Will appear on Seller pages – RECENT SELLER ARTICLES
- The business experiences a sudden, catastrophic loss and all of the owner’s financial eggs are in the business.
- A perfect buyer suddenly appears and makes a fantastic offer, but the owner cannot consummate the sale due to prohibitive (and avoidable, with planning) tax cost and a lack of sufficient independent retirement income.
- An agreement to sell is made with a qualified buyer, but the buyer reduces the offer after finding aged accounts receivable and owner loans on the books. In short, the company’s books were not in order.
- An unanticipated catastrophe hits the business and because the owner failed to have a contingency plan in place, or existing support from legal/financial advisers, the business cannot survive.
- The sole owner dies or becomes permanently disabled, without sufficient (or no) life or disability insurance, no business succession plan, and no estate plan.
- One of the partners dies or the partners have an irreconcilable falling out and there is no clear buy-sell agreement – either of these situations commonly result in expensive litigation, and value erosion.
- The business is struck by a huge, legitimate legal claim with insufficient liability insurance in place thereby irrecoverably impacting the enterprise value and marketability.
- One of the company’s key employees quits, taking the best customers and other employees with him because the company has no non-compete agreement or retention plan to prevent this from happening.
- The owner wishes to retire and sell the business to a family member but there is insufficient time to make the transfer and pay minimal taxes.
- The owner has selected a capable non-family heir apparent, but has no written succession plan in place and the heir apparent cannot realistically fund the transfer.
An earn-out is when part of the consideration received for a business is based on future sales or earnings. Earn-outs usually come in to play in business acquisitions when a business has high risk factors, or when non-linear growth is reasonably expected, or when there is a significant gap in the price expectations between the buyer and seller. In all cases the parties share the risk and reward of future performance.
Bridging a Price Gap
An earnout is often the best way to bridge a gap between what a seller will accept and what a buyer will pay. For example, a seller may think their company is worth $4 million and the buyer thinks it’s worth $3 million. They can agree on a guaranteed price of $3 million, plus an earn-out over a period of 1-2 years, structured to provide the seller with the potential of receiving the extra $1 million, or more if sales or earnings reach a certain level, based on an agreed upon formula.
Devil in the Details
While simple in concept, earn-outs can become contentious during the measurement and payout phase. It is critical that earn-out parameters be carefully thought out and clearly defined in the purchase agreement. There must be no ambiguity in the accounting practices to be used, for example. Even if you continue to manage the business during the earn-out period, don’t assume anything.
At the same time, remember the K.I.S.S. principle. In my experience, the more complicated an earnout gets, the more likely negotiations will fail. It is usually (though certainly not always) best to base earn-out calculations on top-line sales or gross profit, not net income. Also, be sure to design the earnout formula to completely align the interests of the parties.
For another perspective on the use of earnouts in M&A transactions, see this recent article on Axial Forum.
For more information on M&A transaction structuring strategies, or if you want help selling a business or developing a winning exit strategy, contact me at 707-778-2040 or email@example.com.
Private equity groups are active acquirers of closely-held lower middle market companies here in California. Private equity consists of individuals, families and institutional investors that make passive minority investments in partnerships that invest in, provide debt financing for, and operate private companies.
Republican presidential candidate Mitt Romney’s run for the presidency in 2012 brought sudden attention to the private equity world. Romney, who had been the founder and CEO of private equity firm Bain Capital, didn’t go far out of his way to defend the industry during the election, and this growing and increasingly important source of private capital continues to capture news headlines. Business owners may find it challenging to distinguish facts from fiction.
For some businesses, specialized building construction is required — hotels, car washes, wineries, some food processing facilities, etc. — making the business and real estate nearly inseparable, and making owning the real estate almost mandatory. However most enterprises need a more generic commercial, industrial or retail property to support business operations, and the decision to own or lease real property is more elective.
Companies that lease their facilities avoid the sizable cash investment associated with ownership. Because a landlord seeks to receive an adequate return on invested capital (debt and equity) the lessee is likely paying a higher rent than just the debt service on a real property investment. But there are numerous financial issues beyond return on investment to consider. These include the appreciation potential of the facility, how financing the facility will impact financial leverage, tax consequences and even longevity of the business itself.
Looking on the plus side of leasing from a business perspective, growing firms may be wise to invest exclusively in inventory and other working capital assets. In fact, rapidly growing companies may not be able to invest in physical facilities even if they wanted to. Similarly many firms desire the flexibility that leasing provides in terms of expansion potential and having the ability to change locations as market conditions change.
