BizQuest's Business for Sale Blog

Creative Deal Structures When Buying a Business

A common and reasonable concern for any business buyer is to be certain that the business is sustainable after you take over the company.

Of course, it would be nice to buy a business and have the seller provide you with a bulletproof guarantee that you will be successful. Unfortunately, that is simply not reality and probably one of the big areas that separates entrepreneurs from ‘wannabe’ business owners.

In some cases, it does make sense (and is necessary) to institute a performance-based deal structures that will provide you with an added measure of comfort as well as having the seller at risk in the deal after the transaction closes.

Earnouts are a good mechanism to accomplish that (along with seller financing which is something I believe is a must for any deal) however, the nature of the business must justify an earnout. If not, it will be a tough sale to convince to current owner to structure the transaction based upon future performance when they are not even playing a role in the company.

Think about it – would you be willing to bet on someone you don’t know well to takeover your business and succeed?

Earnouts make the most sense when some the following conditions exist in a business:

• There is a high degree of customer concentration (a disproportionate amount of revenue/profit is generated by a very limited number of clients)
• The business has experience a few years of continued decline and you want to be certain the trend can be reversed.
• The most recent period has been exceptionally profitable and you need protection to know it is sustainable.
• The company has recently won a new contract or has implemented new initiatives that will only generate sales after you take over the company.
• There are key supplier contracts that may soon expire and the business needs these to renew in order to operate at prior levels.
• The seller is the business in the eyes of the clients/suppliers and has long-term personal relationships or specific skills/licenses that have been directly attributable to the success of the business. On this note, if you are really concerned that you will not be able to take over the seller’s role, then either hire someone who can, or perhaps you should not be acquiring that particular business.

From a buyer’s perspective, the timeline for measuring an earnout is a double-edged sword. You want it to be long enough to be accurately measured, while at the same time, it should not be so long that the seller will be the beneficiary of your hard work.

Conversely, a seller cannot be expected to be on the hook to perpetuity in the deal.

The key to an earnout is to:

• Specifically identify the item that needs to be measured
• Keep the formula simple

In my experience, earnouts in general can be hard to measure and so by tying them to revenue for example rather than gross margin percentages, can greatly simplify the determination.

Be sure you and the seller agree in writing on how the earnout will be calculated and arbitrated in the event there is a dispute. The last thing you want is to incur expensive legal or accounting fees. The suggestion is to identify in advance, a neutral-third party (ideally, an accountant or accounting firm) that will render the final judgment in the event you and the seller do not agree on the number.

Lastly, although earnouts can be a great way to structure a deal, they have their own challenges so make sure they are warranted and the measurement kept simple.

Letter of Intent or Full Purchase Agreement?

When the time comes to make an offer on a business, there are two choices for the type of  agreement you can present. You can either submit a Letter of Intent (LOI) or Offer to Purchase Agreement (PA).

There are substantial differences between the two and the situation will generally dictate what is best.

What’s the Difference?

An LOI is generally a “non-binding” agreement that simply lays out some initial conditions of the transaction such as price and terms and the timing for future steps of the transaction. It will also refer to subsequent documentation to be presented. Additionally, it can, and should, present a “no-shop” clause which prevents the seller from accepting other offers as long as all of the milestones are met along the way to closing.

LOIs are standard in larger transactions. In smaller deals, the seller and broker can perceive them as not being a serious agreement and may resist tying up the business for any unreasonable length of time. While there is some validity to this perception, it’s not always accurate.

A “full-blown” Offer to Purchase is far more detailed, and will include all of the material deal terms, conditions, representations, warranties. It will also cover non-compete conditions, inventory, financing, training, leases and contracts, etc.

Which One to Use?

Personally, I prefer and recommend that a detailed Offer to Purchase Agreement is used whenever possible. Doing so allows you to set forth all of the terms you are prepared to offer, and eliminates a lot of the ambiguity that can surface later on.

