The Role of Disclosure in the Due Diligence Process when Selling a Business

The Role of Disclosure in the Due Diligence Process when Selling a Business

The Role of Disclosure in the Due Diligence Process when Selling a Business

A business owner who would like to sell their business how they go about the sale can be the difference between a dream ending and a nightmare. There are some things you should know before selling your business.

It is important that the buyer and seller know what’ being sold, bought and what known circumstances might affect the performance of the business after the sale.

If you’re selling a business your best friend is DISCLOSURE! That’s right disclosure. The role of disclosure in the due diligence process is important when selling a business.  You may want to sell your business but when you do, you also don’t want to be in court a year later with a buyer trying to get the money back.

Disclosure is a part of the Due Diligence process. Due Diligence can vary greatly from deal to deal but one thing that doesn’t change is the obligation for disclosure.

Disclosure needs to be methodical and complete. During a sale, many business owners ask, “why is the buyer asking so many ridiculous questions?” As a seller, you should answer honestly and if you don’t know the answer tell the buyer that also.

Buyer Beware: Unfortunately, there are some sellers in the world who would rather look the other way, close the deal and worry about it later. As a buyer, you need to do your homework before finalizing the sale.

Disclosing Material Information

You should also be aware of material information that you should tell the buyer even if they don’t ask. What might that be?

Before the sale, you are talking to your largest customer and they say something like “Joe, just thought I’d let you know, starting in January we won’t need your product anymore.”

Some sellers might think closing on the sale before the buyer finds out is the best course of action, but it is not. In this case, you need to put in writing this information for the buyer. Could it kill the deal? Yes, but that might be better than the legal entanglements after a sale.

Here is what you want to include in disclosure:

  1. Any information the buyer asks for
  2. Any information about actions or impacts that might materially affect the business after the sale

There are plenty of situations that could occur. For example, let’s pretend it’s 2 weeks before the sale of your business is scheduled to close. Your top salesperson comes to you and says, “I’m pregnant, and after the baby comes I’m going to take a couple of years off if you need to fill my position I understand.”

Yep, you need to tell the buyer that. Losing your best salesperson is a big deal, even if you think they are easily replaced. Any small details that could possibly bring a wave of hurt to the company needs to be addressed before the sale.

When you decide to sell your business, you need to go through your business with a fine-toothed comb and be prepared to disclose and discuss.

 

Remember: Bad news about your business before the deal closes is a price problem. Bad news discovered after closing is a legal problem.

 

Buyer’s Responsibility

Along with the seller’s disclosure, the buyer has a responsibility as well. They need to put in the effort and do the homework to ask the right questions so all parties understand.

An experienced and qualified Business Broker can assist the buyer and seller in the Due Diligence process but the obligation for full disclosure is the responsibility of the buyer (who is spending a lot of money) and the seller (who is getting the money).

Business Value Can be Managed if the Business Owner Can Manage Themselves

Business Value Can be Managed if the Business Owner Can Manage Themselves

If you read too many business magazines you might find yourself believing that creating a valuable business is more luck than skill. Business value can be managed and if you manage the value you will become more profitable.

Small business owners often confuse business earnings or profit with the actual value of a business. All profits are not created (or valued) equally. A fundamental method of measuring the value of a business is applying a multiple to earnings. Take two businesses that have the exact same earnings of $100,000. Will they have the exact same value to a business buyer? No.

Why not? There are many, many reasons. Here are some examples of why business buyers value earnings differently, we’ll use the $100,000 earnings for company A and B example.

 

  • What is the quality of the earning? Company A earnings have been growing for 5 consecutive years, company B earnings have been down for 5 consecutive years. Which is more valuable?

 

  • Company B financial statements are cleaner than company A and a buyer will pay more for a company with cleaner books because there is less risk. Uncertainty in the quality of the business financial records drives down value.

 

  •  Company A has 5 lawsuits against it, company B never had any lawsuits.

 

  • Company B has well documented processes and it’s easier to train employees, therefore B’s owner can take lots of time off. Company A, with no processes, couldn’t stay open a week without the owner at the business. Which business has lower risk and therefore higher value?

 

  •  I could give you a hundred more variables as to why one business’ $100,000 profit is worth more, or less, than another business’ $100,000 profit.

 

As you can see business value and corresponding multiples of earnings is based on a number of fundamental factors that a business owner can control and these factors effect how valuable the business is. There are many businesses that are very valuable to the current owner but of little value, or much lower value, to a buyer. There have been several good books written about building value in a small business including Built To Sell.

 

Ready to Buy a Business – Your 401(k) could be your best friend!

Ready to Buy a Business – Your 401(k) could be your best friend!

Using 401(k) to buy a business solves a lot of financing problems. Buying a business is a complex and, at times, frustrating exercise. The easy part is finding a business worth buying. The difficult part is jumping thru hoops to get the business purchase financed. Getting financing to purchase a business makes financing a home purchase look like a walk in the park.

