How-To

Selling a Business Within 5 Years? 7 Best Things to Do Now

Most business owners approach selling a business much like my son approaches his homework – they avoid thinking about it until they absolutely have to. It’s understandable. For many owners, their business is their baby, their employees are their family, and they enjoy the challenge and sense of purpose derived from their work. That said, when it comes to selling, business owners owe it to themselves to begin planning early.

Good preparation leads to a significantly improved outcome – including a higher purchase price, shorter time on the market, and fewer post-transaction requirements. If you are thinking about selling a business within the next 5 years, here are the 7 best things you should do now.

selling your business within 5 years

Focus on Growth and Profitability

Generally, buyers will ask for 3 to 5 years of financial statements as part of their due diligence. Buyers like to see year-over-year growth, and consistent or growing margins. Additionally, the valuation a buyer places on your business will likely be tied to your financial statements. Therefore, it makes sense, in years leading up to a sale, to focus on growth and profitability. Consider developing a business plan to accomplish specific goals within the timeframe you have prior to exiting. To address revenue growth, your strategy might include adding a second shift, launching a new product or service, or hiring additional sales personnel.

To address profitability, you might look to increase prices, eliminate non-essential processes, or reorganize your physical space. Regardless of your strategy, make sure your goals align with your time to exit. Moving to a larger facility, for example, might be a good long-term initiative, but require more time than you have to favorably impact your financial statements.

Tee It Up for a Buyer

Any steps you can take to simplify an acquisition and better position your company for a buyer will improve its valuation. This might mean changing the structure of the business, solving capacity issues, rebranding, or putting better systems and processes in place. If, for example, you have a slow-growing legacy business under the same roof as a new, rapidly growing division, it might make sense to separate the two. Or, if you’re in an industry that is facing some headwinds, you may benefit from getting a foothold in a new market. Think about who your buyer is likely to be, and what they will be looking for in an acquisition – then work to position your business accordingly.

Make Yourself Redundant

The less dependent your business is on you, the more valuable it will be to a buyer, and the more likely you’ll be able to exit without a lengthy transition. If you currently play a critical role in day-to-day operations, look for ways to hand off some (or all) of your duties prior to selling. This might mean hiring and grooming your replacement, transitioning customer relationships to others, or giving more responsibility to your management team.

These are not easy adjustments to make. It can be challenging to trust your team with key functions, and there is some risk that changes could create problems. However, if you are successful in building a structure that allows the business to run independently, it will be a significantly more attractive acquisition candidate. Some owners decide after taking this step that they don’t need to sell after all, instead holding on to what essentially becomes an “annuity”.

move toward predictable revenue

Move Towards Predictable Revenue

Perhaps the most important determinant of value is the extent to which a buyer can predict revenue (and profit) post-transaction. Businesses with lumpy sales, whether project-based, cyclical, or otherwise, tend to be discounted. So, think about ways you can move towards predictable revenue. You might look to roll out a subscription model, offer a maintenance program, or simply ask your existing customers to sign long-term contracts with purchase commitments.

If your business is cyclical, there may be steps you can take to normalize income. A company selling ski accessories with heavy sales in the winter might look to get into beach products. Owners with highly predictable revenue often command a valuation multiple of sales vs. profit, so taking steps in this direction could be rewarding.

Keep Straightforward, Accurate Financials

One of the first steps a buyer will take is to review 3-5 years of profit and loss, cash flow, and balance sheet statements. It is important that you have these statements available, and that they provide a true picture of your business’ financial state. In years leading up to a sale, businesses should make sure they are keeping up with the basics, including taking regular inventory, reconciling bank statements, and properly accruing expenses. While audited financials are not necessary (and are rare for small businesses), buyers do look favorably upon them.

A less expensive alternative is to have your financials reviewed. It might be helpful to hire a CFO or controller, even if fractional/part time, and/or to engage a CPA firm familiar with your industry. Lastly, consider changing any “write off” habits leading up to a sale. While most business owners look to expense everything possible to keep profit and taxes at a minimum, a lower profit on your books could translate to a lower valuation.

