Competition: The Best Way to Sell Your Business

By Stephen R. Rusch
Gray Strategic Partners, LLC

Selling a company is a complex process. It tends to be a multidisciplinary effort that requires expertise in mergers & acquisitions (M&A), finance, law, tax and accounting, and other areas. Pre-transaction planning is critical, as is post-transaction wealth management. Since most business owners sell only once in a lifetime, it is virtually impossible for a business owner to have knowledge of all the areas required to successfully sell a business for maximum value and optimal terms. This is where an investment banker can be helpful. 

“Investment banker” has always been an unusual career title. Investment bankers are neither investors nor bankers. Rather, they are finance professionals who assist businesses with raising capital and in planning and executing M&A transactions. In this case, the investment banker serves as the advisor to a business that is seeking a sale or, in finance jargon, a “liquidity event.” The banker can lead the sale process, marshal resources, coordinate experts, prepare marketing materials on the business, contact investors or buyers and manage negotiations. In a sense, the investment banker is the quarterback of the effort.

General Business Sale Philosophy

In any transaction, a business owner wants to maximize value and achieve optimal contract terms (more below) to minimize any post-closing exposure. While individual circumstances may differ, the proven method to achieve this is termed a “classic two-step auction.”  The banker prepares marketing materials, shares them with multiple potential investors or buyers, and then asks for proposals to acquire the business. (This process will be described in more detail later.) The key point, however, is that competition – the auction process – is the crucial element to a successful sale. It is important to dispel the notion that a one-on-one discussion is faster and easier; it is not and will almost always result in delays in closing, renegotiations, and generally unfavorable amended deal terms. While not every business should be sold through this process, for businesses that are operating well, have good access to information and good future prospects, the competitive sale process is almost always the right answer.

Valuation

Every business owner wants to know the value of his or her business. There are valuation firms that prepare formal business valuations for a fee. This is an academic exercise and is often used for internal share transfers, estate planning, and even divorce proceedings. It is decidedly not based on actual market conditions. Investment bankers are in the market and have a real-time sense of an achievable valuation.

Familiarity with some terminology is helpful. The first is EBITDA (Earnings Before Interest, Taxation, Depreciation and Amortization). This is meant to be a proxy for cash flow generated by the business. There is finance theory that postulates capital structure does not impact the enterprise value of a business (i.e., how it is financed should not impact its theoretical value), hence the “I” for interest. Similarly, tax policy changes all the time, but it should not impact the core earnings potential of the business, hence the “T” in EBITDA. Depreciation and amortization are non-cash items, and while they might reduce taxable income, they are not cash expenses of the business. 

The second key term to understand is Enterprise Value. This is the value of the business irrespective of how it is taxed or financed. Almost all valuations will be expressed as enterprise value. This is distinct from equity value, which is the amount of value that accrues to a business owner. By definition, equity value is enterprise value less net debt. To avoid doubt, if a business had an enterprise value of $50MM, $20MM of debt and $5MM of cash, the equity value would be $35MM ($50MM-$20MM+$5MM). The $35MM would then be subject to taxation, etc.

There are numerous methods to triangulate value for a business, but the following are the most common:

• Public Comparable Companies: Bankers look at publicly traded companies in similar industries to analyze where they trade as a multiple of EBITDA (there are other metrics, but EBITDA is the most widely used and simplest to discuss). They will then apply a range of those ratios to the EBITDA of a business. If the public companies trade at 8x-12X EBITDA, then that is a proxy for range of value for a business. However, companies on a U.S. exchange are large and liquid, for which they often receive a valuation premium. It is questionable as to whether they are comparable to a middle-market business.
• Precedent Transactions: Bankers look at similar transactions to assess where the market has been and ascribe value to a business, in a similar fashion to public comparables. This is obviously a useful tool but with pitfalls. Most transactions are private and any public information is poor, so it is difficult to know whether a transaction is truly comparable.
• Discounted Cash Flow Analysis: The DCF analysis is based on the theory that a company is worth the value of its future cash flows, discounted back to today. This is also a useful tool but has certain limitations. For example, it is based on business projections created by the business owner or the banker; no one truly knows the future. The DCF analysis is obviously very sensitive to growth.
• Leveraged Buyout Analysis: Most everyone is familiar with the private equity investment business. Pools of funds buy businesses by borrowing against the assets or cash flow of a business and investing their equity capital. This is probably the most grounded valuation technique as it is linked to real world metrics, such as how much debt is available and at which interest rates, as well as equity return targets.

