Each year, thousands of small businesses change hands. Some owners decide to retire, others need new capital to exploit market opportunities, and some businesses fail and are liquidated.
According to the BizBuySell.com Fourth Quarter 2014 Insight Report, 7,494 small businesses traded hands during 2014, the largest number of transactions since BizBuySell starting tracking sales data in 2007. While higher than previous years, there are approximately 45,000 small businesses – ranging from restaurants and retail stores, to service and manufacturing companies – available for purchase at any given time.
The motive to sell can arise for both negative and positive reasons. Sometimes, plans do not work out, and business results fall short of expectations. While in the best of circumstances, buyers – drawn by the success of a business – make unsolicited offers to purchase the business. Either circumstance can dictate the potential sale.
Unfortunately, not all owners have a choice whether to sell their companies. The failure rate of small businesses is extraordinarily high, with almost half going out of business before their fifth year, according to Statistic Brain.
Despite their initial optimism, many owners regret starting their business, no longer hoping to get the cheese but to get out of the trap. In such cases, the owners’ objectives are to achieve the highest valuation possible to reduce their losses and restore their business reputation. If a liquidation appears likely, competent legal and accounting advice is essential. Owners may also consider retaining the service of an experienced business broker to help present the company in the best possible light and negotiate favorable terms of sale.
If your business is a successful operation, you may find that potential buyers or their representatives regularly solicit the purchase of your business, perhaps accompanied by preliminary (though very attractive) estimates of market value. But before putting your company on the market or engaging in negotiations to sell the business, there are a number of questions you should resolve.
Questions to Consider Prior to Selling Your Business
1. What Will You Do After the Sale?
Many small business owners endure long days, week after week, year after year, building their business and guiding it through the perilous shoals of competition to create a tangible financial asset. In many cases, the company becomes an extension of the owner, consuming his or her time, effort, and passion. When the sale is complete, many former owners find themselves at loose ends, wondering, “What am I going to do now with my life?”
Some, unable to find a new passion and outlet for their energy, regret the sale of their business and incautiously jump into a second venture without adequate preparation. Others embrace their new freedom and embark on new careers and interests.
Take the time to consider how you will spend your days post-sale. Is it a future you will enjoy? Sometimes, staying in place – even in the face of a lucrative offer – is the optimum decision for happiness.
2. Can You Replace the Income From Your Business?
Small business owners reap a number of financial benefits from their ownership. Many draw a competitive salary, receive regular bonuses as profits increase, enjoy significant entertainment and travel budgets paid by the company, unchallenged expense reimbursements, and maximum contributions to company retirement and health benefits. For example, a small business owner may draw a salary of $60,000 annually, but receive unaccounted-for benefits equivalent to his salary each year.
Before deciding to sell your company, be sure that you understand all of the financial benefits you receive each year as an owner. Upon sale, those benefits may be eliminated, requiring either a lifestyle change after sale or additional income from private investments to subsidize your post-sale income.
3. Does Your Business Enjoy a Competitive Advantage in the Marketplace?
Why would an unaffiliated, objective buyer be interested in your company? Do you have a unique product? Do you dominate your industry competitors in a particular geographic area? Are your revenues growing, declining, or stable?
An inability to define why a buyer should purchase your company invariably leads to a lower sales price. If you don’t know why someone should buy your company, you cannot expect a potential buyer to know either.
4. Who Are Your Potential Interested Buyers?
Buyers for small businesses come in all guises, including your existing employees, local competitors, companies similar to your company looking to expand into new markets, retirees seeking to own a business, and national brands seeking entry into a specific geography or industry. Their motive usually establishes a price range based upon strategic importance.
Remember, it is difficult to sell anything if you cannot articulate the benefits of ownership specific to a particular buyer. Put yourself in the potential buyer’s shoes to determine his or her trigger issues to buy or walk away.
5. What Are the Obstacles to a Sale?
What are your company’s obvious shortcomings? Are sales declining or failing to increase? If so, why? Are your products or services no longer relevant to your potential customers? Are your prices high relative to your competition?
Some specific areas that can easily become obstacles include:
- Poor Accounting Records. The lack of complete and accurate financial records is a nonstarter for most business transfers. Your financial records are the only view into the past, illustrative of the financial progress – or lack thereof – of your company. Trying to sell your business without good records may mean you receive only a fraction of its real value.
- Non-assumable Debts. Many small businesses have debts, usually personally guaranteed by the primary owner, as a consequence of the ongoing business. The debts can include real estate mortgage on properties, accounts receivable and inventory financing, and equipment and automobile term notes, as well as nonspecific loans. Many business owners utilize a single financing source. It is not unusual in such cases that the lenders have a lien over all assets – including intangible assets such as trade names, patents, and customer lists – so that the debts must be liquidated before any change of ownership can be implemented.
- Unfunded Obligations. Aside from financial debts, many companies have pension or profit-sharing obligations, long-term contracts with customers or suppliers, obsolete equipment that needs refurbishment or replacement, or potential and ongoing legal suits. An unquantified obligation can heavily reduce the final sales price, if not negate any interest from potential buyers to move forward with a purchase.
- Labor Contracts. Are your workers covered by union contracts? Do your key employees have employment contracts? How much latitude will new owners have to dictate new working conditions or new wage and salary levels?