On the other hand, there are times when an LOI makes more sense. This can be when:

• You have not yet received adequate information to present an offer on all points.
• The business has attracted a lot of interest and you want to tie up the deal quickly
• There are certain conditions that still need to be negotiated
• The buyer does not believe the seller is serious and wants to get them to play their hand
• The buyer and seller are far apart on their individual valuations and you want to learn if there is any possibility of a deal before spending substantial legal fees

On the last point above, regardless if you use an LOI or PA, you must have it reviewed by an attorney.

Although an LOI is a non-binding document, a buyer should not look at it as anything less than a true commitment and the seller should address it as a serious initiative. Both parties should use it as a platform to demonstrate their mutual sincerity to getting a deal done together.

Buyers should familiarize themselves with the contents of both of these agreements so they are properly informed and can utilize the most effective document for the particular situation.

While both agreements have their place, if an LOI is used, it should simply be a short-term solution. In other words, once you have an LOI signed, everyone should move expeditiously to finalize all other deal points and memorialize the terms in a bona fide Offer to Purchase Agreement.

Hiring the Right Attorney When You Buy a Business

Attorneys have their role in the business-buying process and yes, there are plenty of them who are deal-breakers, but that generally happens when a buyer hires the wrong one. A good attorney will help make the deal happen, and you need to understand their role and how to find the right one.

I just received an email from a visitor to our website who went on about how an attorney they hired “completely blew the deal and the seller won’t deal with them anymore”. He told them that he was “only looking out for their best interests”. He was highly recommended by a family member. I also learned that he was a specialist in patent law. That is just wonderful. The problem is this person was buying a three store retail chain.

Mistake number one – they hired the wrong attorney.

Now, you may be saying, an attorney is an attorney – right? Wrong! If you have a toothache, would you go to a foot doctor? Of course not! So if you’re buying a business, then you need an attorney who specializes in transaction law. Ideally, you’ll want one with experience in transactions of businesses similar in size and type to the one you’re buying.

An attorney plays a very important role, but you need to know what it is. They should not be your negotiator except for any overly complex situations that may require the buyer’s and seller’s counsel to make headway.

Good deals get done between the buyer and the seller and then the attorneys simply scribe it properly. As such, you have to be very clear with them about what you and the seller have generally agreed to and then it is up to them to help you get the deal done in a legal sense.

You want them to bring all the potential issues to your attention. You need them to offer sage advice about any possible exposure you may have. You want them to review any documents that you sign. They need to draft documents that reflect the local law. They are the ones that can effectively assemble closing documents along with any brokers involved. But that’s pretty much the end of it.

You definitely need to consider every issue that your attorney raises but when all is said and done, YOU have to make the decisions.

There is almost always going to be some element of risk in a deal. I have yet to see any deal that is absolutely bulletproof. A good attorney will outline the risks but will also present real-world scenarios. Of course you need to be adequately protected and some parts of the deal are more important than the other. If your attorney tries to hammer the seller into submission, the deal won’t get done.

Buying a business involves a lot of moving parts and clearly having the right team of advisors at your side will make a huge difference. But at the end of the day, you’re the one who has to lead the team.

Think Before You Walk From A Deal

I received an interesting question this week and felt it would be helpful to discuss it on the blog in case you run into a similar situation.

The lesson here is that a good buyer always plays "what if" and exhausts all possible options when a roadblock comes up in your deal 9and rest assred that they will - it's all part of the process).

Question: I am in the midst of a deal and have run into a major problem. The company provides medical supplies and the majority of its clients go through Medicare and Medicaid. After reading your program and being warned about company contracts that may not be transferable I approached the seller. He first said it was not a problem but after pressing him a bit (and thanks to your book), we reviewed the licenses and sure enough, none of the government related contracts/licenses can be transferred or assigned. I like this business. It passes all of the ten commandments in your materials and the deal is fair. The seller and I have met several times and get along well. But I don't know what I can do now. Is this something that should make me walk from the deal? Please help.

