Prepping Your Business For Sale: Five Key Considerations for Your Exit Strategy

Aug 30, 2022 | Insights

Selling your business can be a daunting prospect, but for one reason or another, many small business owners come to a point in their lives where they must evaluate the question: “Is now the right time?”

And then the inevitable, subsequent question: “Am I even ready?”

The purpose of this article is not to answer the first question, because at the end of the day it is a uniquely personal decision with many different factors impacting one’s thinking. Rather, the purpose of this article is to provide points and insights to guide you to a more definitive answer to the second question, and hopefully ease any anxiety associated with the prospective sale and due diligence process.

What Should You Consider When Selling Your Business?

Let’s take a look at five key considerations you should keep in mind as you look to sell your business.

Understanding What Your Ideal Buyer Looks Like

In today’s mergers and acquisitions environment, a potential buyer of your business could come in all shapes and sizes.

Understanding who would be the best acquirer of your company, which you spent years building to the point where it is today, is an important step to reducing any fatigue associated with the early phases of a sale process.

A sell-side representative, such as an investment banker or business broker, a transaction lawyer, or accountants with transaction experience are often able to provide insights and help guide you in the best direction based on your goals. Generally, it is easiest to think about buyers in the scope of three groups.

  • Strategic: Strategic buyers are companies or corporations that are either active within your industry vertical and are looking to expand their footprint or are seeking to penetrate your industry vertical and want a quick means to do so.
  • Financial: Financial buyers, also known as private equity buyers, most often evaluate your business as an investment that they will seek to grow over the coming years through several avenues.
  • Owner Operator: Owner operators are often individuals with capital and business experience who are looking to purchase an established company and step into the CEO role to run the day-to-day.
    When evaluating any of the above, it is crucial to understand why a buyer wants to acquire your business and what the implications may be for your employees, your brand name, and the business’ ultimate valuation.

Data Room Preparation

Understanding what a buyer is going to request before they request it can expedite the due diligence process and ensure smooth communication from the start.

The extensive amount of data that could be requested during a due diligence process may seem intimidating. That said, focusing on assembling the essentials in a data room that can be easily shared early in the process or before even marketing your company for sale will go a long way to answering many of a buyer’s questions before they even have the chance to ask them and cut down on the timeline to close a deal.

Speed and a quick closing are very important in acquisition transactions. To help ensure this happens, you’ll want to have the information below readily available.

  • Company and Legal: While many items falling into this category could be considered informational or “check the box,” they are important for a prospective buyer, nonetheless. Key items to share could include the organizational chart, ownership information, tax status, licenses or permits required to operate the business, and descriptions of any intellectual property or patents.
  • Financial: Financial statements for the last 3-4 years will be the most important to share, but other pertinent financial information could include tax returns, sales breakdown by product / service type, information relating to debt or financial agreements, disclosure of any accounting issues, and breakdowns for accounts receivable and accounts payable.
  • Human Resources: A buyer will not only want to understand the makeup of the employee base, but also the technical aspects involved with the human resources function. Key items to share would be biographies for key employees, employment agreements and compensation breakdowns, descriptions of employee benefits, and any handbooks or related employee resources that are utilized.
  • Operations: Perhaps the broadest of all the categories, a seller may choose to share anything that they feel is crucial to making their business “tick.” This could include contracts with customers, vendors, or suppliers, rationale behind pricing, descriptions of business development initiatives, information on supply chain strategy, descriptions of internal IT systems, or any marketing / sales materials that the company uses.
  • Insurance and Liability: Finally, a buyer will need to understand the history of any liabilities or insurance claims that have occurred in the business. It’s important to assemble and share insurance agreements, summaries of any claims experience, workers’ compensation details, and any applicable loss runs.

We are happy to share our short form due diligence request list to be used as a reference point for sellers or sell-side representatives. If interested, please send an email to lcmteam@lancercm.com.

Quality of Earnings

Quality of Earnings might seem like a scary phrase, but if a seller understands what goes into the process and is prepared with the appropriate information, the analysis can be straightforward.

A Quality of Earnings varies in complexity from a full accounting analysis and findings report to a simple proof of cash analysis.

A buyer will most often engage an independent accounting firm who will understand the scope of the analysis going in and approach from the buyer’s lens to help prove that financial performance and the ultimate cash flows of the business are as stated.

The accounting firm will put forth its own due diligence request list with a more in-depth financial focus, but the most important aspects will include general ledger detail and any adjusting journal entries, bank statements and corresponding reconciliations, payroll information, tax information, and adjustments to EBITDA.

Not all businesses have the strongest financial controls, and that’s okay, but it’s important to fairly represent the performance of the business above all else to reduce headaches and help ensure a smooth process to close.