Address Risk Areas

Some risk areas for a buyer include customer or supplier concentration, pending legal issues, old equipment, insufficient IP protection, or a lease without an option to renew. With a sufficient time-horizon, all of these areas can be addressed and improved. If you have one customer that comprises 25% of revenue year after year, focus on building other relationships and bringing on new customers to reduce the concentration. If your equipment is old, look to update it prior to a sale. Like selling a house, fixing any problems prior to selling will make for a smoother transaction.

net result

In Selling a Business, Know What You Need to Net

An important step in preparing to sell a business is to assess what you will need to net. Is there a number below which it would not make sense to sell – whether for retirement, an investment, reduction of debt, or another purpose? If so, you will benefit from working with your CPA (or another knowledgeable professional) to assess whether you are likely to achieve that number, after taxes, from a sale. Understanding your target will help you to determine your timeframe, and any steps you may need to get there.

So, as hard as it may be, it’s worth thinking through your exit plan if you expect to be selling a business in the next 5 years. You may well be able to identify a few areas where modest steps can have a significant impact on the process and net result.

Images from Pixabay.

Business Purchase Closing: Getting Ready for the Big Day

 

Shake my handBusiness Purchase Agreement & Closing

Depending on the complexity and size of the transaction, a business purchase agreement template can be very simple or very complex. While a simple transfer of a digital asset may only require a bill of sale, the acquisition of an income-producing business is typically accompanied by an Asset Purchase Agreement (APA) or Stock Purchase Agreement (SPA).

Most acquisitions are asset purchases, meaning that the buyer transfers the tangible and intangible items owned by the company from the seller’s corporate entity into a different corporate entity owned by the buyer. These items generally include everything from the website, customers, and inventory to trademarks, patents, and goodwill.

By contrast, in a stock purchase, the buyer acquires the seller’s business entity itself, which includes all of the assets and liabilities contained within. In either case, you will want to work with an M&A attorney and CPA to help you decide which route is best for your situation based on the legal, financial, and tax implications of your purchase. Since most owner-operated business transactions are asset purchases, we will focus on things to consider when drafting your APA. 

asset purchase agreement

Image from Pixabay

Asset Purchase Agreement (APA)

The APA is generally a far more robust document than a Letter of Intent, often 20-40 pages, addressing many of the same items as the LOI but in greater detail. The key elements of an APA include a complete list of the assets being purchased (and not being purchased), liabilities assumed, the purchase price and how it will be paid and allocated for tax purposes, details on the closing and post-closing adjustments, seller and buyer representations and warranties, and the handling of disagreements post-transaction.

There are typically schedules attached to the APA, including financials, organizational documents, contracts, permits and other key items upon which the purchase decision was based. Lastly, there are often separate agreements simultaneously signed at closing that handle elements of the transaction that fall outside of the APA, such as non-compete or consulting agreements. A few things to consider when working with your attorney to draft an APA:

  • Be specific when identifying included assets – detail domains, content, subscriptions, plugins, contracts, inventory and all other components of the business
  • Confirm that the seller owns the assets you are buying and that they are transferable to the new corporate entity.
  • Think through how you can retain some leverage with the seller post-transaction. A seller note or escrowed funds will leave you in a stronger position if, for example, the seller does not deliver on training or other promises.
  • Consider language where you have recourse if the seller does not deliver on promises (e.g. the seller note is reduced accordingly).
  • Optimize the asset allocation and explore creative ways to minimize taxes on the deal – with different depreciation schedules, some asset categories are more tax friendly for the buyer than others (e.g. “Personal Goodwill”)
  • Small deals do not need big contracts – speak up if you feel the template your attorney is working from is overkill.

Summary: Business Purchase Closing

  • Have I carefully read the Asset Purchase Agreement draft?
  • Have I confirmed asset ownership by the seller?
  • What am I asking of the seller post-transaction?
  • Does the agreement fit the deal being signed or do I want something simpler or more complex? 

We hope you took away a few insights that will help you successfully complete a business purchase transaction. Remember, it is always a good idea to have an attorney and/or accountant review any document before signing it. 