- Key Employees. Do you have key employees who are essential to the continuity of your business? Are they under employment and non-compete contracts so that labor stability will be in place for a new owner? How replaceable are employees, and how expensive is their replacement likely to be?
6. Are You and Your Managers Able to Run the Business and Participate in a Sales Process?
The process of selling a business is neither easy nor quick. Business owners, involved employees, and company consultants (especially your accountant) will be required to participate in innumerable meetings, phone calls, and projects during the buyer’s due diligence process. While a business broker might assist in the process, the bulk of the work and time will be spent by the business owner and his or her employees – time which must be taken from the day-to-day operation of the business.
Some business owners, searching for the pot of gold at the end of the rainbow, discover that the due diligence and sales processes are too time-consuming and expensive to proceed. Establish time and dollar limits for your company and employees to be engaged in the process, away from day-to-day operations. Do not jeopardize the company’s existence on the possibility of an attractive final sales price or a presumption that a sale will be quickly completed.
7. How Will Your Business Be Affected During the Sales Process?
Are your employees likely to seek other employment in view of the uncertainty? Are customers likely to seek a new supplier? Keeping the potential sale of a business confidential is virtually impossible, especially during a buyer’s due diligence process. It is important to control the message to your organization from the first day to eliminate rumors and concerns of affected customers, employees, and vendors, all of whom usually presume a sale will affect them negatively.
Consider how your stakeholders (individuals, groups, or organizations with an interest in or concern about your company’s activities) will be affected by a sale. At the same time, avoid overcommitments to those who have concerns.
The Sales Process
Once you’ve established that you’re ready to sell, consider how the process generally goes. Understanding the steps of a typical business sale before the process begins is essential to avoid excessive cost and overly-optimistic expectations.
1. Initial Contact
Whether initiated by the buyer or seller, the first step in the sale process is to establish a mutual interest in the transfer of the company from seller to a buyer. Discussions are exploratory and nonbinding for the sole purpose of determining whether there is a mutual interest in going forward.
2. Preliminary Discussions
Following an exchange of confidentiality and nondisclosure agreements, the parties preliminarily determine the benefits of a transaction for each and define any conditions thought to be nonnegotiable. For example, a seller might require that the current employees are retained for a minimum period following a transaction, or a buyer might require the owner to stay in place for a transition period. Limited financial data, legal documents, and representations might be exchanged for review by each party.
3. Price Negotiations
As a consequence of the data exchanged and each company’s investigations, the parties may agree to a tentative sale transaction called a “term sheet,” which is an abbreviated version of the basic agreement that will be agreed to and executed by the parties. The term sheet is formalized and amended following an extensive verification of the facts and representations of each party.
While a buyer’s decision is often affected by nonfinancial factors, many buyers – especially those represented by business advisors – establish a price based on a multiple of the following:
- Revenues. BizBuySell reported an average revenue-to-sales-price ratio of 0.61 in 2014, so that a company with $500,000 in revenues sold for $305,000.
- Cash Flow. In 2014, the average cash flow multiple for a sold business was 2.24, according to BizBuySell. In other words, a business with $100,000 of annual cash flows sold for $224,000.
- Earnings. A multiple of earnings is usually based on stability and the year-to-year increase of the earning stream. For example, a company consistently earning a profit of $50,000 might sell for a price to earnings ratio (PE) of four to six, or $200,000 to $300,000. A company with erratic earnings would typically sell at a lower PE. Establishing a sales price on earnings of a small business is considered by some to be less reliable than other indices, especially since revenues and expenses are often manipulated for tax and other reasons.
- Net Assets. Some businesses, particularly those who are involved in natural resources, may sell as a multiple of estimated reserve values. Companies that have been in business for a while are likely to have undervalued assets on the books due to use of depreciation.
4. Due Diligence
Following the preliminary agreement, the purchaser undertakes an extensive due diligence review to verify the facts and representations of the seller. This step may entail a review of customer lists, a review and confirmation of the accounting records – if the seller’s financials are not prepared or audited by an independent certified public accountant (CPA) – and a physical confirmation of tangible assets.
Due diligence expenses of the buyer can be high, especially if outside consultants and experts are utilized. At the same time, the seller’s resources can be strained as company personnel are frequently involved in the process, rather than in the day-to-day operations of the company.
6. Price Adjustment
Depending upon the due diligence findings, the final sales price and terms of payment may be tweaked to reflect new disclosures. This negotiation is the last bite of the apple, so to speak, for both parties to amend the purchase agreement. Sellers should be aware that negotiations often continue until the final agreement is reached and signed by both parties.
The closing is the culmination of the entire process in which final documents are signed, and money is exchanged. Both parties may also be subject to future obligations if detailed in the closing documents.
For example, the purchaser may be required to pay an extra amount if revenues exceed a predetermined target in the year (or years) following the transaction. At the same time, the seller may be liable for any undisclosed and documented liabilities.
For many business owners, selling the company is the culmination of a lifetime’s work. With preparation, they can sell on terms that provide financial security for their retirement, or at least funding for their next great adventure. In some cases, they get to have their cake and eat it too by receiving a higher-than-expected sales price while retaining their position as a key manager or employee and enjoying benefits similar to what they received prior to the sale. With proper preparation – and competent legal and accounting help, where needed – you can convert your company into a stable and substantial flow of income.
Do you have any additional tips to sell a business?