If you are buying a business don’t overlook using a 401(k) without triggering a tax bill. There are CPAs who specialize in this investment vehicle. The IRS code currently allows, if structured properly, you to access your 401(k) without triggering income tax or early withdrawal penalties. Consult a qualified 401(k) business purchase rollover expert. Expertise is required to navigate complicated tax laws.

Your 401(k) and an SBA Loan from the Small Business Administration could provide the financing you need to buy a business and build the wealth that is often created when you own and operate a successful small business.

A typical financing structure when buying a business is (20% down often using a 401(k) to buy a business) 75% financing from an SBA loan and 5% financing from the seller.

Typical business acquisition loans are 10-year loans, with interest rates at prime + 2 3/4%. Terms can be improved, if the business purchase includes the purchase of real estate. Purchase of the real estate will significantly lengthen the term of the loan. This can also improve interest rates.

SBA loan terms are typically far better than terms from conventional financing. (When conventional financing is available and most times it is not). The SBA loan guarantee program is utilized by many banks who participate by making SBA guarantee backed loans to individuals and small businesses looking to acquire a business. Here is some info from SBA regarding this option.

Could there be a better investment than investing in yourself?  For free information and complete details click here.

Business Owner Year End Tax Planning

Business Owner Year End Tax Planning

A common comment we hear from business owners who contact Sunbelt Texas about selling a business is “I didn’t know a year (or 2 or 3) ago I would be selling my business so soon.”

Before you file your taxes, keep in mind that a buyer and the buyer’s lenders will look very closely at the financials of a business for 3 full years. That means that if you sell your business in 2020 or sooner, the Tax Return you’re about to file could have a significant impact on the value of your business.

Do your business tax returns clearly and accurately reflect the earnings of the business?

Tax Planning for a Future Sale

Here are 4 areas that we often see need significant improvements to obtain the highest value in the sale of a business. Talk to your CPA about how you can move ahead to increase the value of your business.

Inventory

  • Do you have an accurate inventory count and value booked into your financials?
  • Is all of your inventory in “good and saleable” condition?
  • Do you actually know what your inventory value is?
  • Have you written off the old and obsolete inventory?

Accounts Receivables

  • Are all your receivables good and collectible?
  • Have you written off the A/R you know your odds of collecting are remote?
  • Do you have customer deposits intermingled with the accounts receivables?
  • Do your receivables reflect what is actually owed to you by the customer? (We see companies that when they get a customer deposit for a job, they book the whole job as a sale and book the deposit as a partial payment even though they haven’t actually earned the sale yet)

Employees

  • Are your employees classified correctly 1099 vs W-2? Are your 1099 contractors really employees who should be classified as W-2 employees. (This is a very big issue and the government has an active program to crackdown on this….and the penalties can be severe).
  • If your 1099’s are really 1099’s, do they have an entity (i.e., LLC, S Corp, etc) you pay?
  • Do you have a properly written and valid independent contractor agreement with them?
  • Are your W-2 employees correctly categorized as hourly vs salaried and paid accordingly? You don’t want to lose a claim where, after years the employee claims you owe them thousands of hours of back overtime pay.

Owner Benefits and Compensation –
This is VERY important and can dramatically affect the value of your business:

  • Are the compensation and benefits received by the owners easily identified and properly booked on the financial statements and tax returns?
  • Do you have significant expenses that are not directly related to the business, expensed through the business that are buried in the company expenses?
    • Travel?
    • Entertainment?
    • Expenses run thru company credit cards?
    • Personal vehicles?

Tax Planning Action Item:

If your objective is to sell your business one day then you should get your financials in condition for easy due diligence and maximum value. “Burying” personal expenses in the business financials will reduce the business earnings and reduce the value to a buyer.

Our advice is for business owners to take any compensations as salary, bonuses and draws. Running non-business expenses through the business financials creates problems for proving the earnings in due diligence and raises the risks associated with potential tax liabilities

Conclusion

The most important element of business value is clarity of the business earnings and reduction of the risks associated with all aspects of the business. A buyer will only pay for the earnings that can be proven and the risks a buyer sees drives the multiple buyers will pay for a business.

A business with the lowest perceived risks will command the highest price multiples when being sold.

A Practical Guide to Seller Financing

A Practical Guide to Seller Financing

Selling a business is one thing, getting paid on the sale is another.  The options available for financing the deal are dependent on the business and the buyer. Here are some things to be aware of if you find yourself with a chance to sell your business.