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Acquisition Financing: A Look at Some Best Options

 

 

how to finance an acquisition

Acquisition Financing 

How you choose to fund your business acquisition could set you up for success or be a drag on your bottom line. While nearly half of business purchases are made in cash, looking to leverage your purchase with another funding source or two might give you a better return on your investment. A few questions to keep in mind when reviewing your options:

  • How much cash do I have available for a business purchase?
  • How much debt am I comfortable taking on?
  • How much free cash flow do I need the business to generate to cover my loan payments?
  • Might the seller consider a seller note?
  • Am I comfortable leveraging my home or retirement savings?
  • Am I comfortable with an equity investor?

Depending on how you answered the questions above, some of the following options will appeal more to you than others.

Seller Financing 

Sometimes sellers will allow buyers to finance a portion of the company purchase through the profits of the business over time. This can help close a deal more quickly, especially if you are not a good candidate for a traditional loan. The amount a seller will allow you to finance is usually not more than 60% of the purchase price. The length of the contract is often 5-7 years and can feature a balloon payment at the end. Of course, if other buyers are offering all cash, you will likely be at a disadvantage.

home equity loan

Home Equity Loan 

If you have more than 20% equity in your primary residence, this could be a source to consider. You will want to allow a cushion in case your home’s value declines, but generally your interest rate will be competitive, if not better, than what traditional lending sources such as banks can offer. HEIL and HELOC lenders will look at your credit score as well as your debt-to-income ratio as part of a decision.

Traditional Bank Loan

If you are considering more traditional financing, you should speak with a local bank, credit union, or online bank. Getting financing for an existing business is often easier than for a startup, but it can still be challenging. An existing business will need a good track record of strong cash flows and assets.

You’ll also need a very good personal credit score and may need to put down up to 30% of the purchase price in cash. A line of credit for your business is also a possibility, if you don’t need to finance the whole purchase and just need help managing the cash flow. For example, you may be asked for a business valuation, a record of your business experience, and a business plan. Lenders will likely want to see the following:

personal finances

Personal Finances

  • Personal credit score
  • Business credit score (if you already own a business)
  • Tax returns
  • Cash flow statement
  • Outstanding debts

Finances of acquired business

  • Balance sheet
  • Business tax returns
  • Profit margin

TIP: An SBA backed loan makes a bank more likely to lend.

SBA Loan

Some business sellers will advertise that their business is eligible for a Small Business Association (SBA) loan, meaning that the seller has pre-qualified the business for an acquisition loan. An SBA guarantee will get you a lower interest rate with a bank, because the government agency is shouldering some of the risk of the loan. If a business is not advertised as SBA qualified, you can still apply for one through an eligible lender. The SBA has high standards for qualifying a business and a purchaser, so while desirable, it is not easily obtained. Here is a summary of the main loan types:

  • Standard 7(a): Up to $5 million, 5-10 business day turnaround, 75% guarantee for loans over $150,000, 85% guarantee under $150,000, up to 10-year line of revolving credit.
  • Small Loan 7(a): Up to $350,000, 5-10 business day turnaround, 75% guarantee for loans over $150,000, 85% guarantee under $150,000.
  • SBA Express: Up to $350,000, 36-hour turnaround, up to 50% guarantee, up to 7-year line of revolving credit.

401k Business Financing 

This type of financing is known as ROBS, Rollover for Business Startups. Offered by Guidant Financial and others, it allows you to use your IRA or 401k assets to invest in a new business. Essentially, the retirement fund becomes an investor in your new enterprise by buying stock in a newly formed C Corp. You can then use that cash to help buy the business or manage your cash flow like a line of credit. You will need at least $50,000 in your retirement account to qualify. This type of financing is often used as a second or third tier when needed. The danger is that if the business fails, your retirement savings will be jeopardized.

investor funding

Investor Funding

To avoid the burden of debt and share the risk of an acquisition, some buyers will look to take on investment partners. An investment partner could be a family member or friend that wants to help you get into business, or it could be a partner, angel, institutional investor or crowdfunding partner seeking a return or fee related to their investment. Partners may want equity in the business, a share in the profits, or a simple monthly loan payment. Most small business investors opt for a debt payment, because there is less risk involved.