The ultimate purpose of Quality of Earnings is to identify these types of issues. If there is any concern about the representation of financial performance, having a discussion early on can avoid wasting time later in a process and potentially lead to solutions for all parties.

EBITDA Addbacks

EBITDA stands for Earnings before Interest, Taxes, Depreciation, and Amortization. Most often, a prospective buyer will put forth a valuation based upon this number.

The easiest way to think about your company’s EBITDA is to start with your net income number and add back expenses that are ultimately not associated with the operating performance of the business (Taxes, Depreciation, Amortization), as well as any expenses that would effectively cease to be incurred under new ownership (Interest, One-Time Expenses, Other).

Where sellers will most often hit speedbumps in a due diligence process is around what would be qualified as an expense that would effectively cease to be incurred under new ownership.

For example, let’s say that the Owner of a business also operates as its CEO and is paid a salary of $300,000 per year. The Owner / CEO wants to retire and exit the business completely, therefore, they add back their $300,000 salary to EBITDA because it would cease to be paid under a new owner.

A prospective buyer would look at this addback and argue that it should not be fully applied because while the Owner / CEO’s salary is coming off the books, it will still be necessary for the new owner to find and pay a replacement CEO due to the circumstances.

In this scenario, the prospective buyer could say that the market rate for a new CEO is $200,000 per year and ask that this amount be netted out of the EBITDA number, bringing the total adjustment from $300,000 originally, down to $100,000.

While this is an oversimplification of the analysis that ultimately goes into EBITDA addbacks, it is important for the seller to have a clear understanding of expenses that can and cannot be applied along with the appropriate documentation that can be used as backup. The more aggressive the addback, the more it will be subject to a deep review during the Quality of Earnings phase.

A helpful measure that can be taken by any business owner who’s conscious of a future sale is to add a separate line item onto their Income Statement called “EBITDA Addback Expense” where any expenses that are truly believed to be one-time expenses, such as a new executive signing bonus or legal costs related to a one-time issue as an example, can be recorded throughout the year.

The main reason to employ this strategy is that it can be difficult to remember or parse out what would be considered a one-time expense when looking back at historical financials over a 3-to-4-year period.

Creating a separate line item on the Income Statement, and properly communicating this point with backup documentation will significantly ease the analysis burden in determining the true EBITDA number that a seller deserves credit for as they approach an exit.

Anticipating Diligence Speedbumps

Every business has its own fair share of issues and challenges, but it’s important for a seller to understand that this isn’t a surprise to prospective buyers.

In most situations, there are ways for buyers to get comfortable with items that may cause snags at any point in the process, so it’s important to anticipate and be upfront about these items to better ensure that all parties’ time is being used constructively as they advance to an eventual close.

A couple of common sticking points have already been discussed throughout the course of this article. Ultimately, it’s difficult to put forth a hard and fast list of what to anticipate because some buyers may see speedbumps where others don’t, be it due to personal philosophy, past experiences, understanding of industry nuance, etc.

However, there is one hurdle that has the potential to delay or impact an otherwise smooth sale process to a greater extent than all others and that is the timing of customer contract renewals.

Customer contracts do not apply to every business, but in those where they do, a looming renewal can present itself as a binary risk to a prospective buyer.

The successful renewal of the contract means that the business will continue to perform as expected, but failure to solidify a renewal could wipe out a significant portion of the business’s revenue and subsequent value overnight.

Monitoring these situations is not something that a prospective buyer will take lightly. Therefore, it is important for the seller to understand that it may be necessary to wait those extra 6 months to get through a renewal before engaging in a sale process to ensure that they’re given credit for the full value of the business and its sources of cash flow.

In the End, When Selling Your Business, Communication is Key

As mentioned at the beginning of this article, the question of when to sell your business is not an easy one to answer, but there are many steps that can be taken which will make the path easier to navigate.

A buyer is ultimately the steward of your legacy as a founder or business owner. While it may seem like they’re turning over an excessive number of stones during the due diligence process, it’s important to remember that they’ve come this far because they truly believe that you have built a strong and exciting business.

When closing day arrives, it is paramount that both the seller and buyer feel good about their decisions and the path that they’ve taken.

Our final piece of advice that we would reiterate to those preparing for a sale process is that effective communication is key.

This point has appeared as the common denominator in each of the abovementioned phases because if communicated early and clearly, there are few issues with which a buyer who continues to pursue a transaction cannot gain comfort if they are communicated far enough in advance.

Avoiding surprises is critical in ensuring a smooth transaction process for both buyer and seller. Doing so in an effective manner will only deepen the buyer’s respect for you.

Please reach out to Jackson Bennett (jackson.c.bennett@lancercm.com) with any questions or comments.

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