Answer: Let me answer your last question first: NO, you should not walk from the deal.

The good news is that there is a very viable option. The bad news is that your attorney and accountant may initially object but once you layout the deal parameters they can construct it to provide you with the protection you need.

While the preference for a buyer is to almost always have an asset purchase (and it's the norm in small business purchases), the most viable option is to set up this transaction as a stock purchase so as to avoid having any license transfer issues altogether.

Let's explore the stock sale option.

By purchasing the company stock, nothing should change in the "eyes" of the license issuer. However, you will want to double check that there are no other conditions to the license related to a change in ownership. In other words, verify the contract to be certain there are no other conditions on a sale.

The downside is that by acquiring the stock and not the assets, you effectively assume all of the liabilities past, present and future. This is where your attorney will surely disagree. You may also lose some potential tax savings and this what your accountant may disagree about.

On the legal side, you can include certain protections to mitigate, but not completely eliminate, your liability/risk by having the following in place:

Ensure that the sales agreement provides you with bulletproof indemnification by the seller for any potential liabilities that may have occurred during their ownership but only surface after you close the deal.

Include a significant amount of either seller financing or a holdback in the deal so that you will have adequate leverage to make a claim against the seller in the event any are made against the business. If you don't, you could be faced with defending the claim and also having to go after the seller in a separate suit and when transactions get litigious it is always expensive and never pretty.

Any note or holdback should have a right of set off which allows you to use those funds to settle any claims if the seller does not defend them or provide adequate proof of not being liable.

From a financial perspective you should be aware of the following:

A stock sale is generally better for the seller from a tax perspective as well, while an asset purchase generally favors to the buyer. This is specifically related to restrictions you will incur on deducting future depreciation expense.

I would suggest that you have your accountant run the numbers of the business under both a stock and asset sale scenario with the goal of outlining what tax consequences you will incur and where the seller may benefit. This can provide you with some additional leverage on the purchase price as well. After all, if a stock sale is the only way the business will likely transfer to a new owner, and doing so will not only add some legal exposure and potential tax losses to you, the seller may have to readjust their thinking on the terms and make some accommodations given the advantages they are gaining. If not, they will likely have a difficult time selling the business to any buyer who does not already have the necessary licenses to operate the business.

Also, the possibility exists for you to acquire both the assets of the company and the stock (which will include the licenses). I would suggest that you have your attorney outline the options on this front as well.

So there you have it - the deal is not dead. There are options available - there always are. Sure it is possible that an agreement may not be reached but you must exhaust the alternatives. The key is for you and the seller to have a meeting of the minds of getting a deal done and to both make accommodations to achieve that result.

It is especially important that you get your attorney and accountant involved in the discussion and explain that your goal is to find a solution if possible and not to simply broad-brush a stock sale as a "deal killer".

Naturally, neither party should put themselves in a vulnerable position but with the right mechanisms in place, you can both be adequately protected and not have any reckless exposure.

Read more about deal structures at: http://www.diomo.com/-Deal_StructureQA 

What are the Pros and Cons of Buying the Real Estate along with the Business? - Buyer wonders whether he can afford to acquire real estate along with pool supply business and, if so, whether he should.

Question:
I am looking at a do it yourself pool supply business that's been around since 1977. They have a great reputation and are always busy. There are no nearby competitors. The sale price includes the building. I'm not really sure if I can (a) afford the real estate, (b) if I need it, and (c) how this impacts the valuation of the business and (d) is there anything else I should consider? The seller definitely wants to sell the real estate. Can you let me know your thoughts?

Answer:
This is an excellent question and you have obviously thought out the key concerns one should have in this situation. Let me address each one individually and provide you with the pros and cons of each scenario:

Can you afford it? Generally speaking, it is easier for you to obtain financing on the real estate portion of the business than on the business itself. If you are going to use a third party lender (outside of the seller), it is quite possible that they will want you to acquire the real estate as well. The cash down that you will need may vary between 10-20%. Some lenders require a higher percentage down when the building is owner occupied, meaning that the mortgage payments are in fact predicated upon the performance of the business. Others don't care as much.