If you have a fast-growing business, then an investor may opt for an equity investment or convertible note that could convert to equity in lieu of repayment. This allows the investor to get an interest payment at a fixed rate for a fixed period and also enjoy the benefit of upside if the business does well. The Small Business Investment Companies SBIC has a venture capital program consisting of equity and debt that includes SBA dollars along with private funds. The basics are:

  • Debt: $250,000 to $10 million loans; 9% to 16% interest
  • Equity: $100,000 to $5 million investments
  • Debt with equity: $250,000 to $10 million; 10% to 14% interest

Whichever path you choose, make sure you have a written agreement and that you are comfortable with the terms of the transaction. Having an attorney review it is always advisable. Also, depending on the situation you may be required to get an exemption under federal and state securities laws (e.g. Reg D) or register as a private offering with the SEC.

Lastly, you will need some cash on hand to run the business and to ensure that any loan payments are manageable. Weighing the pros and cons of each option before moving forward on an acquisition will put you in a stronger position for the future. Owning a business can provide a nice income and lifestyle, but you have the best chance of success when you secure the right funding mix for your deal.

Summary: Acquisition Financing

  • Do I plan to pay cash for the business or to finance it?
  • What business finance options give me the best terms?
  • Do I want to use more than one finance source?
  • Can the debt payments for the purchase be met by the cash flow of the business? 

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Due Diligence and Financial Forecasting: What’s at Stake

 

puzzle shapes

Due Diligence and Pro-forma Financials

Once a letter of intent or similar document has been signed, the next steps are for the buyer to conduct a more formal due diligence and to develop pro forma financials. The main goals of due diligence are to confirm that the target company is in fact as presented, and to gain a clear understanding of the risks and opportunities associated with the business. The high-level areas of focus for due diligence are legal, financial, business operations and market. Gaining a clear understanding of these items will allow you to develop a thoughtful set of pro-forma (forward-looking) financials, so you can get a read on how the business’ financials will look post-transaction.

Your Team

Depending on the size of the business and the skill sets you have personally, it may be advisable to hire others to help with due diligence. For larger business acquisitions, an attorney will typically drive legal due diligence and a CPA will drive financial due diligence. You might also consider engaging a broker, buy side advisor, financial advisor, or industry consultant to help you assess business operations and build knowledge of the industry.

When choosing team members, look for individuals with mergers and acquisitions experience and with as much specific knowledge of the space as possible. In addition to becoming knowledgeable about the business operations and industry, you will be the project manager through due diligence. Create a master list of all items you wish to address through due diligence, assigning them to team members and checking them off as they are accomplished. Professional assistance is expensive, so use your team members judiciously to get the information you need.

legal

Legal

The purpose of legal due diligence is to assess whether the company you are acquiring is in good legal standing and whether there are items that could present future risk to you as the new owner. The key areas to address include:

    • Corporate Structure – review the corporate structure, capitalization, organizational documents and general corporate records of the company in order to ensure that everything is in order.
    • Taxes – review historical income tax liabilities and assess any tax carry forwards and their potential benefits.
    • Intellectual Property – understand the company’s technology and intellectual property, as well as its protection.
    • Assets & Liabilities – scrutinize the value of the assets that will be transferred with the sale, whether tangible or intangible, as well as all debts and liabilities against them. Your attorney can help with a lien search.
    • Contracts – review all contracts and commitments of the company. Remember, if you are purchasing the company’s assets (vs. it’s stock) you may need to update the contracts to reflect your new corporate entity as the signatory.
    • Compliance & Litigation – probe any pending, threatened, or settled litigation, arbitration, or regulatory proceedings involving the company and whether the company has faced any regulatory or compliance issues.

Financial

Similar to an audit, the purpose of financial due diligence is to verify that financial statements presented are accurate, and to gain a clear understanding of items that could impact the future financial performance of the company. For larger acquisitions, a CPA or other third party can prepare a Quality of Earnings (QoE) report to detail the components of the company’s revenue and expenses. The extent of financial diligence performed, and the quality of information available will vary considerably with the size of the company being acquired. Some exercises that can help gain clarity on the business and its financials:

    • Review 12 months of monthly and 3-5 years of annual profit & loss, balance sheet, and cash flow statements.
    • Examine 3-5 years of tax returns.
    • Trace bank statements to bank reconciliation, and reconciled statements to tax returns / general ledger; if possible, trace affiliate statements and/or merchant processor statements to bank statements.
    • Review past Accounts Receivable and Accounts Payable balances against subsequent deposits and payments.
    • Study customer and supplier concentration risk by reviewing sales and profit by customer and supplier.
    • Perform a trend analysis of sales, COGS and expenses by category and year over year to understand trends and fluctuations.
    • Confirm tax and payroll filings are current.
    • Assess sales and use tax requirements and confirm compliance.

