Dennis Zink: Welcome to SCORE Business TV. I’m Dennis Zink. In this series experts share their knowledge on a variety of topics. Today we’re presenting part one in a series of episodes addressing business succession. Today’s topic, Cashing in and How to Exit Your Business.
But before we begin, I’d like to introduce two experts in this field. First Mark Dunlop, vice president with Bank United. We also have Ken Chapman, attorney and partner with Bowman George, Sarasota’s oldest law firm.
Mark, what are the most common exit strategies that you see?
Mark Dunlop: Good morning Dennis. Thank you for having me.
There are six different ways that we see to exit a business. Number one, close it down. Unfortunately some businesses have just run their course, they’re no longer profitable, they no longer serve a niche, and there are times where there’s just not a logical seller. Obviously this is not the most beneficial way for an owner to get out of a business, but often it has to happen.
Secondly, settle with third party, find an outside person who’s interested in taking over your business. You’re probably going to get the highest valuation going this route, but it’s liable to take a little longer than some other options.
Number three, you could sell to your partners. If you’ve got people been involved with this business from you from the beginning, it’s likely one of them would like to see the business continue. The downside is it’s probably going to be the most realistic valuation. They know the business inside and out and they know what it’s worth.
Fourth, sell to a competitor. The competitor is going to know the industry. They’re going to know how your business ought to operate and there may be some strategic value to them to own your business. The downside is if the deal doesn’t happen, you have revealed a lot of very important information to your competitor that may not be advantageous to you.
Fifth, sell to your employees. If you have one or two key people in that business that can run it in your absence, you may be a great candidate for selling to your employees. And if the business is large enough, an employee stock ownership program could make a lot of sense.
Dennis Zink: What size would a business be for an ESOP?
Mark Dunlop: Well, we think a good rule of thumb is probably about $10 million in revenues.
Dennis Zink: There’s a lot of fees involved in it.
Mark Dunlop: There’s a lot of fees involved, absolutely, absolutely.
Dennis Zink: And Ken, what would be an optimum time for a business owner to consider selling their business?
Ken Chapman: Ideally from day one. When an owner goes to the market to sell their business, it’s all about being able to present a business that is well prepared, organized, and there are a lot of documentations, documents that need to be maintained, whether it’s the financial records, it’s the legal records, if it’s contracts with vendors, customers, things of that nature, that starting as soon as possible becomes very important.
The very least amount of time I’d like to see is about a year because there are things that are going to come up that have to be cleaned up, looked at in order to make sure that they’re addressed, so a potential buyer coming in won’t be spooked away from the deal or that those certain circumstances can be explained away.
Dennis Zink: Can you give an example of when someone might have started too late?
Ken Chapman: Heavens, if they don’t have their financial records well kept, if they don’t have their legal records well kept, if their contracts perhaps are stale, if they haven’t made enough time to get their intellectual property secured, do they have liabilities or conflicts, potentially lawsuits out there that need to get resolved before someone goes to the market and decides to sell their business. All these things can detract from the inherent value of a business because essentially it just creates a mess, it creates hair if you will, and those are the deals that don’t tend to go as quickly and as smoothly as they could otherwise go.
Dennis Zink: Mark, are there key considerations that you would suggest for someone selling their business?
Mark Dunlop: I think two come to mind. One is understanding who your potential buyers are. If you’re selling to employees, you’re selling to family members, you may have some flexibility in timing and structure that you may not have with the other options available to you. But primarily the thing that I see most often is timing. When a seller of a business waits too long, they’ve lost interest in the business, sometimes it’s two or three years that they’ve had interest in the business. The client base begins to erode, the profits go away, and now they’re trying to sell an asset for a lot lower value than they could’ve received had they planned better and sold it at the peak.
Dennis Zink: Ken, how can a business owner increase the value of their business?
Ken Chapman: Increasing the value really is going to be driven mostly by the financial side of the equation. Where I can advise a client on how to fortify that value is rest within what does it look like, are the financial records well kept, are the corporate records well kept, do they have contracts that are solid that they haven’t gone stale, is there intellectual property secured, have they filed for patent applications, trademarks, or copyrights as the case may be?
On the other side of the equation you have liabilities. What are the liabilities or risk out there that could be managed and made to go away? Are there claims, are there warranty claims, are there lawsuits, things of that nature that should not factor into in someone who’s trying to sell their business.
The other side of the equation goes back to the assets is key employees, those are critical asset to the business and have they been secured either with contract or some other form of like a golden handcuff incentives to stick with the business.
Dennis Zink: How significant, you mentioned legal aspects. So if there’s a legal action or a lawsuit, how does that tie in?
