CONSIDERATIONS IN BUYING AND SELLING A BUSINESS

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1 CONSIDERATIONS IN BUYING AND SELLING A BUSINESS David H. Pettit, Esq. Feil, Pettit & Williams, PLC Charlottesville, VA I. Ownership A. Are the owners of sound mind and in agreement? B. Can the transaction be closed without 100% approval? If not, what is the approval requirement, and should an agreement among the owners be entered into in advance? C. Are key owners prepared to enter into agreements that may be necessary for a sale, such as employment, consulting and non-competition agreements? II. Keys to the success of the business what is the source of its value? Just as importantly, can the keys be passed on to a new owner? A. Managers it may be a good strategy to lock in key managers with an agreement to pay a transaction success bonus, contingent on remaining available for employment by a new owner for a specified period. B. Good will 1. How will good will be impacted by the change of ownership? 2. Is it corporate or personal? Company name/trade name recognition vs. personal name recognition. 3. If it is personal, how will a Buyer capture the good will? A longer transition period may be required. If so, how long are the owners willing to remain involved, how will they be compensated, and how will that commitment be documented? C. Long-term customer relationships D. A highly recognized product or product line with customer loyalty E. A trained, experienced and reliable workforce F. Business locations that work well, and potentially are a deterrent to competitors G. Competitive position 1. Customer loyalty 2. Exclusive products, services or expertise 3. Exclusive patents, trade secrets, or other intellectual property Dec2012

2 4. Control of the marketplace 5. Barriers to entry 6. Number of competitors and risk of increased competition H. Potential for product liability claims, including potential for successor liability for product claims against Seller. III. Valuation A. Capitalization of historical earnings Average after tax earnings of the business over a 3-5 year period, divided by a capitalization rate calculated as a combination of market risk free rates, industry risk premiums, and company specific risk premiums. Many small businesses are valued at a capitalization rate in the range of 20%, which equates to 5 X average after-tax annual earnings. Higher or lower rates may be appropriate, based on an assessment of risk. B. Determining the value based on capitalized earnings 1. What are the historical earnings? 2. How do they need to be adjusted to accurately reflect results of operations? Owners may understate earnings to minimize tax liability, and overstate earnings to maximize business valuation. 3. What is the right capitalization rate? This is determined based on an analysis of all the factors discussed in Section II and Section III. 4. Is the earnings stream steady or volatile? 5. How likely is it that the new owner will be able to duplicate historical results? Factors to consider include market conditions, competition, expertise, and all of the other factors that go into creating value and profitability. C. Asset-based valuation may be more appropriate where the profitability is not sufficient to justify a higher number, or where the risk is so great that Buyers are not willing to pay a premium. General contracting firms often trade at book value because of the competitive pressures in the industry. 1. Book (depreciated) value 2. Appraised value 3. Are the assets in good working order, or are they likely to need substantial repair or replacement? IV. Financial statements A. Is the accounting organized and reliable? Have accounting methods or practices changed that make it difficult to analyze performance over time? Dec Considerations in Buying & Selling a Business

3 B. Without reliable financial records and reporting, Seller can expect to have value discounted due to uncertainty. C. Are the results of operations volatile or stable? D. Are there items in the P&L or balance sheet that are misleading and need to be adjusted for presentation purposes? 1. Owner perks (or owners working without adequate compensation?) 2. Family employees 3. Leases at above or below market rates 4. Extraordinary items E. Working capital V. Management 1. What is working capital? The general definition is current assets minus current liabilities. In practice, working capital is often cash, accounts receivable, work in process and inventory less current accounts payable and other current liabilities. The working capital accounts are highly dependent on each other (e.g., when payables decline, cash often does also. Short term debt, like a revolving line, and the current portion of long-term debt, are generally included because of the immediate impact on cash. Note that accrued vacations and sick leave are generally considered a short term liability for these purposes. 2. It is often advisable to determine historical average working capital for the time of year in which the sale is expected to close, and provide that any excess or shortfall at closing relative to the average will result in an adjustment to the purchase price. This eliminates the incentive for a Seller to manipulate the business to its advantage. For example, if cash is excluded but receivables are included, Seller is motivated to accelerate collections in order to get the benefit of the payments. 3. How much working capital is required to properly operate the business? 4. Will the Seller have sufficient working capital to allow the business to be successful? A. Key employees B. Impact on valuation C. Will the new owner have sufficient skills, expertise, contacts to be successful? D. For the Buyer, securing the services of key managers going forward may be essential to the transaction Dec Considerations in Buying & Selling a Business