TIP: Verify what has been presented and potential risks to the business.

business operations

Business Operations

The purpose of business operations due diligence is to gain an understanding of the business’ people, assets, technology, and processes. For online businesses, some of the most important assets are often the business’ sources of traffic, its platform, and its reputation.

  • People
    • Most importantly, can the seller of the business be trusted? You might consider a background check to determine if there is a criminal record and to confirm the validity of education, employment history and other activities from the owner’s past. Determine what duties the seller performs at the business and whether you or your staff will be able to assume these.
    • If the size of the business warrants it, create an org chart for the company with a short bio for each employee. Are there areas where experience is thin, potentially requiring future investment in training or additional staff? Are there areas of overlap with your skills? What changes do you envision over the next 5 years and how might that impact the financials? For larger businesses, you will want to review policies and procedures, assess employee benefits, plans, compensation and bonuses, and make sure the business is in compliance with all HR related requirements. With larger businesses, you might want an HR expert to help with this effort. Finally, work with the seller to understand all contractor relationships and make sure you have their contact information. Remember, if you create a new corporate entity, you may need to put new employee and contractor agreements in place for your new corporation.

  • Digital Assets –

    • Traffic – A key component of due diligence for an online business is understanding the nature of its traffic. Start with Ubersuggest, Google Analytics (GA4) or other similar tools to analyze the traffic coming to the site. Google Search Engine Console is a good way for webmasters to check the indexing status of the site and its visibility. How many users does the site have per day, month, year? What is the engagement rate (ideally >50%), user behavior, site return rate, and how have these numbers changed over time? Where is traffic coming from and are the sources paid or unpaid (e.g. direct search, paid search, social media, referral, organic)? Make sure you understand the backlink profile, the specific sources of referral traffic, whether the sources are paid or unpaid and whether paid traffic is appearing on the company’s financial statements. An untrustworthy seller could take advantage of a buyer by paying for, and not accounting for or disclosing, traffic and backlinks, artificially improving the site’s search engine ranking.
    • Platform – It is important to gain an understanding of the platform upon which the business is built to ascertain whether it is a viable solution for the business as it grows. This requires an assessment of the platform itself as well as the plugins and extensions used. Is the technology likely to be viable and supported over the long term? Will the current set up allow for growth? Similarly for software and SaaS businesses, you should have the code reviewed to ensure that it is proprietary and of high quality.
    • Reputation – Understanding a business’ reputation, both online and offline, is a critical component of due diligence. Check out reviews, message boards and other online venues to see what customers are saying about the business and its products/services. Sometimes owners will allow a buyer to conduct a customer survey, perhaps posing as a marketing consultant. The seller may be persuaded to allow this if you agree to provide a written report of the results and remind the seller that the information will be useful to the business whether or not the transaction consummates. Similarly, are there posts from current or future employees about working at the company? This can be valuable information. As a final step prior to closing, the seller may allow you to meet with the employees. If you receive this permission, you can inform them about the sale and determine if they plan to continue with the business post-transaction.
    • Other Assets – While we have emphasized traffic, platform and reputation given our online focus, there are of course a wide variety of assets that can be conveyed as part of a business acquisition – tangible and intangible. Whether inventory, equipment, real estate, patents, domains, or insurance policies, you should have a clear understanding of the items included in the sale, their value, and confirmation that the seller is the owner of the items. For larger businesses with inventory, it is common for a third party to conduct an inventory assessment to assess its quality and whether its value has been captured accurately in the financial statements.
    • Technology – In addition to the business’ platform, you will want to understand the broader technology infrastructure, and the level of IT investment that will be required to maintain and grow the company. This means an assessment of the company’s network, software, databases, computers, mobile devices, outsourced relationships, subscriptions and other IT-related items. With larger businesses, a third party assessment can be helpful. With smaller businesses, it is important to understand the seller’s role in maintaining the IT infrastructure. If you are stepping into the seller’s shoes, is this a role you are comfortable doing?
      • Processes – Lastly, you will want to ensure you have an understanding of the business’ internal processes, both to assess whether they present any risks to you as the new owner, but also to equip you with the knowledge you will need to run the business. Questions will vary widely depending on the type of business you are acquiring, but examples of questions include:  How does the company acquire customers? How are products sourced? How do customer orders flow through the company’s systems? How are orders ultimately fulfilled and recorded? What is the flow of customer communication? How is financial record-keeping handled? How are employees’ schedules managed? How are personnel issues addressed? Consider gaining an understanding of company procedures by interacting with the company as a customer – order a product, send an email to customer service, or subscribe to the newsletter.

