Imagine a potential buyer — let’s call them Buyer A — has just offered $20 million all-cash to acquire your company. Another potential buyer — let’s call them Buyer B — also offers $20 million, but their offer is paid out in equal installments over a period of 10 years.
If nothing else differed between the two offers, which would you choose? Most would take the $20 million paid up front from Buyer A, rather than wait to get paid by Buyer B and take the risk that some of those future payments might never occur.
That much is pretty clear. But what if Buyer B increased their offer to $25 million, still payable over 10 years? Would the $5 million increase in total price outweigh the need and risk to wait to be fully paid? If you would still choose Buyer A’s $20 million all-cash offer, then what if Buyer B upped the offer to $30 million? Then which would you choose?
Different Buyers Will Offer Different Prices and Terms
This hypothetical exercise may seem over simplistic, but it’s quite relevant in the real world. When selling your company at exit, different buyers will not only offer different prices, but they will also offer different terms.
There are a wide variety of potential differences in terms. In the example above, Buyer B offered a different payment schedule — time was the difference between the two offers.
But buyers can use a complex array of different terms. They can vary the currency they use in their offer: cash, stock, notes, etc.
Buyers can also vary the deal requirements, such as whether or not they require you to stay involved with the company for some period of time post-sale and/or if you must sign a non-compete agreement.
Put all these pieces together and the picture can get complicated very quickly. Comparing different prices from different buyers is easy; comparing different sets of terms can be arbitrary and difficult.
If you eventually sell your business at exit, don’t be surprised if you find yourself more concerned about the deal’s terms than about the total purchase price. In other words, the highest-priced offer to buy your company might not be the winning bid. Many owners who have the opportunity to choose from multiple offers select the buyer with the most attractive terms, rather than the buyer paying the highest total price.
Strengthen Your Company Before You’re Ready to Sell
This issue is important now, even if you are not planning on selling your company for a while. Buyers often use deal terms to address a perceived weakness in the target company. Knowing the reasons for these deal terms gives you the information you need to rectify any potential such perceived weaknesses and set yourself up for favorable terms when you do finally sell.
Here are a few common examples:
- A buyer might hold back cash and require an earnout in the offer price when the buyer is not convinced that the company future growth’s will be as robust as the seller forecasts. The buyer’s doubts might be created by inconsistent or subpar growth rates or by a business plan that is unclear or unconvincing.
- A buyer might insist as part of its terms that you must remain with the company for a designated period of time post-sale if that buyer has concerns about the company’s leadership team performing well without you. (Ask us how to overcome this.)
- A buyer might hold back cash in an escrow account if your company has a small number of large customers, any one of which could leave as a result of the company sale.
To minimize the risk that you will be forced to accept burdensome terms when you sell your company, it is important to work on strengthening the company’s value well before you are ready to sell.
It can take several years to address the issues within a company that lead to less than favorable deal terms at sale. Getting started now puts you in the driver’s seat, driving toward the best of both worlds — the highest price AND the most attractive terms.
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To learn more about the steps necessary for a successful exit, contact Tim for a complimentary consultation: 772-221-4499 or email.
Here’s the story of how one business owner’s buy-sell agreement understated his company’s value by a factor of 10, and what you need to know for your own business value and exit planning.
We recently spoke with the majority owner of a professional services firm who has several minority partners. All of them have signed a buy-sell agreement1, which is typically a good and advisable way to mitigate risk.
The majority owner contacted us because he was suspicious that their agreement was drastically understating the value of his company, and as a result his minority partners were expecting to one day purchase his majority interest at a drastically lower price. He was right to be suspicious.
Book Value Isn’t Always an Important Factor
His company’s buy-sell agreement stipulated a formula of 2.5x book value to determine the overall value for the company. The problem was that for a professional services firm, book value is next to meaningless.
Book value is commonly understood to mean the net value of the company if you simply sell off all the assets and pay off all the debts. Book value therefore ignores the potential value of the company as an ongoing enterprise, including its goodwill.
While book value can be an important factor in asset-heavy industries such as manufacturing and distribution, it usually has little relevance in service-oriented companies. Rather, this owner’s company would ideally be valued based on a multiple of its profits (or revenue in certain circumstances).
Because we have worked with other clients in the same industry, we knew the relative value of his company if he sold to an outside buyer in the open market. That number was about 10 times greater than what his buy-sell agreement stipulated. Needless to say, this majority owner had no intention of selling his company to his two minority partners for a 90% discount, which is exactly what the agreement stated would happen.
The gap between this owner’s market-based business value and what his buy-sell agreement called for was pretty dramatic. However, his situation is common. Many owners are unaware of what their company is worth — according to their own legally-binding buy-sell agreements.
Why Do Such Disparities Happen?
Too often, what the buy-sell says is considerably different than what the company could be worth to an outside buyer, creating the potential for serious problems should the agreement ever be invoked.
This disparity happens for several reasons. First, market conditions change. The value or valuation method used when the buy-sell agreement was written may be considerably different than a value based on current market conditions.
Even if a formula was used, presumably to allow for some change and flexibility, that formula may be out of date. At the speed with which markets change, it can only take a year or two at most for the buy-sell agreement valuation to become a problem.
Second, businesses change rapidly, too. Where your business was and what your business looked like when the buy-sell agreement was written might be materially different from what the company looks like today.
Needs and objectives change with time as well. That’s what happened to this particular business owner. At the time the buy-sell agreement was written, he was trying to get several key employees to buy into the company at an affordable price, thus his advisors wrote a discounted price into the legal document. That may have made sense at the time, but since then his company had dramatically increased in both size and value, making the 2.5x book value approach not only obsolete but even harmful.
How to Maintain a Good Buy-Sell Agreement
What do you need to do with your company’s buy-sell agreement to avoid a similarly contentious situation? Consider these steps:
- Review the agreement no less than annually. Do not let it grow stale.
- Get input from your advisors — not only your attorney (because this is a legal document) and accountant, but also exit planning advisors who can provide perspective and data on current market conditions
- Be flexible. Your buy-sell agreement does not have to apply the same valuation methods to all situations. For example, if you want to sell a portion of your company to a key employee at a lower price, you likely can do so without hard-coding this lower price into every circumstance addressed in the agreement.Also, your buy-sell agreement can apply different valuations to different events. For example, if a minority owner dies, the buy-sell agreement might call for a buy-out of that person’s interest at full price, but if a minority owner is fired for reasonable cause the same buy-sell agreement might apply a deeply penalized, discounted price when buying back those shares.
For more help on this issue and dealing with business partners and co-owners, download our free ebook, Creating Co-Owner Exit Alignment. Or contact us if you have a quick question about your buy-sell agreement.
1 Also called a shareholder agreement, a buy-sell agreement is a legal document that usually has provisions that predetermine how certain ownership-related situations will be handled, such as the buyout of one or more owners due to death, disability, or other separation from the company. In many situations the buy-sell agreement is a standalone document. However, sometimes the buy-sell provisions are embedded in another legal document, such as the operating agreement in the company if it is an LLC.
To learn more about the steps necessary for a successful exit, contact Tim for a complimentary consultation: 772-221-4499 or email.
Tim is a Consultant to Business, Government and Not-for-Profits Organizations specializing in innovative and challenging ways for organizations to survive, to thrive and to build their teams.
