussion of wealth replacement, income and liquidity strategies, and the possibility of the use of hedging and derivatives before the deal, rather than after. In addition, it almost always makes sense to implement estate planning strategies well before any sale to maximize the benefit of techniques, such as a Grantor Retained Annuity Trust (GRAT) or a Family Limited Partnership (FLP). These estate planning tools can help the business owner with the efficient transfer of wealth along with his liquidity and income needs after the sale of the company.
When it comes to advising a business owner, it really is all about the competency of the team. There should be a significant amount of deal expertise at the table. The business owner has likely not been through the process of selling a business. When representing a business owner, you should make sure to advise the owner at all stages of the life of their business. The best time to begin pre-sale planning is as early as at the time of the creation of the business. Make sure to consider topics such as those below; unfortunately, many of these are often overlooked and should be considered well in advance of any discussion of sale.
Consider when starting a business:
• Choice of entity. This can affect the tax treatment on the sale of the business, and the types of financing sources the founder can use (e.g. Subchapter S facilitates assets sales and may provide tax benefits to the owner in early years when the business may lose money, but it limits the type of shareholders in the company).
• Reward and motivate employees through the use of equity to retain key people in preparation for a potential sale. The tax consequences and value of the equity to employees is typically better the earlier they receive equity in the company, even if their stock is subject to repurchase or forfeiture if they leave the company.
Consider 1-2 years before a sale:
• Resolve any problem areas such as settling any litigation or other disputes, and cleaning up the balance sheet (e.g. resolving bad debt issues).
• Think about target buyers.
• Manage profitability. The owner of a "lifestyle company" usually manages the business for minimal profits and taxes, but since valuation is always to one degree or another based upon earnings, companies for sale should be able to show a period of significant and growing earnings, to the extent possible. Sellers never receive full value for "recast" financial statements that show what a buyer would have made if the seller wasn't taking so much out of the business. By paying himself an extra $500,000 bonus in the year before a sale the seller could cost himself 5 to 10 times that amount in the form of a lower purchase price.
• Retain key employees with incentives and employment/non-compete agreements.
Consider 6 months to one year before a sale:
• Develop a list of likely interested buyers.
• Discuss types of structure (e.g. stock sale, asset sale, merger of equals, etc.) and issues such as earn-outs, security for future payments, etc.
• Make sure that the company's records and files are organized to facilitate due diligence by prospective buyers.
• Consider the seller's future role in the company. This is an emotional issue that can have tremendous financial implications, as with the example above. In addition, if the seller will have an employment contract following the sale, consider the terms carefully. Above all, the seller needs to be prepared to accept the loss of control to which he was previously accustomed.
• Consider income replacement. Once the seller leaves the business, how will he replace his salary income with portfolio income, particularly if he is bound by a non-compete agreement?
• Balance the pros and cons of stock versus cash. When selling, cash is usually preferable, but not always an option. How will the seller protect himself from the risk inherent in having a concentrated position of someone else's stock?
• Consider capital market issues. If the buyer has made other acquisitions and has other shareholders who will be selling shares of the buyer's stock in the public market before the seller, this could significantly affect the seller's personal liquidity after the sale.
• Be aware of non-compete agreements: These can be strict agreements and are more likely than not to be enforced by a court in the context of the sale of a business, so it is important to balance the buyer's need to protect the value of the acquired business with the seller's future ability to use his skills in another business.
• Understand lock-ups and securities law limitations on stock sales. Don't be surprised after the sale with restrictions regarding when the seller can actually sell his stock.
Valuing the business
While the seller is preparing for all potential contingencies, one remaining issue remains paramount - how much is my business worth? In today's market there is no standard formula but there are a number of customary factors for consideration. Look closely at the following factors, among others: trading prices for comparable companies; recent acquisitions of similar companies; the strategic value of the business to non-financial buyers such as competitors or companies seeking to enter a new market; current availability (or lack thereof) and the cost of debt financing; and the impact of an acquisition on a publicly-held buyer's earnings per share.
Put yourself in the purchaser's chair and ask yourself the same questions he is asking, such as: How protectable is the product? Is it scalable? How well are expenses managed? What does the customer list look like? Is it balanced? How big is the market? And perhaps most importantly, how vital is the owner's continued involvement to the success of the acquired business?
Think "team" effort
Many business owners are accustomed to making their own decisions and taking full credit for their own success. They alone put in the hours; they alone came up with a plan that they alone executed. Surely they have advisors and service professionals, but often they deal with each one on one, and may think that this one-on-one method is the best way to develop their exit strategy.
Business owners will do better by adhering to a team approach. Bring the advisors together to develop one plan with all financial aspects of the seller's life in mind. Remember, the time for the team to talk, question, disagree and plan is long before the transaction. And it is time well spent if the seller walks away financially prepared for the next phase in his life.