market

Market

Market due diligence is unlike other aspects of due diligence in that information is gathered from outside of the company rather than from within, with the purpose of understanding industry trends, the competitive landscape, and the buyers and vendors in the market. When buying an online business, it is important to investigate the underlying market, not just its category. For example, if you are conducting due diligence on an eCommerce business that resells fridge and HVAC filters, your due diligence should include learning about the market for fridge and HVAC filters. What opportunities or risks might be on the horizon? How, for example, will “smart” refrigerators and IoT connected HVAC systems impact the market?

In addition to conducting secondary market research from written reports and materials and on the web, you will benefit greatly by conducting primary market research – talking with individuals who are intimately involved in the market and can answer your questions. For example, you might reach out to staff members with an industry association, individuals who work with similar (non-competitive) companies, consultants in the space, or visit a trade show to meet industry participants. What changes are happening in the market? Are there competitors that could pose a threat? What opportunities might not be obvious?

Similarly, you can learn a lot about the competitive landscape in a market by understanding the customer’s perspective. Try ordering a fridge or HVAC filter from Amazon and Lowe’s and compare the experience with that of ordering from the company you are evaluating. What are the positives and negatives of each experience? Lastly, research the company’s suppliers. Are they large, reliable vendors, or is there product availability risk? Are there substitute suppliers, or do they hold power over their customers?

man in a mission

Pro-forma Financials

An important exercise for any buyer, regardless of the size of the business being acquired in an M&A deal, is to develop a set of pro-forma (forward looking) financials. The goal of pro-forma financials is to assess your income, cash flow and balance sheet after the transaction, taking into account the new expenses you will have as a buyer and removing expenses that are no longer relevant after the sale. Your pro-forma financials will ideally include monthly figures for the first year, and annual figures for 2-4 years following. It is important to include monthly figures for the first year, as that is when the business is at its most vulnerable from a cash flow perspective.

While you are learning to operate the business, you may also be paying off debt, making investments, and perhaps paying the seller under a consulting agreement. Your pro-forma financials will help you assess the amount of debt you can afford to take on with the purchase, understand the amount of working capital you will need, and gauge your return on investment under different assumptions. You might consider working with your CPA on pro-forma financials as part of your financial due diligence exercise. A few items to think about when developing the document:

  • Start with the company’s historic financials – add back expenses no longer pertinent (e.g. the former owner’s salary) and include new expenses (e.g. your salary).
  • Include your debt service – interest payments should be included as a pre-tax expense while principal payments are an after-tax expense.
  • Take into account the timing of cash flows, particularly for the first year – when will you actually get paid and when will payments actually be made?
  • Include your expected capital expenditures.
  • Make sure fixed and variable expenses are properly categorized.
  • Develop conservative, moderate, and aggressive forecasts.
  • Include a row on the spreadsheet that tracks your cumulative cash to assess the months and years in which the company is at its most vulnerable – ensure you have sufficient working capital (money) to cover these stretches of time.

Summary: Due Diligence and Financial Forecasting

What professionals will assist me during the due diligence process?

What due diligence can I conduct myself and what do I want a professional to do?

How will I recognize a red flag in the process? 

What do my pro-forma financials tell me about the business I’ll be running?

