Business Exit Strategies

Family-Owned and Other Business

Frederick D Lipman

• Publisher: WSPC
• Year: 2017
• eBook ISBN: 9789813233232
• Topic: Business
• Subtopic: Entrepreneurship
• Index: Business

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This book analyzes various business exit strategies for both family-owned businesses as well as other businesses, both in the United States and throughout the world. Approximately 80% to 90% of all businesses in the world are family-owned. The book discusses, among other things, 12 common mistakes in attempting to sell a business to third parties, methods of marketing the business, negotiation of key sale terms, negotiating employment and consulting agreements, avoiding traps in sale agreements, creating a professional advisory team, and alternatives to a sale to an unrelated third party, such as ESOPs, leverage recapitalizations, selling to other family members or key employees, and going public transactions.

--> Contents:

• Six Common Mistakes in Selling a Business to an Unrelated Third Party
• Six More Common Mistakes in Selling a Business
• Marketing the Business
• Letters of Intent and Due Diligence
• Negotiating Key Sale Terms
• Negotiating Employment and Consulting Agreements
• Avoiding Traps in the Agreement of Sale
• Creating a Professional Advisory Team
• Leveraged Recapitalization
• Selling to Other Family Members and/or Key Employees
• The ESOP Alternative
• Going Public in a Traditional IPO
• The Regulation A Alternative
• Appendix I: IRS Form 8594

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--> Readership: Professors and students of business schools; entrepreneurs, business consultants, attorneys, accountants, advisors to start-up and middle-market companies, angel investors, private equity funds. -->
Keywords:Exit Strategies;Family Business;ESOP;Going Public;Leveraged RecapitalizationReview: Key Features:

• Describes 12 common mistakes in selling a business which can either prevent the sale of the business or reduce the purchase price
• Provides 5 alternatives which should be explored prior to selling the business to an unrelated third party
• Discusses the negotiation of key sale terms and employment and consulting agreements which are both important in maximizing the after tax sale proceeds to the business owners

CHAPTER 1

SIX COMMON MISTAKES IN SELLING A BUSINESS TO AN UNRELATED THIRD PARTY

This chapter and all subsequent chapters up through Chapter 8 assume that each of the alternatives to sale (Chapters 9–13) have been explored and none of these alternatives are practical for the business. Accordingly, the business must be sold to an unrelated third party.

The unrelated third party may be someone in the same business (a strategic buyer), a pure private equity fund, or a hybrid private equity fund which includes an existing portfolio business to which they wish to “bolt” the business.

The following are six of the most common mistakes made by businesses in attempting to sell the business to an unrelated third party:

• Failing to resolve “deal killers” before the exit date;
• Poor timing of the exit;
• Lack of audited financial statements;
• Failure to minimize working capital;
• Failing to create positive and negative incentives for key employees;
• Failure to discuss the exit decision with the family members.

Six more common mistakes are discussed in the next chapter.

Failing to Resolve “Deal Killers”

The following are three examples of common “deal killers” discussed in this chapter:

• Tax problems must be resolved well before the projected exit date. A common problem in businesses is an inventory cushion. Other common tax problems include payments to family members for services which exceed the reasonable value of those services and the use of company property, products or services by family members without reasonable compensation. Each of these activities may constitute a disguised gift, potentially subject to gift tax, or a disguised dividend, which was improperly deducted for income tax purposes.
• Environmental issues must be addressed and resolved.
• Other business risk issues which must be resolved include, but are not limited to, such issues as employee misclassification as independent contractors which results in a violation of both tax and labor laws.

Resolve Tax Issues Well Before Exit Date

Outstanding tax risks can prevent the owner from selling the business and may take many years to resolve. For example, assume that the business has a so-called “inventory cushion.” The existence of a material inventory cushion can prevent an auditor from providing an audit opinion on the financial results of operations. Without an audit opinion, many potential buyers will be turned off since these buyers will not have the comfort of the opinion of an independent auditor and may not be able to obtain financing to pay the purchase price.

Moreover, the business entity (assuming it is not a tax flow-through entity) will have tax liability for the inventory cushion, together with interest and penalties. This is a major risk. Again, potential buyers may be turned off by this risk, thereby lowering the sale value of the business, assuming it is at all saleable. Even if the business corporation is a tax flow-through entity (such as a Subchapter S corporation or a limited liability company), that entity could have potential liability because of failing to provide correct tax information to the equity owners.

Payments to other family members or others which exceed the reasonable value of their services will also create tax risks for a potential buyer. To the extent that these payments are really disguised gifts or dividends, these payments will not be deductible for federal or state income tax purposes or may result in gift tax. If these disguised gifts or dividends are material, potential buyers will likely lose any incentive to bid for the business or will require a substantial escrow at the closing of the sale.

To resolve these tax issues may take several years and require amending previously filed federal and state income tax returns. If the business owner fails to anticipate these tax issues, they may find that they are really unable to sell the business when the time is right.

Environmental Issues

Another turn-off for potential buyers is the existence of material violations of federal, state or local environmental laws. It may be very difficult for a potential buyer to quantify the cost of an environmental remediation. As a result, the buyer may well require such a significant escrow at closing that it may make the net purchase price to the selling equity holders unattractive.

It may take years to actually remediate the environmental problems of the business. Accordingly, it is important for the owner of the business to start the remediation process well before the expected target date for a sale. The remediation should start with a Phase I and Phase II (if required) environmental study by a reputable environmental firm. In some cases, environmental insurance may be available.

