A Value Proposition

0915Selling-Business

For business owners looking to sell their companies, the challenge is to get maximum value and protect themselves and their businesses during the sales process

Story by Rick Berg

When Doug LaViolette first pondered selling Green Bay-based Executive Office Interiors in 1995, he and his wife, Renee, were still reeling from the untimely drowning death of their son, Brian, three years earlier. Though they had owned and operated that successful business for more than 20 years at that time, the LaViolettes felt it was time to move on and devote more of their time to the Brian LaViolette Scholarship Foundation.

“We just really felt at that time that there were more important things in life than selling furniture,” LaViolette said.

They eventually managed a successful sale of Executive Office Interiors in 1999. But that first attempt in 1995 did not go well, and it provides a cautionary tale for any business owner considering the sale of his or her business.

First, partly as a result of dealing with their son’s death, the LaViolettes saw sales flat lining by 1995 after two decades of solid growth. That, LaViolette said, is no time to be selling a business. It tends to undervalue the business and leave the seller vulnerable to prospective buyers – especially competitors – who want to get a better deal on the business, LaViolette said.

That’s exactly what happened during the negotiation process in 1995, during which prospective buyers focused on current sales and thus valued the business well below what LaViolette knew the true value to be.

Worse, negotiations with one prospective buyer led to a seller’s worst nightmare – a breach in confidentiality. Although LaViolette and the buyer had a nondisclosure agreement in place to guard against such a breach, one family member on the buyer’s side, perhaps unaware of the nondisclosure agreement, disclosed the negotiations in a social setting. Word spread quickly and it didn’t take long for the rumor to reach the ears of LaViolette’s employees.

Since the negotiations had broken down by that time, LaViolette was able to tell employees in all honesty that there were no plans to sell the business. Still, LaViolette said, “We lost a couple of good people over that.”

The nondisclosure agreement gave LaViolette the legal option to recover damages, “but what would I gain in that case? I just didn’t want to go there,” LaViolette said, noting that any further action would only bring more attention to the consideration of selling the business.

Willing to walk away

By 1999, when LaViolette again considered selling the business, sales had rebounded nicely and he was in a stronger negotiating position. On June 18, 1999, the sale closed with terms the LaViolettes considered a fair value for the business they had spent a good portion of their life building.

The nondisclosure agreement also held firm this time around and no one – not even long-time employees – knew anything until the morning LaViolette announced the sale.

“You have to do it that way, as difficult as that may be, especially with long-time, loyal employees,” LaViolette said.

Today, LaViolette is president of The LaViolette Group, which provides marketing services to clients nationwide, but he keenly recalls the challenges faced when trying to protect the business and his family during the selling process.

At one point during the 1999 negotiations, LaViolette was presented with a proposal he considered to be “a deal breaker.” He stood firm and eventually got the deal he felt comfortable with.

“You have to be confident in your numbers and be willing to walk away,” LaViolette said. “I was and I walked away during negotiations. Ultimately they came back with a more acceptable proposal and it worked out for everyone.”

Protect yourself at the start

LaViolette credits the expert counsel from his attorney, accountant and broker during the sales process for the success of the negotiations. Long-time experts in business acquisitions and sales say there are several key elements necessary to protect your business and family during the sales process.

It all starts with having a nondisclosure agreement in place before confidential financial information such as tax returns and financial statements change hands. The nondisclosure agreement also binds both parties to confidentiality about the fact that discussions are taking place.

“If it becomes known that you are in discussions to sell your business, the risk is that there is a negative perception in the community among vendors and customers and bankers,” according to Stephanie Geurts, CPA, a partner in the Oshkosh office of Suttner Accounting. “You absolutely do not want to release information until you have nondisclosure in place – and you should have an attorney or business broker involved at this point.”

“One important factor is that if a deal isn’t reached, the nondisclosure agreement should require that all documents and confidential information be returned to the seller,” said Tony Renning, an attorney and partner at Strang, Patteson, Renning, Lewis & Lacy, the Green Bay-based employment law and business law firm with offices in Oshkosh and Madison. “You don’t want to have that information floating around out there.”

Once negotiations have progressed beyond the exploratory stage, it’s time for a letter of intent from the prospective buyer, Renning said.

Katie Blom, managing partner at Epiphany Law in Appleton, added that disclosure of confidential information before receiving a letter of intent should be limited to tax returns and basic financial statements. With a letter of intent in place, the seller can feel more secure in releasing detailed financial information. However, “secret sauce” kinds of information – customer lists, contracts and other proprietary material uniquely valuable to the business – should be withheld until there is a purchase agreement in place.

First of all, Blom said, “it’s important to do your due diligence on the buyer to see their history of acquisitions, to make sure they’re reputable and not going to steal your information.”

Then, she continued, “we usually advise our clients to have that NDA (nondisclosure) right away, before any significant discussions take place,” Blom said. “If they’re an educated or well-represented buyer, they’re going to want to see tax and financial information in order to evaluate the opportunity. But there are some things we advise our clients to hang onto as long as possible. And we want to see as many contingencies as possible eliminated from the purchase agreement.”