4 VI. Backlog A. This is hugely important, especially in the construction industry. Seller must be able to document the existence of an adequate backlog. VII. Key contracts A. Business contracts B. Leases C. Employment or Non-competition agreements (may not be assignable) D. Supply agreements E. Agreements with customers F. Licenses G. Franchise agreements VIII. Consents A. Many contracts contain provisions that prohibit assignment without consent of the other party to the contract. Some define assignment to include a change of control of the company; such a contract could prohibit a sale of the company, or cause a sale to constitute a breach of the contract. All material contracts need to be carefully reviewed for this issue, among others. B. Lender consents a transfer of ownership generally triggers a default unless consent is obtained. IX. Assets A. Are the assets in good condition, or are they run down and in need of repair or replacement? B. Are all the assets necessary to operate the business owned by the business? 1. If key assets are owned by the stockholder(s) and have been made available at below-market rates, the income statement will be misleading. C. Are there assets in the business that aren t necessary for the operation of the business? If so, they represent a windfall for the Buyer unless Seller negotiates for an increase in the purchase price Dec Considerations in Buying & Selling a Business

5 D. Are the assets subject to liens, leases, or other encumbrances? If so, these will need to be assumed or satisfied. E. If the assets include inventory, there is substantial risk for the Buyer unless a properly supervised physical inventory is taken at or about the time of closing. X. Stock purchase or asset purchase? A. Buyers often like asset transactions because the assets can be purchased without an assumption of all the liabilities of the Seller. The general rule is that a purchaser of assets does not automatically become liable for the liabilities of the Seller, but there are numerous exceptions to the rule, especially in the product liability context, and care is necessary. B. Sellers generally prefer a stock transaction, because of the ease of transfer (the stock is transferred instead of the assets, so there are no deeds, assignments, recordings, etc.) C. Circumstances may dictate a stock transaction, such as assets that are cumbersome to transfer, contracts that cannot be assigned but permit a change of ownership, licenses, permits, or other rights belonging to the Seller. XI. Tax issues A. Very generally, if the Seller is a limited liability company taxed as a partnership or an S-corp, the gain on a sale of assets flows through to the owner and is subject to taxation once at the partner/shareholder level. To the extent that the sale is a sale of capital assets, the partner/shareholder will be taxed at capital gains rates. The Buyer gets a step up in basis of the assets purchased to their new cost, and the Buyer can begin depreciation on the depreciable assets based on their new cost basis. B. If the Seller is a C-corp, an asset sale will result in 2 levels of tax. First, profit at the corporate level will be taxed at a maximum federal rate of 35%. If the corporation then dissolves and distributes the sales proceeds to the shareholders, the amount by which the proceeds exceed the shareholder s cost basis is taxed again at capital gains rates. C. IRS rules require that the purchase price in an asset transaction be allocated among the assets in accordance with their fair market values. Allocations by agreement of Buyer and Seller are generally accepted by the IRS. Allocation of the purchase price can significantly alter the tax results of the transaction for both Buyer and Seller and are often vigorously negotiated. D. There are many other tax issues that are beyond the scope of this outline. They can be very complex, and the services of a competent tax advisor are essential Dec Considerations in Buying & Selling a Business

