This month’s article is a collaboration with Eric Duffee, Director and Co-Chair Mergers & Acquisition Practice at Kegler Brown Ritter + Hill. Each month, Eric looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
This month we look we explore the 8 steps you need to take to prepare your business to be sold.
8 Steps to Prepare to Sell Your Company
If you ever watch Shark Tank on TV, you might get the impression that selling all or part of your company is as simple as walking into a room with lots of rich people, answering a few questions, and then cashing your check.
Of course, deals don’t really get done this way. But many new and established business owners don’t have a clear picture of what really goes into selling all or part of a company.
Most well-executed sales are the culmination of many months – or years – of preparation. With that in mind, here are some relatively simple steps you can take now to prepare your company for a successful future sale:
1. Operate the business with an eye toward a potential transaction.
It’s important to set up an organizational structure that is flexible enough to permit future investment and/or a sale. Even after tax reform, a limited liability company is usually – though not always – the right vehicle, as it can be adapted for several different situations. Also, thoughtful use of subsidiaries to limit risk and segregate assets from the outset may improve the risk profile for future buyers. More broadly, careful attention to the organizational formalities sends a positive message to potential buyers about the meticulous care the owners have taken toward the business.
Also, contracts with third parties should be structured to permit transition of those contracts to a potential buyer without the third party’s prior consent. Otherwise, those third parties may pose a risk to your deal. At best, they may be non-responsive when you need their consent to the deal. At worst, they may withhold consent entirely, or use their newfound leverage to renegotiate their deal.
The time to start planning is now. More on this below.
2. Think like a buyer.
Generally speaking, buyers evaluate potential targets and assign valuations based on (1) their assessment of risk, and (2) their level of confidence in the ability to grow the business after the closing. As such, buyers are constantly thinking about risk factors that might prevent them from assuming the full value of your business, and then taking it to the next level. For example, if your software development company has a single developer who is the only person who really knows your product’s code, a buyer will be rightly concerned about business continuity if the developer quits or uses his or her power to extract a pound of flesh from a new owner to which he or she has no loyalty.
Similarly, targets that have a very high level of customer concentration may also present major risks to the buyer. While simply expanding your customer base is easier said than done, steps can still be taken to lock down the relationship with those major customers, including long-term contracts – if you can do so while still securing favorable terms.
Finally, every company has warts. The key is addressing and dealing with those warts head on. Waiting and hoping the buyer doesn’t find them is a losing strategy. A proactive strategy that identifies these issues and adopts a plan for addressing them will build major trust and confidence with a buyer. This is most effectively done by someone who is not the buyer, but who is also not attached to the business emotionally – an objective third party you can trust.
3. Lock down your assets.
On Shark Tank, the sharks almost always ask “What’s proprietary about this?” Every business has something to protect, and buyers will want confidence that the target company has taken appropriate steps to protect its intellectual property assets; in most cases, that’s what they’re buying.
Most people think about patents and copyrights when they think about protecting their intellectual property assets, but brand protection (in the form of trademark protection) and trade secret protection (in the form of confidentiality agreements) are equally important. An “IP audit” with a qualified intellectual property attorney is a good way to get an understanding about what can be protected, and the related costs and benefits.
In addition, many technology companies are shocked to learn that paying a contractor to do development work isn’t enough to give the company ownership over what the contractor develops. A written work-for-hire/assignment agreement is legally required to ensure that the company owns this asset. You really want to get these agreements signed at the outset. We’ve had many experiences where we’ve had to track down a developer on the eve of closing. Assuming we’re successful in tracking the developer down in the first place – no small feat given that developers can work from anywhere in the world – these developers sometimes catch on that they have additional clout to demand more money.
While additional steps to protect intellectual property may be necessary for some businesses, putting in place a simple work-for-hire agreement with any employee or contractor involved in development and a basic confidentiality agreement with anyone who may have access to your confidential information will save you a lot of hassle – and potentially dollars – later on, and the cost is not as much as you might think.