On the other hand, your primary goal has to be to sustain and build the business and so you need to determine if your capital will be better allocated to marketing and other strategies versus being tied up in real estate.

Also, have you discussed the possibility of the seller holding the mortgage? Doing so may even allow you greater leverage on then financing the business portion as well since they will have additional security and many sellers who provide financing for the business will feel more comfortable knowing that you're in their building where they can keep an eye on you.

Do you need it? This is probably the best question to ask. The best answer lies in whether or not the business relies on the location to drive the business. Given that they have been around for nearly 30 years, it's obvious that customers know their location well. If you do not buy the property then it behooves you to have a long-term lease with the owner. If that is not possible and you are forced to find a new location most customers will follow you but it is very possible that a competitor will try to open in the former premises. As such, the rule here is this: if the business depends upon the location to drive the sales, then you must either buy it, or have a long-term lease in place. If this is not the case, then you can consider whether it makes sense from a financial and investment perspective.

How it impacts the valuation of the business? It shouldn't. The real estate should be valued as a stand alone entity using industry comps, current market factors, and other such criteria common with real estate valuations. Further, a certified appraiser should be engaged to determine the value.

One thing to consider is there can be a premium for the property if the business depends upon it to drive the revenue. Likewise, the value can be decreased if only this kind of business can be located there which one would see in cases such as nurseries, car dealers, etc.

Other Considerations Personally, I usually like to avoid buying the real estate associated with the business initially because I almost always want to allocate as much capital as possible to building the business and for working capital of course. However, I would always be sure to keep my options open and suggest you do the same should you decide not to buy the real estate right now. To accomplish this you can:

• Include a Right of First Refusal clause in the purchase agreement so that in the event the seller gets an offer on the building after you own the business, you can match the offer;
• Take an option on the building with the seller that gives you the right to buy the building at a pre-determined price within the first 12 months or so. Normally, there is substantial consideration to be paid by you for this option; however, if you limit your option period to a year or less, you may get away without it. Although, with the way real estate is appreciating, it can be a bit of a sales job that's needed.

As a final note, consider having the seller hold the mortgage on the building. You can likely negotiate a minimal down payment with them compared to a bank. You may want to consider a premium interest rate. Look at the various payment options available as you are usually better off to pay a higher rate and get a longer amortization to less severely impact the business' cash flow.

What is a Fair Partnership Arrangement?

I am interested in opening a retail shoe store, but I don't have enough capital. My friend is willing loan me the capital for a stake in the business. I will do all the work and my friend will be a silent partner. What would be a fair arrangement for us as partners?

This is an excellent question and an interesting situation from both a financial and personal perspective. Financially, if you will be running the business, then you should be entitled to receive a reasonable salary for the work that you perform and possibly a bonus based upon achieving certain levels of profitability. If your partner/friend is not working in the business then he/she should not be entitled to a salary but rather a reasonable return on their investment plus a financial stake in the business.

Obviously, it behooves you to negotiate the greatest percentage of equity for yourself in this deal but you must be fair. Of equal importance is to have an arrangement whereby you will be able to make all of the daily business decisions without their involvement. To do so means you will need to be the majority shareholder and only major decisions such as hiring people at certain salary levels, incurring any debt, binding the company, or selling any portion of the business must be subject to unanimous consent. You'll want to seek the input of a competent attorney to formulate an equitable shareholder agreement.

On a personal level, your relationship will be forever changed with this person. You both have to be mature enough to try to keep business issues separate. No opportunity is worth jeopardizing a friendship in my opinion. Plus, you must realize that they are the vehicle by which you will be able to become a business owner and that brings a substantial amount of implied debt on a personal level.