Ken Chapman: Losses can be a big problem. No one wants to buy a business that’s in the middle of litigation, whether that’s with a customer, a vendor, or perhaps in worse case scenarios if it’s intellectual property related. Those types of matters can really be a quelch on a transaction, can slow it down significantly. So get those out of the way before you decide to go the market.
Dennis Zink: Can you give us some examples without mentioning names?
Ken Chapman: The one example that does come to mind is actually related to income tax returns. Someone had outstanding tax liabilities. The way we ultimately got around that scenario was we set aside some cash from the seller into an escrow account. If the actual claim, the IRS claim or the taxes were not satisfied within a certain period of time, then the escrow funds were to go pay that particular liability off.
Dennis Zink: Mark, can you tell me about some common tactics used to purchase a business?
Mark Dunlop: Certainly. It really depends on who the buyer is. We finance a lot of these transactions and there is conventional means to do it. We use the SPA quite a bit. The SPA is a great source for us for financing the purchase of a current business primarily because it reduces the amount of capital that the buyer has to put in and gives them a longer immunization period.
Dennis Zink: What percent will the SBA guarantee the loan?
Mark Dunlop: Well, I’ve seen cases where they’ve lent 80, in some cases up to 90% of the transaction.
Dennis Zink: And when they talk about a guarantee, who’s doing the guaranteeing?
Mark Dunlop: The SBA actually guarantees a percentage of that loan. So the bank is on the hook for a percentage and then the SBA guarantees the larger percentage. A lot of times it’s 25% with the banks, 75% guarantee with the SBA. If that loan goes bad during the term and the bank has done everything it was supposed to, the bank only suffers the 25% loss.
Dennis Zink: Is it easier to finance a franchise?
Mark Dunlop: Well it can be. We use the SPA a lot for franchise financing, primarily because the SPA keeps great records on success and failure of franchises. There’s actually a list on the SPA’s website of all the approved SPA franchises. When we start the conversation with a client about buying a franchise, we refer to that list first of all. If they’re on the list, we don’t touch it. But the SPA has such a great track record understanding the success of these franchises that it gives us a lot of comfort that this is going to be a good investment.
Dennis Zink: Ken, regarding franchises, what does that add or take away from the equation when you’re looking at someone selling their business?
Ken Chapman: And essentially you have to step up time and going to the next level of making sure that the buyer is going to be approved by the franchisor, understanding what the process is for the franchisor to approve the transaction, and whether or not the franchisor is going to need to interact at a level with the landlord, which is often the case, to make sure that there is smooth transition should the new owner not succeed in the purchase business and the franchisor needs to step in. There are different additional layers. It just is more time and then it’s not overly complicated. It’s just a matter of stepping through those hoops.
Dennis Zink: Is intellectual property theft an issue?
Ken Chapman: It can be. It is. If intellectual property is a key part of the business, then that really needs to be looked at it from as are the patents secured? If the patents are secured, sometimes it could be a revenue source. If you find somebody who is actually taking advantage of infringing upon a patent, that creates the opportunity for the owner to go after those infringed upon patent rights.
No one wants to get into a lawsuit. The better approach is to make sure that if an owner owns patent rights, or trademark rights, or copyrights, that they make sure that those are not being infringed upon going into the transaction. If something comes up, they need to be addressed quickly. Having that type of conflict for a buyer is going to be problematic because now all of a sudden it puts at risk the core source of revenue that ultimately the buyer is going to want to take advantage of when they close.
Dennis Zink: Mark, how important are audited financial statements?
Mark Dunlop: Audited financial statements are important depending on the deal size. Typically, if a deal is less than $1 million, we’re not going to worry too much about audited financials, but the larger the deal is, the more important it becomes. Typically, if the sale is going to be a million or more, audited financial statements are very important.
Dennis Zink: Can you provide a couple examples of some success stories?
Mark Dunlop: Certainly. Recently we financed through the SBA a $3 million purchase of a roofing company. In this case I wouldn’t say that the buyer went about it the way that we would like to see. In fact, I was told the buyer had pretty much decided to close the business down until one of his financial advisors came back to him and said, “Listen, I think there’s some value here.”
If he had sold it a few years earlier, he could’ve gotten a lot more for it, but it turned into be a very good transaction for both parties and in the case of our buyer it was probably the fourth business he had looked at, a gentleman who wanted to relocate from the Mid West to Florida. As he looked at this business, realized it something that he could grow. There were key employees in place that he knew he could hold onto and mentor and build, so it turned in a good win-win for both parties.
Dennis Zink: Good. Ken, can you give an example as well?