4. Manage your people.
Most sellers correctly want to keep the potential sale confidential for as long as possible. Loose lips sink ships – and sometimes deals. However, it’s almost impossible to keep the transaction confidential from everyone involved in the business. The seller will likely need information and assistance from a handful of key employees. In addition, the buyer will usually want to talk to several key employees – both to learn what they know and potentially to offer them post-closing employment.
In these cases, a robust confidentiality agreement, often coupled with a “stay bonus” or “change of control bonus” or other incentive, will be critically important. You want these key employees to be focused and incentivized to get the deal done rather than worrying about their own future employment. These are delicate conversations, but an appropriate incentive structure will make those conversations easier and help facilitate a successful deal.
Also, think about whether to require non-competition agreements from any of your key employees. Non-competition agreements with key employees will give a potential buyer comfort that key employees – like the sales representative who has the primary relationship with your largest customer – won’t simply walk out after the sale…and take your customers with them.
5. Know your value – and how to improve it.
We’ve touched on the value of your business a couple of times, and of course like any seller, you are probably very interested in what the value of your business is. Entire courses are taught on this subject, and while no two business appraisers are likely to arrive at the same exact estimate of your business’s value, they do all work to understand the same drivers of business value: cashflow, the market and risk.
Cashflow is the stream of cash produced by your business each period. Buyers prefer companies that produce predictable, growing streams of cash. The market is the industry you serve. Buyers offer premiums for certain industries, software for example. Risk is a measurement of how likely the predictable, growing stream of cash will NOT be predictable or will NOT grow.
Owners should concentrate business performance improvement efforts on making cashflow, or profit, grow steadily and predictably. Owners should also eliminate risks that might interrupt that steady growth pattern. Owners often look to sales first, and while increasing sales is certainly a laudable goal, it is more effective to work on growing sales margins because profits drive business value more directly than revenue. In fact, a company that reduces revenue, but increases profit dollars, is worth more than a business with larger revenue and the same profit dollars.
We often get the question from clients: “when should I start preparing the business for sale?” If you’ve watched Shark Tankyou’ve certainly seen the poor inventor who walks into that room unprepared. They invariably learn a lot, but don’t you wish they had figured everything out in advance? Selling your business in the real world is no different – the buyer is looking for a reliable, growing stream of cash produced by your business.
Start building that track record of a reliable, growing stream of cash right now.
6. Get your financial house in order.
The buyer and the bank financing the buyer will want to see the track record of the business. They think differently than the owner does. Once you own an asset, research shows, you no longer look at it the same way. You become emotionally attached. However, a buyer is objective and risk averse, so they look with skeptical eyes, comparing the business to a bond that would yield the same stream of cash.
You will be asked for historical financial records, and 3-5 years of audited financial statements is not an unusual request. During due diligence, firms with poor financial records require more time – and much more expense – to build financial statements the buyer and their bank will accept. This process can be frustrating due to the increased expense of historical audits (which are more expensive than a regular audit), and the reduced initial estimates of the business’s value that may result from their findings.
A proactive firm that has a thorough financial review or audit completed annually avoids surprises during due diligence. As a side benefit, good solid financial statements and a scorecard are an excellent foundation for performance improvement efforts to increase the business value discussed above.
7. Build your team.
Time for the self-serving plug: it is very important that the seller assemble a team of experienced financial, accounting, tax, legal, strategy and other specialist partners (e.g., security, insurance, environmental, etc.) who understand these deals. An experienced team will educate you on market trends and ways to help ensure that the deal gets done – on the terms you want. A good deal team will produce value that exceeds the cost, in terms of take-home price, risk mitigation, and perhaps most importantly, deal certainty.
8. Focus on the letter of intent.
The letter of intent is a key document for both parties, but is extremely important for sellers. As such, it’s never a good idea to sign a “back-of-the-napkin” letter of intent. So what should go in the letter of intent? Stay tuned or email me to discuss.