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Deal Structure and Business Offer: Getting a Win

 

how to structure a deal and present an offer

Deal Structure

After identifying a business to buy and completing your initial research, the next step is to make a business offer. The deal structure will then follow. Remember, your goal is not to convince the seller of your viewpoint, but as a buyer, to identify a proposal that works for both parties. As such, there are a number of considerations beyond your analysis and value assessment to consider. Moreover, relationship-building and trust through your discussions are critical components. A few things to consider:

  • Manage the seller's expectations
  • Listen and understand the seller's point of view
  • Allow a third party to wear the "black hat"
  • Start with a simple, one-page term sheet

manage the seller's expectations

Manage the Seller’s Expectations

As you build rapport with a seller through discussions, it’s common to want to avoid discussion of what you think the company is worth. This can lead to a lot of wasted time. It’s best to manage the seller’s expectations right from the start, particularly if there is a significant discrepancy between an asking price and what you are willing to pay. Be upfront with how you plan to finance the deal, especially if you expect the seller to finance a portion of the deal.

As the deal progresses, make sure to specifically address anything “new” or not aligned with prior discussions, even if it’s something that seems trivial. It’s easy to lose trust or create animosity when there are surprises, so work to proactively head them off. In-person meetings or video conferences are generally better alternatives to phone, text, or email when addressing sensitive topics, and it’s often better to work through issues directly with the seller rather than through a team member.

seller's point of view

Listen and Understand the Seller’s Point of View

There are often personal factors influencing a business owner’s decision to sell, and specific deal points that are important to them. You will have a better chance of reaching an agreement if you understand the owner’s drivers and then tailor your offer and deal structure to address them.

Some sellers, for example, hope the sale of their business will allow them to retire. How much cash will they need to receive after taxes from a sale to make this possible?  Can you structure your offer to help get them there? Or maybe the seller has a family member involved with the business whose livelihood will be impacted with a sale. Is there a way you can keep this person involved post transaction?

wear the black hat

Allow a Third Party to Wear the “Black Hat”

Whether a CPA, an appraiser, a buy-side advisor, or other knowledgeable professional, it can be helpful to involve a third party when discussing sensitive topics like valuation. Involving a third party will help you to maintain a strong, cordial relationship with the seller while at the same time making a case for a more favorable deal.

Presentation of your position is key. Any written assessment of the business or its value should be clear, concise and easily understandable to the owner. The individual you work with should have a relevant background, present themselves professionally, and be able to articulate your position in a respectful way.

TIP: Listen to the seller and identify a proposal that works for both of you.

one page term sheet

The Offer: Start with a Simple, One-Page Term Sheet 

When conveying your offer, it is advisable to initially do so in the simplest way possible. Distill your offer to its key points and place them in bullet format into a one-page term sheet. Points conveyed should be the purchase price, payment terms, any personal guarantees, specifics on the assets or stock being purchased (and not being purchased), handling of accounts receivable, accounts payable and inventory at close, specifics on any non-compete or consulting arrangements, specifics on any property or other leases (or purchases), and any conditions to the offer.

Once accepted, you can develop a more formal letter of intent (LOI) to be reviewed by an attorney and signed by both parties. Self-drafting the LOI ensures the more formal, legal language of an LOI does not impede the seller's understanding of your offer, and helps to minimize attorney involvement.

Summary: Deal Structure and Business Offer

How can I build trust with the seller?

How can I work with the seller to reach a fair transaction agreement?

What are the key points of my offer?

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Analyzing a Business to Buy: What’s Most Important

 

calculator and notepads

Analyzing a Business to Buy: Pre-Offer Analysis and Business Valuation

Before sharing details on a business, most brokers and sellers will ask that you sign a non-disclosure agreement (NDA). You should not need to put money in escrow in order to get basic information on the business. As part of your pre-offer analysis, some initial high-level topics to explore with the seller or broker include the following:

  • A general overview including the business’ products or services, competition, industry, and the state of the business
  • The underlying technology, traffic, and platform 
  • Revenue, profitability, and employee count
  • Any concentration risk with customers or suppliers
  • Specifics on ownership, motivation to sell, and the goals of a sale
  • Thoughts on valuation and deal structure

Remember, when you are talking with sellers and brokers, it should be a two-way conversation. While you’re assessing the business's value, the owner or broker is likely assessing your ability to buy and run it. Come prepared to answer questions about your background, goals and sources of financing. Once you have gained a high-level understanding of the opportunity, it is reasonable to request some basic financial information and detail on the assets that will transfer with the sale.