Ken Chapman: SBA loans that I’ve closed have probably been at last four, five deals I’ve done. If I had to add up the amount of loans collectively, probably close to $8 million. The biggest was about a $6 million transaction for a very, very large trade operations. Then I also did a transaction that involved acquisition of a real estate brokerage firm. What really kind of surprised me in both those transactions was how fast SPA reacted, how fast the lender reacted, and how quickly we were able to close on those two purchases.
Dennis Zink: Was the paperwork from the SBA as far as requirements go voluminous or reasonable?
Ken Chapman: It’s relative honestly. It is more paper work than you would otherwise see because essentially you’re going through the same loan transaction twice. You have a set of documentation which the lender will provide, and then you have a set of documentation that the SPA itself will provide. But at the end of the day considering the rates and the general benefits that the SBA loans will afford it’s worth it. It really is.
Dennis Zink: Can you tell me some unsuccessful opportunities?
Ken Chapman: There have been a couple recently. One that comes to mind was an actual stock transaction where individuals came to me after they had actually signed a contract closed on the transaction, they asked me to see if I could help straighten it out. They tried to save a little money and got a purchase agreement off the internet. What they didn’t realize is that the seller had a credit card with a balance of about $45,000. After they closed, the credit card company starts sending them notices and demanding payment. Well, the buyers went back to the sellers and said, “Hey, you need to pay your credit card.” The seller said, “No, I got a better idea. I’m going to file bankruptcy.” The buyers actually wound up having to absorb that $45,000 figure.
Another situation was I had a client who sold an operation to a competitor. The competitor was overextended. Candidly is in one of those industries that is starting to have less and less brick and mortar value because the internet provides so much competition and now my clients essentially have to take back the business and we’re just going to try and resell it for what the assets are worth, but yes, it does happen.
Dennis Zink: An asset sale versus a stock sale, could you give us a summary of pluses and minuses?
Ken Chapman: In an asset sale what you’re essentially doing is you’re taking all the benefit and good aspects of a business and leaving all the bad. The way I’ll describe that is I usually tell clients, “Think of it this way. If you need a bucket to carry something, you get a brand new shiny bucket. It’s in perfect condition. You take all the assets that are in the seller’s bucket and that may be dinged up, it may have holes, it may have rust, you don’t know, but you don’t care because you’re going to take the seller’s bucket, dump it into your bucket. Off you go with your brand new bucket and all the assets that you purchased. You’re leaving the seller with their problems and the bucket. That’s an asset transaction.
In a stock transaction you take the old bucket with the holes, the rust, and everything, and if you don’t do your due diligence carefully and thoroughly, you can learn like this one client learned that, hey, there may be a liability out there that wasn’t properly disclosed and outside of being able to put some escrow cash into a fund, there really isn’t much for a recourse for someone who gets into that situation.
Dennis Zink: Mark, do you have any negative stories that you could tell that didn’t quite work out?
Mark Dunlop: Well probably the most recent one was a classic example of the seller waiting too long and losing interest in a business. The buyer approached us. We looked at the financials. Three years ago the asking price made perfect sense. Today it does not primarily because the client base’s eroded, the profits have gone away, the sales have gone away, the business broker to try to make up for that had a lot of creative ad backs that they try to put in the deal to make the cash flow look better. But underwriters don’t really care about add backs. You can add back depreciation and that’s about it. This deal didn’t make sense for the bank or for the buyer. So we encouraged them to walk away from it.
Dennis Zink: Have you done any franchises?
Mark Dunlop: We have. We have. Franchises are a great opportunity because what it really gives the buyer is a blueprint, it gives them a business plan to execute. If they buy the right franchise, this is a business plan that’s been executed across the country, and if they follow the plan, they’re going to be successful.
Dennis Zink: Interesting thing that caught my attentions with the add backs. If the person who’s selling the business takes their wife out to diner and buyers personal items, shouldn’t that amount be added back because the new owner is not going to have those kinds of expenses?
Mark Dunlop: It should’ve been included in the first place. The underwriters look at it and say they don’t want to make assumptions about what expenses should and should not have been included in the first place. They’re looking at it and saying, if these were reasonable expenses for the old owner, they’re probably reasonable expenses for the new owner. So unless you have three people involved in ownership, each taking a salary and now you’re going to have one, there aren’t many other things that you can add back in.
Dennis Zink: Ken, what other items might a seller hide or try to hide from a prospective buyer?
Ken Chapman: That really depends on how creative they want to be. Some of the common ones are car expenses, insurance, insurance on their home, they may be able to bury insurance on their house, meals out, vacations. Someone who could turn around and say, “Okay, I’m going to take a trip to Europe because I’m going to visit businesses which are just like mine.”
