Why do people wish to sell their business? Some reasons include retirement, boredom, partnership dispute, illness, or death. Whatever the reason may be behind desiring to sell a business, the parties involved should follow certain steps in order to properly sell their business. If followed correctly, the business sale will be a smoother process.
Performing Adequate Due Diligence
Due diligence is a main aspect in selling a business for both buyers and sellers. The purpose of due diligence is to verify income, expenses, assets, contracts, licenses, good standing, contingent liabilities and assets, etc. An advantage of performing due diligence is to ensure that the numbers are accurate and no “skeletons” will pop out. Failure to perform due diligence can sometimes result in a civil lawsuit for breach of fiduciary duty, for instance. For buyers, due diligence begins the moment a letter of intent is signed. Buyers will request certain documents from the seller to properly understand the business. Some of the documents that are analyzed by potential buyers include financial statements (including the income statement, balance sheet, and statement of cash flows), inventory, tax returns, contracts, agreements, and accounts receivable. When buyers inspect these documents, they will have a better understanding of the business’ condition that is being sought for sale. If the buyer discovers red flags during the due diligence process, it might not be the right time or opportunity. In addition, the buyer will investigate the seller by conducting some sort of background check; if the seller is not divulging all information, there is probably reason to look into another seller from the buyer’s side. On the other hand, it is of utmost importance for sellers to also conduct their own due diligence and research to determine if the buyer has enough experience and expertise to take over their business. It is significant for the seller to determine if the buyer will be a helpful party for the business to grow in the future and keep the reputation of the company going.1 You can find a detailed due diligence checklist by clicking here.
Normalization of the Financial Statements
Another main step to address properly in terms of selling or buying a business includes normalizing the financial statements. Normalizing the financial statements is a process wherein the financial statements are adjusted to reflect the recurring and/or on-going economic earnings that can be expected by a purchaser of the business. This process generally involves eliminating items such as one-time gains or losses, other unusual items, non-recurring business elements, and expenses of non-operating assets, as well as normalizing officer and owner compensation to fair market terms and eliminating discretionary expenses of the business. For example, in many closely-held companies, the seller will often pay non-business related benefits to friends and family members which will need to be added back to the prospective earnings. In addition, the salaries of the owner may be significantly above (or below) fair market salaries and such salary must be adjusted to better reflect what it would cost to hire someone in the business. Businesses may also have unusual one-time charges for lawsuits or one-time revenues from a discontinued line of business that must be properly adjusted to estimate the prospective earnings power of the company. Normalizing adjustments are significant in that such adjustments reveal the true income stream that is available to the buyer going-forward. Failure to make these adjustments can mask the true operating performance of a business and may result in the over or under payment for a business. 2
Negotiating Restrictive Covenants & Transitionary Agreements
While the sale of a business can give benefits to the seller, the buyer will put restrictive covenants on the seller to protect themselves. For example, a non-competition covenant will, many times, be required by the buyer to complete the transaction. This type of agreement is designed to protect the buyer’s acquiring of an asset to not be diminished in value due to certain actions of the seller. Specifically, sellers need to follow certain aspects of a “non-compete,” and should investigate certain topics. Some of these subjects include defining what a competitive business or enterprise consists of, the duration of the covenant, the geographic scope, and restrictions effecting the seller’s ongoing relationships with customers and employees of the business that is being acquired. From the seller’s perspective, restrictive covenants may limit a seller’s ability to engage in similar business activity, and such limitations may affect the true purchase price a buyer is receiving. Furthermore, sometimes when a buyer does not have the proper management or systems for a particular business, a transitional service agreement is created to properly have the seller provide services for a fee. The seller can provide infrastructure support for human resources, information technology, and accounting, for example. Transitionary services are valuable to the buyer and may affect the purchase price that they are willing to pay for the business. A transitionary services agreement is generally taxable as ordinary income to the seller (not a capital gain), which can affect net proceeds.3
Structuring the Sale