business financials

Business Financials

An initial information request usually includes 3 to 5 years of financial statements. Take the time to develop a spreadsheet that lays out income statements, balance sheets, and cash flow figures so that they can be compared across the years provided. How have the sources of revenue changed from year to year? Are the expense categories consistent over time or do they change? Are there noteworthy balance sheet items? Use your analysis to develop a set of questions for the seller's team that can help provide you with a more accurate picture of the business’s history and any challenges that might lie ahead.

business assets

Business Assets

Gain a clear understanding of the physical assets and intellectual property that will be included as part of the sale. Also, understand the assets that are not part of the sale. If there are items contributing to business operations that will not transfer with a sale, your valuation should take this into account. Similarly, items above and beyond what is needed to run the business, such as excess inventory, will also have an impact on valuation.

The next step after your pre-offer analysis work is complete is to place a valuation on the company. There are many different ways to valuing a business, from asset-based and market-based approaches, to an assessment of historic and future earnings. Different approaches are favored based on the size of the organization, its growth trajectory, the profile of the buyer, and the state of the business. For buyers of smaller, closely-held companies, a few useful methods are:

(1) the multiple of earnings method, and

(2) the market value method.

mutliple of earnings method

Multiple of Earnings Method

For an owner-operated business, the metric often used as the number being multiplied is “Seller's Discretionary Earnings” (SDE). SDE is typically calculated by subtracting the cost of goods sold and operating expenses from annual gross income, and adding back non-recurring, non-cash and discretionary expenses. Operating expenses are the necessary costs to running the business and are non-discretionary.  Examples of expenses that are often added back to the businesses’ earnings include owner’s compensation, depreciation, charitable contributions and personal vehicle expenses. For larger companies where the value is less tied to owner benefits, the metric often used as the number being multiplied is “Earnings Before Interest, Taxes, Depreciation, and Amortization” (EBITDA).

For businesses that are rapidly growing, have recurring revenue models or have high value to the buyer, “Revenue” is often used as the number multiplied. Since our focus is owner-operated businesses, we will use SDE as our example metric, however many of the same principles apply for other metrics. Multiples for smaller businesses usually range from 1.5x to 4.5x SDE. Determining where a business falls within the range is tied to the predictability of future earnings and the effort required by people to maintain and increase them. Greater predictability and less effort lowers risk and improves the multiple.

  • What is the business category? Businesses that require more advertising to gain customers or have a less reliable customer base will typically have a lower multiple. More predictable revenue businesses will command a higher multiple.

 

  • What is the customer retention rate?
  • How stable are the earnings?
  • How vulnerable is the company to new entrants in the field?
  • Is the business easy to replicate?
  • How quickly is the business growing?
  • How easily can the business be transferred to a new owner?

TIP: Keep enough cash on hand to run your business.

market value method

Market Value Method

Reviewing “comps'' can be a great way to check whether your valuation assessment is on target. Comps can be obtained through brokerages and online platforms. DealLink is a good place to start. As a first step, conduct a thorough search for business listings similar to that which you’re assessing. Next, narrow down the group, identifying the 5-10 businesses closest in type and size to yours. Add these businesses to a spreadsheet, calculating a multiple of SDE or Net Profit for each (be careful to ensure that the figures being multiplied are “apples to apples”).

You may want to include notes for each on your spreadsheet, as their unique attributes may help to further refine your range (e.g. “does not include inventory valued at $10k”, or “includes 5 patents”). Lastly, remember, the purchase prices you source online are “asking” vs. “selling” prices – you may need to take this into account when negotiating with a seller.

choose someone to value the business

Choose Someone to Value the Business

To further support your offer, you might consider engaging a professional for a third-party opinion on the business value. CPAs, appraisers, and business brokers are all good candidates to help with valuing a company. 

In addition to the Multiple of Earnings and Market Value method, a valuation might employ other approaches including discounted cash flow, asset based, or capitalization of earnings. Make sure you understand the assumptions behind each approach before presenting the result to the seller. 

Summary: Analyzing a Business to Buy

What information do I need from a seller to decide if I want to move forward with an offer?

What valuation method do I intend to use to make a price assessment?

Am I comfortable with comps or do I want to speak with a professional third party to confirm the value of the business?

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