The other one that is quite often overlooked and very quite obvious is cash. Cash just may never hit the books. The downside with that is if someone is from the seller’s perspective is hiding cash, then it’s hard to create a value within the company and that tends to hurt when you’re going in to sell the business because you’re kind of taking out of one pocket, you’re stealing from yourself in essence, and by doing so you’re only hurting the long-term value of the company.
Dennis Zink: It would seem to me that the benefit would be much less than you would get, when you sell the business, you’re going to get a multiple of some cash flow number. So if you’re not showing the cash, it didn’t exist. Is that correct?
Ken Chapman: That’s exactly right. But a lot of times individuals will take the bird in hand today versus trying to get that multiple down the road because they know they have the cash in front of them or they have expense in front of them that they could take advantage today and they may be applying time value of money.
It’s hard to really kind of ascertain where someone wants to draw that line. I tell my clients don’t do it. At the end of the day, if you’re selling your business, you want that business to be as desirable and as clean as possible. I literally did a transaction where someone came to me and said, “Now the seller said these are books that he uses for the government and these are his private books.” I always thought that that was essentially a joke, but it in fact did happen one day and I was absolutely astounded of it.
Dennis Zink: Mark, how important is cash flow versus receivables and assets and other items?
Mark Dunlop: Cash flow is really the key. As we underwrite any deal, we look at the business’ ability to repay, that only comes out of cash flow. To Ken’s point, when people are not reporting income because it’s cash, they may be helping themselves in the short-term by reducing their tax liability, but they’re hurting themselves the long-term because all we can look at is the actual cash flows reflected in their financial statements. If a company doesn’t produce the essential cash flow that it takes to repay the debt that’s going to be created by this new loan being used to purchase their company, then the buyer can’t get financed. If there’s no financing involved, they still run the head of the problem that they’ve decreased the value because they’re probably going to get some multiple of what the cash flow is.
Dennis Zink: Mark, is there one piece of advice that you can leave our viewers that maybe we haven’t discussed yet or something perhaps we have and that you want to reemphasize?
Mark Dunlop: Certainly. Two things come to mind. One is understand who your potential buyers are. That gives you some flexibility perhaps. If you’ve got employees or family members you’re going to be selling to, you may have some flexibility in the time that it takes to close the deal, how you structure the deal, how you get repaid, that you’re not going to have if you’re selling to an outsider.
But timing, I keep coming back to this. We’re here talking about strategies. Strategies imply that you’ve got a plan in place. The business owners need to be working with people such as SCORE mentors frankly that can help them understand the timing, help them prepare to sell at the top, not wait until they’ve lost interest, not wait until something else has come up, not wait till there’s been a family crisis or a health crisis to try to sell their business, but sell it when that asset has its top value. Maybe that means you’re getting out of it before they plan to. But if that’s the best return they can get, then they need to have a good strategy in place to sell at the peak.
Dennis Zink: Ken, I have the same question for you. What one piece of advice could you give or perhaps reemphasize a point you’ve made earlier to a prospective seller?
Ken Chapman: Start the process as soon as you can. Once you as a seller or an owner realize you’re going to at selling the business, you need to start planning for that as soon as possible. You need to create your transition team. You’re going to need to pull in a qualified experienced CPA. You’re going to need to bring in legal council who has experience in merger acquisition, buy/sell type transactions.
The other side of this equation is going to involve someone who can help you present your business in its best light, to make it most desirable. Candidly that’s a phone call to SCORE. The counselors at SCORE have done this. They’ve got the experience, they have the expertize. They should be leveraged off of. This is going to be the most singular largest transaction that a person can do. They’ve poured their energy, their life, their blood into this particular business. They need to go about it in a way that’s methodical, it’s organized, and it’s thorough. So starting as soon as possible to get that process going is critical.
Dennis Zink: Ken, how can our viewers get more information on how to reach you?
Ken Chapman: I can be contacted at my office by telephone. My phone number there is 941-366-5510. Or I can be contacted by email. My email address is [email protected]
Dennis Zink: Mark, same for you.
Mark Dunlop: Yes sir. You can reach me via email at mdunlop, that’s M-D-U-N-L-O-P, @bankunited.com or via cellphone 941-524-3285.
Dennis Zink: Mark and Ken thank you very much for being our guests today on SCORE Business TV. We also want to thank our viewers and our sponsor Bank United, and we want you to tune in next time for business valuation. This is Dennis Zink for SCORE Business TV. I may be reached at [email protected].