Determining if the sale is an asset sale or stock sale is an important factor. An asset sale involves the purchase of individual assets the business owns, and liabilities, whereas a stock sale is the purchase of the owner’s shares of a corporation, which includes the corporation’s assets and liabilities. Specifically, in an asset sale, the seller retains possession of the business interest but transfers its assets to the buyer. Generally, cash is not included in the transaction. Also, asset sales will generally result in the sale of the assets of the selling corporation, which will result in a taxable gain at the corporate level for the business. The taxable gain will be based upon the inside basis of those assets held at the corporate level. The income tax will be paid based upon the nature of the asset being sold. This requires a purchase price allocation, Form 8594, to be filed indicating the allocation of value to each of the assets sold; in turn, this will dictate tax due at the corporation level. C-Corporations, therefore, will pay tax at the corporate level and then the company will have to make a liquidating distribution to the shareholders. S-Corporations, on the other hand, will have the corporate gains flow through to the individual shareholders. Unlike an asset sale, stock sales do not require separate transfers of each individual asset because the asset titles are owned within the corporation. In addition, a stock sale involves a merger and taxation will be based upon the outside (ownership) basis of the selling shareholder. The purchaser will acquire stock and inherent the inside basis of the assets, unless a 338(H)(10) election is made. Typically, business sales are sold as asset sales, rather than a stock sale. If it is a sole proprietorship, a partnership, or a limited liability company, the sale must be done by ways of an asset sale since none of these types of businesses have any stock.4
Valuing the Business
Now one of the most important questions, how is the business valued? The three fundamental business valuation approaches include income, market, and asset approaches.
The income approach describes that the value of an ownership interest in a business enterprise is equal to the present value of all future benefits of ownership, including periodic cash flows and the ultimate sale or residual value of that interest. The two methods within the income approach include:
The discounted cash flow method is a method under the income approach that involves projecting future economic benefits and discounting them to present value using an appropriate risk adjusted discount rate, or cost of capital. This method is appropriate for businesses whose economic benefit streams have failed to stabilize and/or are expected to grow unevenly in the future.
The capitalization of cash flow method involves capitalizing a sustainable measure of economic benefits by a capitalization rate, which reflects a rate of return commensurate with the risk of the business less a sustainable, long-term growth rate. This method is most appropriate for business enterprises whose economic benefit streams have stabilized and are expected to grow at a long-term sustainable rate. This method is appropriate for companies that have exhausted their growth opportunities.
The market approach utilizes the pricing multiples of companies that operate in the same or similar industry as that of the subject company. Two different market methods:
The publicly traded guideline company method, which relies upon the pricing multiples of publicly traded companies. This method can be quite difficult to value a business with because the proper publicly traded companies have to be comparable.
The private transactions method is a method that relies upon the pricing multiples obtained from recent sales of similar businesses. The analyst using this method seeks to compare the subject company’s financial data and ratios to companies of similar size and nature of business activity. The valuation multiples of the similar companies are then used to determine an estimate of value for the subject company.
Lastly, the asset approach involves estimating the economic value of the company’s assets and liabilities. Below describes one of the asset methods: The net asset value method is the primary method within the asset approach. With this method, the net asset value is determined by taking the fair market value of the assets less the fair market value of the liabilities. The method is based upon the economic concept of replacement cost, or the principle that the investor should be willing to pay no more than what it costs to create a desirable alternative investment.
Selling a business is a time-consuming venture, involving financial and emotional issues. It may not be an easy task, but with the proper expertise and guidance, it will be a calmer undertaking to properly complete. Now, it is time to reevaluate your business! If you need assistance, give Moore, Ellrich, & Neal a call!
1 “Selling Your Company: Working Through the Due Diligence.” Selling a Business | Working
Through Due Diligence. Allied Business Group, Sept. 2011. Web. 15 Nov. 2016.
2 “Normalizing Adjustments to the Income Statement.” Mercer Capital. N.p., n.d. Web. 15 Nov. 2016.
3 Drake, Mason H. “Non-Competition Covenants: Seller Considerations and Approaches.” Stout
Risius Ross. N.p., n.d. Web. 15 Nov. 2016.
4 “Asset Sale vs. Stock Sale: What’s the Difference?” Allied Business Group. N.p., Oct. 2013. Web.
15 Nov. 2016.