Seller Financing:  The good, the bad and the uh oh

Seller Financing as the ONLY Financing

The Good:

  1. Seller provided financing opens the sale up to a wider range of buyers (though not necessarily higher quality buyers).
  2. Without a 3rd party lender (SBA, Bank, etc) the deal can likely get to closing faster than if bank financed
  3. Buyer usually isn’t as price sensitive since there usually isn’t a 3rd party valuation
  4. You may be able to cross-collateralize or obtain cross default agreements to tie up assets.
  5. If you get a personal guaranty from buyer you may have better chance to get paid.

The Bad:

  1. If the buyer defaults on the note it can be expensive to try to collect
  2. If you worry as much about the note payment as you did about the business are you any better off?
  3. Unless done properly there can be all kinds of tax issues

The Uh, Oh:

  1. If the buyer has a lease on facility you may need a landlord subordination agreement or you won’t be able to get to the collateral or worse, you might have to pay the back rent in order to get to your collateral.

Hints:

  1. Get the landlord subordination agreement at the time of the sale.
  2. If you can, cross default the lease and note so that if buyer is in default on either they are in default on both.
  3. Make certain to file a UCC1 on the collateral assets so the whole world knows your note needs to be paid before the assets can be sold.
  4. Try to get a really high default interest rate on the note so that the financial pain of default is high.
  5. Consider a sub-lease to the buyer rather than buyer getting a new lease. That way you retain control of the facility and can act faster if you need to intervene.
  6. Try to get collateral other than business assets. Does buyer have a vacation home? Other assets?
  7. Guarantors – get as many guarantors as possible also make sure spouse signs guaranty if required in your state.
  8. Require buyer to provide financial statements and tax returns to you for as long as the buyer owes you money so you can keep an eye on the business health.

Seller Financing with Other Types of Financing

SBA Loans with subordinated Seller note:

The Good:

  1. The Bank is likely to screen the buyer more thoroughly than most sellers
  2. The seller note is likely to be less than 10% of the total selling price.

The Bad:

  1. The bank will look very carefully at the business cash flow (several years), seller financials need to be in good order.
  2. Bank will require a 3rd party valuation to make sure the price the buyer and seller agreed to is fair.
  3. SBA limits any “after the sale” arrangements between buyer and seller.
  4. The seller note will likely have a period (usually 2 years) whereby the seller gets NO payments and only interest accrues.
  5. If buyer defaults on seller note the Bank will limit what actions the seller can take to get paid.

The Uh, Oh:

  1. Because of the restrictions in the bank subordination agreement the seller note is usually the first obligation that goes unpaid.
  2. If the seller stops paying you it’s usually a sign of other significant problems with the business.
  3. If the buyer stops paying the note the seller recourse is basically limited to enforcing the personal guaranty.

Revolvers (also known as Asset Based Loans) – with associated seller note

Definitions: a “revolver” is a bank loan or financing company loan that gets adjusted every month (or week or even day). These revolvers are tied to accounts receivable (a/r) and/or inventory and are a % of those items. For example a common revolver term is a bank loans the business up to 70% of current accounts receivables and/or 20% of good inventory at cost.  (The a/r % is high because a/r is highly liquid and can be collected quickly. Inventory is much more difficult to liquidate and has high costs associated with liquidation i.e., warehousing, transportation, auction costs etc.)

The Good:

  1. A revolver is flexible in that if funds cashflow when the business is growing.
  2. A revolver usually has fewer covenants.
  3. The “credit worthiness” of the business is less stringent than normal bank standards

The Bad:

  1. The seller note will lose a/r and inventory as collateral.
  2. The revolver lender usually can “pull the plug” at any moment
  3. The cost to the borrower can be significantly more expensive than an SBA term loan.

The Uh, oh:

  1. Revolver loans normally have many fees and opportunities for lender to squeeze a few more dollars out of borrower
  2. Revolvers are famous for high cancellation fees if you want out of the deal.

Credit Card Loans Against Receipts – along with seller financing

Description – With these loans a lender “forecasts” your credit card receipts and lends you money in advance, then when the customer credit cards are process for the business sales then the money is redirected to lender to pay off the loan they advanced. Generally speaking these loans are used for retail stores, restaurants, etc with high % of credit cards sales and highly predictable and regular sales. Take the time to calculate the real costs of this kind of financincing, it can get expensive quickly.

The Good:

  1. If you have high volume of regular credit card sales these loans are not difficult to obtain
  2. The cashflow is steady

The Bad:

  1. These loans can be very expensive
  2. The CC lender gets paid before the seller note by taking their money out of the sales revenue.

The Uh, oh:

  1. Because these loans have a claim on all revenue it is very unlikely any other 3rd parties would provide financing.
  2. The process of payment takes control of cashflow out of biz owners hands (which could be a good thing in some cases)

If you are selling a business you’ll need to risk adjust the price depending on the financing structure that the buyer and seller agree to. Also, make sure to get good legal and accounting advice to understand what the net value is. And finally, look closely at the risks associated with any financing arrangements.