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  • Financial Components of a Business Sale

    Nov 21, 2014

    Families in the Pacific Northwest will gather on November 27 for Thanksgiving. A majority of the meals will feature turkey, sweet potatoes, and pumpkin pie. However, meals will also have salmon, mashed potatoes, and pecan pie. The goal of the Thanksgiving holiday is to gather with family and/or friends to share a meal, conversation, and fellowship. Specific individual components of the meal are not necessary to achieve this goal. A similar statement can be made about a business sale negotiated in “good faith” between a buyer and seller. The goal of the transaction is to complete the purchase and sale of a privately held company or family business in the best interest of each party. However, the financial components of the transaction can vary significantly based on the parties, nature of the business, and sources of capital employed by the buyer to acquire the company.

     

    The most straight forward financial component employed to acquire a business is cash. Sources of cash can include the buyer’s personal assets, a loan from a bank, and/or investment or loans from private individuals or companies. Sellers traditionally want to receive as large a percentage of the sale price in cash as possible to minimize risk and facilitate post transaction investment of the proceeds. Many buyers favor employing cash to acquire a business to keep the transaction terms simple, minimize post transaction involvement in the business by the seller, and/or obtain favorable terms for repayment of acquisition capital.

    The second most common financial component employed to purchase a business is a promissory note from the buyer to the seller. The advantages of having the seller finance a percentage of the sale for a buyer include the relative ease in obtaining financing & lower origination costs versus obtaining a loan from a bank, vesting the seller in the success of the buyer post transaction, and creating a mechanism to address liabilities that surface after the transaction is completed that were not identified or disclosed. The potential advantages for a seller of financing a portion of the transaction include increasing control over the timing for completion of the transaction, obtaining interest income above the sale price, and minimizing the tax implications of the sale. It should also be noted that it is a common bank requirement that the seller finance a portion of the transaction (10% +/-) when acquisition capital is obtained with a SBA (Small Business Administration) backed loan.

    A financial component that is often employed in transactions involving service companies, when there is perceived business continuity risk, or the future performance of the company is hard to predict is an earn-out. An earn-out is a variable financial component where the seller receives proceeds based on the performance of the company over a period of time post transaction. If negotiated appropriately this financial component can create a mechanism for a seller to receive a “fair” value for their business if post transaction performance equals or exceeds expectations. An earn-out can also mitigate the buyer’s financial risk when transitioning ownership of a privately held company or family business. In a perfect world, an earn-out results in a seller receiving a “fair” value for their business and the buyer paying an appropriate amount for a business. IBA has successfully negotiated earn-outs in transactions to the benefit of the parties in the sale of software companies, professional practices, to address risk associated with a high concentration of revenue with a single customer (e.g., Boeing, the government, or military), and when a company is growing exponentially.

    Financial components that benefit individual shareholders or owners are often employed in transactions involving privately held companies and family owned businesses. These individual centric financial components take the form of employment and consulting agreements. Buyer motivation for creation of employment and consulting agreements is traditionally focused on creating an environment where the seller has financial incentive to facilitate a smooth transition of ownership. We have also witnessed the use of employment and consulting agreements for tax reasons and as a mechanism for a retiring seller to maintain health insurance coverage until Medicare eligibility is achieved.

    Cash, a seller promissory note, earn-out, and employment & consulting agreements are the most common financial components occurring in transactions involving the sale of a privately held company or family business. However, there are many more options available to willing & creative parties including stock in publicly traded or privately held companies, stock options, and real estate swaps. It is our recommendation that both the buyer and seller consult with an accounting professional knowledgeable in transactional accounting prior to committing to any financial component in a “good” faith negotiation related to the purchase or sale of a business.

    The sophisticated process involved in selling a privately held company or family owned business requires knowledge, experience, and a strong negotiation/facilitation skill set. The financial term deal structure is a foundation component of a properly structured “win-win” transaction. Similar to construction, if it is not properly built with the right mix of components, future issues can develop that are detrimental to the success or financial remuneration of the parties.
    IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, and mergers & acquisitions community on subjects relevant to the purchase & sale of privately held companies and family owned businesses. IBA is recognized as one of the best business brokerage firms in the nation in terms of successfully negotiating transactions that are “win-win” in an environment of full disclosure between the parties.

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