Independent Contractors

Another common tax risk is the use of so-called “independent contractors” who may in reality be employees. Potential buyers may walk away as a result of the failure to withhold income tax from these so-called “independent contractors” if the liability is material. Likewise, the business may be liable for the failure to pay overtime and other violations of labor laws.

Poor Timing of the Exit

It is important to understand the primary drivers of the valuation of the business and to time the sale process to coincide with a period of high valuations. We can divide the valuation drivers into two categories: macro factors, such as the state of the economy and the industry, and micro factors which relate to the peculiar aspects of the business such as revenues, business prospects, etc.

The best way of getting a low value for the business is to sell it when either the macro factors concerning both the economy and the industry or are poor or when the micro factors are unattractive.

Macro Factors

The macro factors affecting the valuation of the business refer to whether the economy is in an upward cycle or depressed. Macro factors also include the state of the industry or industries in which the business operates.

For example, no matter how well the business was performing in 2009 (the “micro factors”), this was a bad year to sell the business because of the macro economic factors affecting the entire economy and very few sales were consummated. The value of the business during a recession is typically significantly lower than the value of the business during prosperity. The business may, from a micro point of view, be doing well in a recession. Nevertheless, the valuations will tend to be depressed if the economy is not doing well.

During a recession, banks and other financial institutions will typically lend less money to financial buyers. During a prosperous economy, a bank might be willing to lend close to five times earnings before interest, taxes and depreciation/amortization (EBITDA) to a financial buyer. However, during a recession, that same bank might lower the multiplier of EBITDA to three. This has the effect of lowering the valuation which will be placed by the financial buyer on the business.

Even strategic buyers will tend to have a lower valuation for a business during a recession unless there are unusual synergies.

A key to maximizing the sale price is to sell at a time when there is the maximum number of potential buyers. It is important to time the sale so that there are financial buyers available to compete with any strategic buyers. Financial buyers are most likely to be available when the banks and other financial institutions from which they borrow have the most generous lending terms and afford them the largest amount of leverage in making the purchase. If there are a significant number of potential financial and strategic buyers, this will enable the owner to conduct an auction, which typically will give the business the highest possible sale price, as discussed below.

The macro factors relating to the industry in which the business operates are also extremely important. If the industry is viewed as being in a decline, that decline will also adversely depress the value of the business. Potential buyers who use either a discounted cash flow method of valuation will tend to creating higher risk discount figure, thereby adversely affecting the value of the business. Potential buyers who use the multiplier of EBITDA method of business valuation will likewise place a lower multiplier of EBITDA during the period that the industry is in decline. The lower EBITDA multiplier means that the business will be worth less.

Micro Factors

The best time to sell a business is when the business is doing well and its prospects are excellent. Many owners of businesses tend to panic when business is poor and do not attempt to correct the problems of the business. Obviously, there are times when the problems cannot be corrected and selling the business at a depressed price is better than bankruptcy.

As noted in the Introduction, it is important for the business owners to understand how the businesses will be valued and the specific factors affecting the valuation. This can be accomplished by obtaining a valuation of the business from an independent valuation firm as early as 5 years before any projected exit date. However, there are specific factors which can affect the valuation as described in the attached chart from my book entitled Valuing the Business: Strategies to Maximize the Sale Price (John Wiley & Sons, Inc., 2005).

FACTORS THAT INFLUENCE VALUATION
Factors Increasing Valuation	Factors Decreasing Valuation
1.Strong customer relationships at all levels.	1.Weak customer relationships and frequent turnover.
2.Proprietary products or services.	2.Lack of proprietary products or services.
3.No single customer accounts for more than 5% of revenues or profits.	3.A single customer accounts for over 15% of revenues or profits.
4.Strong management team (important mainly to financial buyers).	4.A weak management team (so-called one-man-show syndrome).
5.Excellent employee turnover and relations.	5.Poor employee turnover and relations.
6.Consistent revenue and earnings trends.	6.Inconsistent revenue and earnings trends.
7.Plant and equipment in good repair.	7.Plant or equipment has been neglected and requires significant repairs.
8.Intellectual property assets which are legally protected.	8.Lack of legally protected intellectual property assets.

The adverse micro factors noted in this table should be corrected, to the extent possible, well before the projected exit date for the business.

Lack of Audited Financial Statements

Many businesses believe that they save substantial money by obtaining from their accounting firm only a compilation opinion or a review opinion, but n...

Table of contents

• Cover Page
• Title
• Copyright
• Dedication
• Other Works by Author
• About the Author
• Acknowledgments
• Contents
• Introduction
• Chapter 1 Six Common Mistakes in Selling a Business to an Unrelated Third Party
• Chapter 2 Six More Common Mistakes in Selling a Business
• Chapter 3 Marketing the Business
• Chapter 4 Letters of Intent and Due Diligence
• Chapter 5 Negotiating Key Sale Terms
• Chapter 6 Negotiating Employment and Consulting Agreements
• Chapter 7 Avoiding Traps in the Agreement of Sale
• Chapter 8 Creating a Professional Advisory Team
• Chapter 9 Leveraged Recapitalization
• Chapter 10 Selling to Other Family Members and/or Key Employees
• Chapter 11 The ESOP Alternative
• Chapter 12 Going Public in a Traditional IPO
• Chapter 13 The Regulation A Alternative
• Appendix I IRS Form 8594
• Index