Bankers are market-driven creatures. They will have a market-based point of view on the value of a business from experience, irrespective of any theoretical valuation. Furthermore, any good banker will always recommend a competitive process.

There is one further important point to make around valuation. Corporate or strategic buyers look for synergies. Synergy is management consulting jargon that means “What more can I do with a business with my resources than it could do on its own?” This could mean consolidating facilities, adding a sales force, or purchasing raw materials more efficiently. Sellers can get paid for some of that, and it gets figured into the value.

Preparation

The key message of this article is obviously competition. Preparation is critical to create a competitive process, before anyone talks to the first buyer or investor. The idea is to make it easy for someone to buy the business on every issue except for price.

Bankers will do their own due diligence asking all sorts of detailed questions and requesting voluminous amounts of data on the business. This is because they want to understand the business and properly present it to investors and buyers, as well as to identify any issues that must be addressed or managed. Honesty is important, as eventually a buyer will know everything through a due diligence process; if a banker knows about an issue, it can be managed.

Unaudited businesses should consider an audit or review before approaching the market. Third-party opinions on financial information enhances the credibility of a seller. Consider a quality of earnings (QoE) review by an independent accountant. A QoE is a deeper dive into a company’s financial information and gives further comfort to a buyer on its accuracy. It can identify issues that may need to be addressed. The company should also create a business plan and five years of projected financial information. Although the future is unknown, buyers will expect a point of view and in current parlance, it will allow the seller to shape the narrative around the business and its opportunities. If a business owner has not done this before, the banker can assist or recommend a strategic business consultant.

Private business owners should also carefully consider the concept of an add-back.  This is simply the notion that certain expenses may flow through the income statement that are not critical to running the business, and they should be added back to demonstrate a clear picture of EBITDA. Recall that most buyers and investors think of valuation in terms of multiples of EBITDA. The car, boat and condo on the books that cost $500K per year could be worth $4MM of value if a buyer is paying 8x EBITDA for the business.

In addition, it is important that business owners undertake personal tax and earnings-replacement planning. Philosophically, every person should pay all the taxes owed and not a penny more. So, it is important to plan in advance for taxes in order to maximize net proceeds from a sale. Most business owners’ largest asset and source of income is a private business. Business owners should think through – and perhaps work with a wealth manager – to determine how to properly manage their proceeds to provide proper current income and future gains.

The Competitive Sale Process (Two-Step Auction)

The “two-step auction” is so called because there is a qualifying round for buyers and investors (the indication of interest) and then a final round (the final bid). Before describing the competitive sale process, it is best to define some relevant terms:

• Teaser: A one-to-two page overview of the business that can be presented to buyers and investors on a no-names basis.
• Non-Disclosure Agreement (NDA): A short legal document that investors and buyers execute before receiving confidential information, where they promise to keep the information confidential for a period of time.
• Confidential Information Memorandum (CIM): A detailed (often 50-page +) description of the business for sale. No third parties receive it until after having executed an NDA.
• Indication of Interest (IOI): A nonbinding proposal to invest in or acquire a business based on information in the CIM.  This becomes a qualifier for moving on to the second round of the sale process.
• Data Room: A secure electronic repository of the company’s information, used by buyers and investors for due diligence. In years past, the data room was just that – file cabinets and paper in a room.  Today, it is all online.
• Management Presentation: Buyers or investors that qualify are invited to meet management, hear a presentation on the business and ask questions. Bankers typically prepare the presentations and then edit and rehearse them with company owners and management.
• Letter-of-Intent (LOI): A letter of intent is an interim document outlining the understanding between two or more parties which they intend to formalize in a legally binding definitive agreement.  Often, the only binding provision is an exclusivity period, which means that a seller cannot talk to any other parties during the term of the LOI.  Sometimes this is required, as investors and buyers will not invest time and money into due diligence without it.
• Final Bid or Offer: Buyers or investors that have heard the management presentation and conducted due diligence (data room review, et al), make a final bid. This usually includes a final purchase price and contract terms, timing to close, intended roles for management, evidence of financing and often a mark-up of a definitive agreement.
• Definitive Agreements: A definitive agreement is a stock- or asset-purchase agreement that specifies the legal terms of the agreement.  Often, it is prepared by the seller to (once again) control the “narrative”; the buyer or investor marks it up and the final product is executed by both parties.

Bankers’ extensive up-front due diligence on a business leads to the production of a Confidential Information Memorandum (CIM). This is a marketing document meant to present the business and its prospects in the best light. It also could be the correct venue to disclose issues within the business – as well as potential solutions to those issues. Typically, when the CIM is complete, it will be slimmed down into a non-confidential teaser version. At the same time, the information collected as part of banker due diligence will be organized into an electronic data room. 

Bankers develop a buyers and investors list, and typically have it formally approved by the seller. Once the list is approved, bankers contact buyers and investors by email and phone to make the pitch. This is generally followed by forwarding a teaser and NDA to interested parties. Parties that execute an NDA receive a CIM. Some weeks after receiving the CIM, interested parties are invited to submit an IOI. This is non-binding, as noted above. Bankers discuss each IOI with their clients and then make a judgement on whom to invite to meet business owners and business management. Typically, at that meeting, management delivers a presentation on the business, there is opportunity for Q&A and often then a dinner to build chemistry and personal relationships.

Following the management meetings, the data room is often opened to interested parties so that they can begin preliminary due diligence. Seller’s counsel usually drafts a definitive agreement which is then sent to interested parties along with a request for a formal and final bid to acquire or invest in the business. The final proposal typically includes a mark-up of the agreement as well as key terms – like purchase price – remaining due diligence, and time to close. 

Bankers will lead the negotiation of the formal and final bid. Price is critical and so are contract terms. There can be trade-offs among price, terms and timing, but experienced bankers (and attorneys) can guide business owners through that. Here are two examples:

• The purchase price (or valuation) may be attractive, but the terms of the contract may not. The seller may be liable for all sorts of post-closing exposure. A buyer may ask for funds to be held in escrow for a period to back-stop potential exposure; no seller wants his or her proceeds to be held up if it can be avoided. A banker can negotiate with a buyer and balance that risk.

• A buyer may say that their firm can move quickly with minimal due diligence. That may be fine, but it also may mean that they have contractual post-closing rights to claw back funds. It might be more effective to move more slowly, let them finish more due diligence, and minimize post-closing exposure. Due diligence may take longer, but it may lead to a contract that is more advantageous to a seller. Once again, an experienced banker can help manage these competing interests.

Again, the key theme here is competition. Buyers and investors know that they are in a competitive process when an investment banker is involved. Competition can not only maximize value, but can also lead to better contract terms, as interested parties recognize they must compromise to win the day – in a competitive environment.

Who to Trust for Advice

Gray Strategic Partners is designed to address all these areas. The firm is led by experienced investment bankers who are close to the market, have a point-of-view on market-based valuation, and can manage a sale process to maximize value and optimize terms. Further, the firm is affiliated with Gray, Gray & Gray, an eight decades old accounting and wealth management firm. The firm can handle pre-transaction preparation and planning, manage the sale process, and then manage any proceeds through a wealth management affiliate, Gray Private Wealth.