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So, the business you started 20 years ago has been successful, and now you're thinking about moving on to the next phase of your life. If you’re "lucky," the next generation in your family has been groomed to take over and your only real issue is to find the most tax advantageous way to pass it down. Remember, before you do, though, statistics show only about 1/3 of family businesses make it through the 2nd generation and then only 1/3 of those make it through the 3rd generation.
If selling is the option you're looking at, you're about to enter a different world - and, unfortunately, one that you probably don't know much about. For most small business owners, selling their company is something they only do once. The buyer, on the other hand, is more likely to have previously acquired a company than you are to have previously sold one. And, even if he is a first time buyer, the odds are that he has looked at other companies before yours and has gone through the analysis, pricing scenarios and possibly the negotiating process. In other words you're quite possibly facing someone who has "been around the block" a few more times than you have.
Relative experience aside, the best place to start when selling your company is to put yourself in the buyer's shoes. After all, when he buys your company, he's making an investment and, if you can figure out how to satisfy the buyer's investment and operational requirements, you've gone a long way toward facilitating the sale and, hopefully, have put yourself in a stronger negotiating position.
In general, there are two ways to look at how much your company is worth - valuing the assets you are selling and valuing the Free Cash Flow (FCF) of the company (and the ultimate sales price may be some combination of the two). The market value of your company's assets really represents a floor on the value of the company, because you could always close the company down, sell the assets for what they're worth, and pay off the company's liabilities, with the balance going to you.
Your business' FCF, on the other hand, is a reflection of the value of your company as an operating entity. It’s the amount of income that your company can consistently generate, after compensating the owner(s) at a market rate. Because a potential buyer is making an investment, he should be willing to pay you some multiple (or number of years) of this FCF, as long as he can expect to get his investment back in a reasonable period of time. As a rule of thumb, I think it's reasonable for the buyer to pay an amount that he can earn back in 5 years. In other words, the buyer should expect that the earnings of the company over the next 5 years will cover a market salary for him and then throw off enough cash to allow him to recover his investment in 5 years. If he pays less than this, he may have gotten a great deal; if he pays more, he may have paid too much.
There are other things related to pricing that the buyer is going to be thinking about. First, which 5 years should he consider? If earnings are a lot higher in the most recent year before the sale, he will not consider this a sufficient trend to pay for. He'll want to average earnings for the past 2, or 3 years and lower the FCF that he’s paying for. As a seller, though, you'll want to maximize FCF and include the next couple of years, if you expect earnings to keep going up. Second, the buyer may believe that he has to make some investment in the company, itself, after purchasing it. If this is the case, his total investment is higher and he'll want to pay you less, so that he can still recover his total investment in 5 years. These are obviously negotiating points; just be aware when you sell that the buyer is probably taking them into consideration.
The best thing you can do for yourself is to think about and prepare for the sale long before you are ready to do it. You understand your company's future better than the buyer, but the buyer knows that and he'll need to be reassured that things are as good as you represent. The more information you've collected, tracked, and have available to give to the buyer, the easier this will be. In other words, the better your business looks on paper, the more leverage you have in getting a price closer to what you want. You can create a real advantage for yourself, when you capture as much detailed information about your company as possible, by having the ability to "prove" to the buyer that your company is what you say it is.
Another important thing to understand is that the buyer and the seller can have very different perspectives about the ultimate deal structure and the tax implications of the transaction; in fact individual elements of the deal structure favor either the buyer, or the seller, but not both. The seller wants to maximize his capital gains income (taxed at a lower rate); the buyer wants to structure the deal in any way that allows him to expense the purchase price through the company he is buying as much as possible. For example, it's an advantage to the buyer to pay for the acquisition partly through a consulting contract, or a covenant not to compete, because his company can then deduct those as operating expenses; the seller, on the other hand, is receiving ordinary income, rather than capital gains income.
Finally, the seller is best served by selling the stock of the company, because any legal liability created by the company goes with it, rather the staying with him. The buyer, on the other hand, would normally prefer to buy the assets of the company, because they don't carry the same legal liability as buying the stock and he can write-up the value of the assets and gain a future tax advantage by doing it.
The bottom line - start thinking about the sale of your company early! By early, I mean years prior to the time you think you might want to sell. It’s obvious that you'll need good advice from an accountant, an attorney, and even a broker. But, these experts tend to be brought in toward the end of the process. You'll gain the biggest advantage by taking a strategic approach to selling, thinking about it long before you want to pull the trigger, and structuring the company and collecting supporting information that will let you present it to a buyer in the most attractive way.
Jim Deyo is the President of Business Advisor Online, an internet based service that provides small businesses with the ideas they need to grow and the resources they require to make the right decisions. As a former Sr. Vice President with a major banking institution, Jim worked extensively with small and medium sized companies and has over 30 years experience in commercial and consumer lending, accounting, finance, marketing, and strategic planning. Visit the website at http://www.businessadvisoronline.com and sign up for a six week free trial of the service, or e-mail Jim at jimdeyo@businessadvisoronline.com.
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