Forming a Strategic Partnership with Vendor

Q: We are currently pursuing a strategic partnership with a vendor of ours. We would like to have a better degree of control on resource allocation in his business. I am curious as to how you would investigate making a move like this? What things should be considered? Equity partner Vs. non-equity partner? We are looking to expand our product base to our customers by using this vendor to build the products and don't want to have problems down the road. Any insight you could give would be helpful.

A: This can be a double-edged sword. The relationship you have with this vendor can be adversely affected should this business deal not work out. At the very least you'll want protection to be certain that you can continue to have them as a source of supply in the event that the business deal goes sour.

Personally, I always prefer partnerships where everyone has a meaningful equity stake and a say in the business commensurate with what they bring to the business. By the same token, you don't want to be in a position where your hands are tied at every step because there are too many generals and not enough soldiers. The business needs a clear definition of who makes the key daily decisions. Don't turn this into a committee run business. Partnerships are great when everyone contributes but they can become an awful mess when all parties have an equal stake and say on all matters. You can tie up the entire decision making process. Therefore, if you will be running the business day to day, then you have the final say on all matters (except for: borrowing money, selling the business, taking in new partners, hiring high prices individuals, etc).

The key for you is to determine what it is that you want this partner to deliver now and down the road. Who will run the business? You mention that you would like to have a "better degree of control on resource allocation in his business". I'm not certain what this means however, if this component is your priority then make certain that every mechanism is in place to be certain you achieve your goal. It's worth it to give in on other issues to realize what you want.

Buying Assets Vs. Shares - None

Q: I am not sure whether to buy assets or shares? What's the difference?

A: You want to buy assets NOT shares. Sellers will want a stock purchase because it will eliminate their future liability. As a buyer you will want an asset purchase to accomplish just the opposite. The first thing you should know is that nearly every small business purchase is an asset purchase, and so it is the norm. Here is a recap of the reasons why you will want an asset purchase:

• As noted above, when buying assets you will not be responsible for any of the liabilities of the business or the seller. Should any situations arise in the future that are as a result of actions by the former owner, it is their responsibility, not yours. Imagine if a former employee sues the business for something that happened before you owned it. With a stock sale YOU would be responsible.
• You will be able to "step-up" the assets you purchased and depreciate them again. In a stock purchase, you would only be able to depreciate the assets for what the remaining depreciation schedule is in the business. This is a huge advantage for you.

In very rare situations, a stock purchase may be your only option. This can happen when the business has certain licenses or permits in place that are crucial to the business but may not be transferable and it would be prohibitive for you to try to obtain the same licenses. In this case, you can complete a stock purchase but there are two things you need to do:

• Ensure that the sales agreement provides you with bulletproof indemnification by the seller for any potential liabilities that may have occurred during their ownership but only surface after you close the deal.
• You must have a significant amount of seller financing or a holdback in the deal so that you will have leverage to make a claim against the seller. Imagine if you don't: you'll be faced with defending the claim and having to go after the seller also in a separate claim.

Asset sales are the norm. It's to your advantage. Unless you have absolutely no choice but to make it a stock purchase simply to operate the business, don't do it!

Buying A Business With One Very Large Customer

Question:
I'm considering the purchase of a distributor business I've seen and like. My only worry is that one of their customers generates about 40% of the business. How can I protect myself?

Answer:
The seller has to guarantee that this client will remain on board for a least a year. That's why seller financing is key: if the customer disappears then you can have a clause to lower the balance of sale. As an example, let's say you pay 2 times Cash Flow. And this client represents $50,000/year in CF. If they stop buying within a year then you reduce the Balance Of Sale by 2 times the $50,000 or $100,000.

Your other option is to include an earn out clause whereby you agree on a total price of the business, but "x" amount is not paid at closing and only is awarded to the seller after certain contingencies are met during an agreed upon time frame. For example, after the first year, if the clients is an active customer, the earn out amount is considered to be earned. Also, try to negotiate this earn out amount to be paid as part of the existing or new seller note.