Getting good value

As LaViolette discovered in his negotiations, there are almost always differences between how the buyer and seller value the business. Sometimes each will bring his or her own accountant – ideally a certified valuation analyst – to the table, leading to competing valuations that must then be negotiated.

More often, according to Geurts, the parties will agree upon a third-party certified valuation analyst.

“Usually that report will be honored by both sides, although certainly one side or the other might challenge some parts of the valuation and that becomes a point of negotiation,” Geurts said.

The real question often comes to down which valuation method will provide the fairest valuation for a specific business. The asset approach might work well for a retail or manufacturing operation in which tangible assets and inventory make up a significant portion of the sale, but less so for a service business.

“The asset approach can be book value (basically the equity on the balance sheet) or liquidation value,” according to Geurts. Either way, she said, in many cases it may not be “very useful since it is historical cost and might not be relevant to what (the business) is worth.”

For service businesses, the revenue or income potential approach “works well for service industries that don’t have a lot of equipment or inventory that is worth much,” Geurts said. That approach, she added, “uses historical revenues and earnings and normalizes any expenses that are unusually high or low such as officer compensation.”

The market value approach – which uses data from similar businesses, recent sales or industry rule of thumb – is favored by many sellers. However, Geurts said, “it can be tough to find comparative data.”

Perceived business value can also be impacted by goodwill, which is an intangible asset resulting from characteristics such as name, reputation or customer loyalty. The valuation might also be impacted by how critical the current owner is to the success of the business, according to Blom. For a business heavily reliant on the current owner’s participation, the valuation might be as low as four times EBITDA (earnings before interest, taxes, depreciation and amortization), while a business less reliant on the current owner might bring a valuation as high as seven times EBITDA, Blom said.

In the end, if the offer to purchase comes in at below what the seller would want, there are options to help bridge the valuation gap. For example, Geurts said, the offer could include an “earn out” provision, which would enable the seller “to be eligible for an earn-out based on financial performance.”

Asset sale or stock sale?

The purchase price might also be affected by whether the buyer and seller agree to a stock sale or an asset sale, both Blom and Geurts noted.

“In an asset sale, the seller retains the company and the buyer purchases individual assets of the company, such as equipment and inventory,” Geurts said. “The buyer gets additional tax benefits when they purchase the assets, because they are able to step up the depreciable basis of the assets. Buyers usually prefer asset purchases because they avoid potential liabilities like contract disputes, warranty issues, environmental or regularity issues and employee lawsuits.”

For sellers, on the other hand, “asset sales generate higher taxes so they typically want a stock sale,” Geurts said. “Usually the sale of assets will be taxed at the ordinary income tax rates (10 to 39.6 percent) versus the capital gain rates of 0 to 20 percent for a stock sale.”

For those reasons, Geurts said, “a buyer is often willing to pay a higher price to purchase the assets so they can get the increased depreciation expense and not have as much risk of unknown liabilities, while a seller is often looking for a higher price when selling assets since they will have more in taxes.”

“We had a client who was doing an asset sale, but the tax implications were going to be significant,” Blom said. “We were able to restructure the deal so that it would be a stock sale. It worked out well for both sides. The buyer asked for a price reduction from what they had offered in the letter of intent, but the net still came out far ahead for the seller, even with the reduction of purchase price.”

Transitions

The transition from current owner to new owner takes multiple forms. In many cases, the buyer will want the seller to remain on in some capacity for a period of time after the sale – either as an employee or consultant. Also, in some cases, the purchase agreement calls for the buyer to pay part of the purchase price over time, generally called “seller financing.”

For the seller, a long-term payout can be fraught with risk. LaViolette, for example, stood firm on immediate payout, in part because he had seen too many business acquaintances come up short of full payout when they went that route.

For business owners, seller financing may be the only way to complete the deal – either because the buyer can’t summon the total purchase price or, more likely, because the buyer has concerns about a potential loss of client base.

In that case, Blom, Geurts and Renning all agree the seller is often well advised to stay on in some capacity for a period of time to ensure a smooth transition and continuity of business – thus ensuring his or her payout. The buyer may also request a noncompete agreement to prevent the seller from opening a competing business and siphoning off customers.

The purchase might also contain an attrition clause, Geurts said, “so some money may be held back or required to be paid back if key customers are lost within certain time frames. That also motivates the seller to stay on and help with the transition.”

Renning, who specializes in employment law, said buyers also need to do their due diligence on labor issues related to the purchase. That includes being aware of regulations regarding potential layoffs, and in the case of union shops they need to understand their status as “successor employers.”

An often-ignored post-sale factor is that of communication with existing employees, Renning said. “Once everything has been hammered out and the need for confidentiality is gone, it’s critical that the owners communicate with the employees and keep them in the loop about what’s going on.”

LaViolette’s experience might have been more difficult than many. Besides the 1995 negotiations, LaViolette spent more than six months negotiating the 1999 sale. Still, he said he has had no “seller’s remorse” after letting go of a business he founded and operated for 25 years.

“It was time to move on. For us it was a new beginning.”

Rick Berg is a freelance editor and writer based in Green Bay.