Exit Strategies – Cashing In
July 18, 2019
My discussion with two experts: Mark Dunlop is a business banker with BankUnited and a preferred SBA lender. Ken Chapman is a transaction attorney and partner with Bowman George, Sarasota’s oldest law firm.
Mark, what are the most common exit strategies to Sell a Business?
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 buyer. Obviously, this is not the most beneficial way for an owner to get out of a business, but often it has to happen. Second, sell to a third party. Find an outside person who’s interested in buying 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. The third option, you could sell to your business partner(s). If you’ve got people who have been involved with this business from the beginning, it’s likely one of them would like to see the business continue. The downside is that it’s probably going to be the most realistic valuation. They know the business inside and out and they know what it’s worth. A fourth option is 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.
What size business would be a threshold for creating an ESOP?
Well, a good rule of thumb is probably about $10 million in revenues. There’s a lot of fees involved. Ken, what would be an optimum time for a business owner to consider selling their business? 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 is a lot of good documentation: such as financial records, legal records, contracts with vendors, customers, things of that nature. Starting as soon as possible becomes very important. The 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 and 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.
Can you give an example of when someone might have started too late.
If they don’t have their financial records well kept, if they don’t have their legal records in order, if their contracts are stale, and 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 value of a business because it creates a mess. Those are the deals that don’t tend to go as quickly and as smoothly as they could otherwise.
Mark, are there key considerations that you would suggest for someone selling their business?
Two suggestions come to mind. One is understanding who your potential buyers are. If you’re selling to employees, or 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 since 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.
Ken, how can a business owner increase the value of their business?
Increasing the value 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 with-what does it look like. 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 risks that could be managed and made to go away? Are there any claims such as warranty claims, are there lawsuits? These types of situations should not factor into someone trying to sell their business. The other side of the equation goes back to the assets. With key employees, those are critical assets to the business and have they been secured either with contracts or some other form of golden handcuff incentives to stick with the business.
If there’s a legal action or a lawsuit, how can that be handled?
Lawsuits 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 a worst-case scenario, if it’s related to intellectual property. Those types of matters can hamper a transaction and slow it down significantly. Get those out of the way before you decide to go to the market.
Can you give us some examples without mentioning names? 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 used to pay that particular liability.
Mark, can you tell me about some common ways to purchase a business?
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 SBA quite a bit. The SBA 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 pay-back period. How much will the SBA lend? I’ve seen cases where they’ve lent 80% and up to as much as 90% of the transaction.
When they talk about a guarantee, who’s doing the guaranteeing?
The SBA guarantees a percentage of the loan. 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.
Is it easier to finance a franchise?
It can be. We use the SBA a lot for franchise financing, primarily because the SBA keeps great records on success and failure of franchises. There’s actually a list on the SBA’s website of all the approved SBA franchises. When we start the conversation with a client about buying a franchise, we refer to that list. If they’re not on the list, we don’t touch it. But the SBA 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.
Ken, regarding franchises, what are some pluses and minuses for someone looking at selling their business?
You have to be sure that the buyer is going to be approved by the franchisor. They must understand what the process is for the franchisor to approve the transaction, and whether or not the franchisor is going to need to interact at with the landlord, which is often the case. This happens 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 takes more time and it’s not overly complicated. It’s just a matter of stepping through those hoops.
Is intellectual property theft an issue?
It can be. If intellectual property is a key part of the business, then that really needs to be looked at. Are the patents secured? If the patents are secured, sometimes it could be a revenue source. If you find somebody who is 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.
Mark, how important are having audited financial statements?
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. Can you provide a couple examples of some success stories? 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 seller 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 being a very good transaction for both parties and in the case of our buyer it was probably the fourth business he had looked at. It was a gentleman who wanted to relocate from the Mid-West to Florida. As he looked at this business, and realized it was something that he could grow. There were key employees in place that he knew he could hold onto, mentor and build, so it turned in a good win-win for both parties.
SBA loans that I’ve closed have probably been the last four or 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 large trade operation. Then I also did a transaction that involved acquisition of a real estate brokerage firm. What surprised me in both those transactions was how fast the SBA reacted, how fast the lender reacted, and how quickly we were able to close on those two purchases.
Was the paperwork from the SBA voluminous or reasonable?
It is more paperwork than you would otherwise see because 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 SBA 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.
Can you tell me about some unsuccessful situations?
One that comes to mind was a stock transaction where individuals came to me after they had signed a contract and closed-on the transaction. They asked me to 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 started 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 had to absorb that $45,000 debt. In aother situation, I had a client who sold an operation to a competitor. The competitor was overextended. It was in an industry that is starting to have less and less brick and mortar value because the internet provides so much competition. Now my client has to take back the business and we’re just going to try and resell it for what the assets are worth.
Please explain differences of an asset versus a stock sale.
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. 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 their 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 that there may be a liability that wasn’t properly disclosed. Outside of being able to put some escrow cash into a fund, there really isn’t much recourse for someone who gets into that situation.
Mark, do you have any negative stories that you could tell that didn’t quite work out?
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 eroded and the profits have gone away. The sales have gone away, the business broker listed a lot of creative add-backs that they tried 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. We encouraged them to walk away from it.
Mark, tell me about the franchise deals that you have completed.
Franchises are a great opportunity because it gives the buyer 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.
An interesting comment you made caught my attention regarding add-backs. If the seller takes their spouse out to dinner and buys personal items, shouldn’t that amount be added back because the new owner is not going to have those kinds of expenses? 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.
Ken, what items might a seller try to hide from a prospective buyer?
That really depends on how creative they want to be. Some of the common items are car expenses, insurance, health insurance, 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 obvious is cash. Cash just may never hit the books. The downside with that is if someone 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.
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.
If you’re not showing the cash, it didn’t exist. Isn’t that correct?
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 of today and they may be applying the time value of money.
It’s hard to 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 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.
Mark, how important is cash flow, receivables, and assets?
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 in the long-term because all we can look at is the 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 headfirst into the problem that they’ve decreased the value because they’re probably going to get some multiple of what the cash flow is.
Mark, is there one piece of advice that we haven’t discussed yet or something that you want to reemphasize?
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. This flexibility is not going to be the same if you’re selling to an outsider. 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 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.
Ken, what one piece of advice could you give a prospective seller?
Start the process as soon as you can. As a seller/owner 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 counsel who has experience in mergers and acquisitions, 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 expertise. They should be leveraged. This is going to be the single largest financial transaction that a person experiences. 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, organized, and thorough. Start as soon as possible and get that process going in the right direction.
Please contact me at [email protected] if I may be of help to you.