On the plus side of ownership, many firms prefer the control (of rent increases, location, specialized improvements, maintenance, being asked to leave at the expiration of the lease, reducing risk in a sale of the company, etc.) that is only provided through facility ownership. I have seen businesses devastated by losing their location prematurely resulting from landlord actions. In addition, as the mortgage is paid down, an owned facility represents a potential source of collateral in the face of financial challenges to the business. If you determine that your business has long-term viability, cash to invest and will not outgrow the facility; when you sell the company down the road, your lease to the buyer can provide retirement income, especially when the mortgage has been paid down substantially.
Generally, for small to mid-size private companies, real estate is held outside the company, in an entity owned by the same or similar group of shareholders. The holding entity purchases the real property and leases it to the operating company. Most holding companies are organized as an S-Corporation or LLC with pass-through tax treatment. The facility owner(s) enjoy the tax advantages of depreciation, avoid double taxation, and can reap the benefits of any long-term appreciation of the real property. If the rent is market-based, as it would be in an arm’s-length relationship, which it must be to avoid IRS scrutiny, the valuation impact on the operating company is non-existent.
If you are faced with the choice of owning or leasing real estate, keep in mind it may be difficult to predict the long term future of the enterprise. Understand that your eventual exit from the business could be helped or hindered by owning the real estate. Your best buyer may be a synergistic buyer that already has a facility and would consolidate facilities, leaving you with an empty building to sell or lease.
I’ve really just scratched the surface of this topic. I’m leaving many considerations untouched. There is no single answer to my initial question. Your choice to own or lease should be based on your unique business model, circumstances and objectives, and should be carefully thought out. This can be a complex business question that deserves professional M&A, banking, tax and legal guidance in order to make a final determination.
For advice on selling, acquiring of valuing a California business with or without real property, Email Bob Altieri or call him at 916-905-5706.
A potential client has been dragging his feet on having a business valuation done. Most recently, he asked, “Is it too early to have my business valued?” A better question may be, is it too late?
This baby boomer wants to exit his business and retire in the next 2-5 years. He said, if the business isn’t worth much, he would probably hold on to it and transition management of the business to a group of employees over time. If the business is worth a lot, he would sell now and retire as soon as he had transitioned the business to the buyer. Inherent in that discussion is the fact that he really doesn’t know how much his business is worth.
As I pointed out in my blog post of February 26, 2014, “Why Should I Get My Business Valued”, for most business owners, their business in one of their biggest assets (often their biggest). Every month you know what your securities portfolio is worth. You can go to Zillow.com for an estimate of your home’s value. Similarly, you can go to Loop.net to get an idea of the value of your commercial real estate holdings. But where can you find the value of your biggest asset? The only ways are: 1) to market and sell your business or 2) to have your business valued by a qualified valuation expert.
My response to this business owner was:
“No, it is not too early. If you end up deciding to transition the business to your employees, it will take time. Doing it right can take 3-5 years or more. If you want to retire in 3-5 years, you already may be behind the game. And…if the business is worth enough for you to retire now, what are you waiting for?”
Most likely his business is worth somewhere between the two extremes that are occupying his mind. An accurate and well-documented business valuation will help him make better decisions with respect to managing the business and exiting in the right manner and in the appropriate time frame.
- Roy Martinez is a Certified Valuation Analyst (CVA) and business broker/M&A adviser. He can be reached at firstname.lastname@example.org or 707-778-2040.
Recent clients “Jane and John Doe” were satisfied with the market value estimate of their manufacturing business, as determined by the independent valuation we prepared. Armed with this essential piece of information, they were ready to sell the business they had founded and grown with much effort over many years.
John thought they should try to sell the business themselves. After all, weren’t they the best salespeople for their business? And why should they share a portion of the proceeds with a broker? Jane was not so sure and began to research whether hiring a business transaction intermediary was warranted.
One article that Jane found contained the results of a poll conducted by Partner On-Call Network LLC in which sellers of small and medium sized businesses were asked why they hire business brokers instead of trying to sell themselves. The poll identified 62 reasons, including these top eight, in order of frequency cited:
- Brokers know how to sell businesses; most sellers don’t
- Seller doesn’t want to be distracted from running business
- Confidentiality preservation and knowledge of what/when to show buyers
- Access broker’s database of potential buyers and investors
- Maximize price buyers will pay for the business
- Owner does not know how to find buyers
- Prepare owner to sell and prepare business for sale
- Broker understands and can depersonalize negotiations
After discussing this and other inputs that they had received, the Doe’s decided that hiring an intermediary was the prudent decision if they wanted to maximize proceeds from the sale of their business and reduce the risk of no deal or a flawed deal.
All 62 reasons can be found HERE.
For a certified business valuation or assistance with successfully exiting your California company, you can Email Jim Leonhard or call him at 916-800-2716.