6 XII. Due diligence how does the Buyer make sure it is getting what it bargained for, and that it has recourse against the Seller if the business is not as represented? A. Financial statements and records B. Contracts and other legal documents C. Liability insurance policies (most are occurrence policies, meaning that if the coverage was in force when the wrong was done, there is coverage for the claim, even after the policy is cancelled) D. Title to assets, condition of assets, quality of inventory E. Quality of accounts receivable F. Investigation of potential unknown liabilities G. Employee issues employment claims, immigration compliance H. Review of work in process and cost to complete contracts is the work remaining on the books going to be profitable? I. Environmental practices and history XIII. Financing A. Is the Buyer adequately capitalized to close the deal and operate the business? B. Sources of financing include owner cash, investor cash, borrowed funds, and Seller financing. C. Senior (bank) debt is likely to be secured with a lien on the assets and a personal guarantee, leaving little unencumbered security available for Seller financing. Nonetheless, Seller should expect both collateral security and a personal guarantee from Buyer as a condition of making the loan. XIV. Key contract issues A. The purchase price 1. Cash at closing, or part cash and part deferred 2. In situations in which value is uncertain, part of the purchase price may be measured based on future performance (an earn-out ) B. Identification of the assets purchased C. Identification of liabilities assumed Dec Considerations in Buying & Selling a Business

7 1. Who will be responsible for warranty obligations post-closing? Often the Buyer doesn t want to assume these liabilities, but Seller no longer has the capability to perform warranty work. A common compromise is to obligate Buyer to perform the warranty work, and provide that warranty obligations in excess of an identified threshold will be reimbursed at cost by Seller. 2. Accrued vacations and sick leave are sometimes overlooked if they haven t been booked. 3. If payables are to be assumed, Buyer will want to either have a cap on the payables to be assumed, or a working capital adjustment so that if the working capital is less than anticipated, the purchase price is adjusted. 4. The purchase agreement should expressly exclude assumption of all liabilities except those to be assumed. D. Excluded assets and liabilities 1. Non-operating assets are often excluded from an asset transaction, and can be excluded from a stock transaction by providing that they be transferred to the owners prior to closing. 2. Selected liabilities (e.g., long-term debt) are often excluded, which means they remain the responsibility of the Seller. Unknown liabilities, tort liabilities and tax liabilities are generally excluded. E. Representations and warranties 1. These are critical to providing a snapshot of the business being sold, and providing recourse to the Buyer if the business turns out not to be as represented. The representations and warranties allocate risk between Seller and Purchaser. In some cases they may appropriately be subject to knowledge qualifier to the knowledge of Seller. They generally include the following, and others will be appropriate to address specific circumstances: a. Corporate status of Seller and authority to enter into transaction b. Identification of assets to be acquired and their condition c. Identification of liabilities to be assumed d. Accuracy of financial statements e. Absence of undisclosed liabilities, including taxes, tort liability and breach of contract liabilities f. List of contracts and representation that Seller is not in breach g. List of permits, licenses, etc. and representation that all can be transferred Dec Considerations in Buying & Selling a Business

8 h. List of required consents, and representation that all have been obtained. i. Prior insurance policies j. Absence of material adverse change k. Compliance with laws l. Environmental matters F. Restrictions on Seller competition post-closing 1. These are essential to obtaining the benefit of the good will. 2. Enforcement can be very difficult, and they must be very carefully drafted to impose the minimum restrictions necessary to protect the legitimate interests of the Buyer. G. Conditions to closing 1. Financing 2. Consents and approvals 3. Governmental approval H. Employment agreements to retain key managers I. Post-closing covenants J. Generally the Seller agrees to indemnify (hold harmless) the Buyer against any damages suffered by the Buyer as a result of a breach of the representations and warranties of Seller, and Buyer agrees to indemnify the Seller against assumed liabilities or liabilities arising out of the Buyer s operation of the business. Indemnification obligations are generally subject to a cap, and to time limitations Dec Considerations in Buying & Selling a Business

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