Negotiate Payment Terms Before Locking Down Price
Other than the purchase price itself, the terms relating to payment are the most important items that must be determined. Indeed, payment terms can have a big impact on the price you'll accept for your business, as well as on the price the buyer is able and willing to pay.
It is essential that payment terms are generally agreed upon before the letter of intent is signed.
Some of the payment terms that you may want to consider are
- the down payment;
- seller financing;
- earn outs;
- escrow arrangements and
- stock as payment (for corporate-to-corporate sales)
What Is an Acceptable Down Payment?
The best kind of deal is one where you receive the entire purchase price for your business, in cash, at the time of the closing. With this kind of deal, you can walk away from the business, free and clear. Many owners would gladly reduce their price significantly if the buyer would pay all cash.
However, it's a rare purchaser who can come up with enough money to satisfy the owner. This is occasionally possible where the buyer is a large corporation or where the business itself is cash-rich enough to be partially self-financing (for example, the business has excess working capital, a buildup of investments, and/or receivables or inventory that can be used to redeem the stock or as collateral for an asset-based loan.) However, in most cases, the payment terms will involve a down payment with the remainder paid at a later date, or dates.
What is your absolute minimum down payment? You'll definitely want to be able to cover the taxes that you will owe upon the sale, so you need to have an estimate of what that will be. Be sure to include any state and local taxes, such as sales tax, stock transfer tax, or real estate stamp tax, that will be due on the transaction.
You will also need to net enough cash after taxes to pay off any business loans that the buyer is not assuming. Finally, don't forget to include other transaction costs that must be paid at the time of the closing, such as broker's commissions, appraisal's fees, attorney and accountant fees, etc.
When considering your minimum amount, remember that many commercial lenders will require a down payment of at least 25 to 30 percent, to be sure that the buyer isn't going to walk away if the going gets tough. This is a good requirement for you to adopt. The buyer should have a significant amount of his or her own money invested in the company.
Are You Willing to Finance the Deal Yourself?
One important question that a buyer is likely to have is: "Are you willing to finance at least part of the deal?" This is a very fair question. During periods of tight bank credit like we've been experiencing since 2008, seller financing is common in many, many business sales. Even as the credit crunch eases, sellers are likely to provide at least some of the financing in a majority of business sales.
Sellers are often willing to do this because they can usually postpone some of the capital gains tax on the sale if they comply with IRS requirements regarding installment sales. Buyers are relieved because business acquisition loans from banks can be hard to come by.
Earnouts May Help When Value of Business Is Disputed
Where there is disagreement about how much the company is worth, it's fairly common to include an "earnout" as one of the terms of the deal. An earnout is a contractual arrangement in which the purchase price is stated in terms of a minimum, but you (the seller) will be entitled to more money if the business reaches certain financial goals in the future. These goals should be stated in terms of percentages of gross sales or revenues, rather than net sales, because expenses are easy to manipulate and thus net sales are too easily distorted.
A simplified example of an earnout provision would be one stating that the seller is entitled to 1 percent of all gross sales between 1 and 2 million dollars, and 2 percent of all sales over 2 million, payable annually for the first three years after the sale.
If you do use an earnout, it's important to state in the contract exactly who will be reviewing the books and verifying the business's performance. From the seller's perspective, you should be more likely to agree to an earnout if you'll maintain an employment or consulting relationship with the buyer. That way, you'll be able to keep an eye on things to make sure the buyer is taking all steps necessary to reach the goals, is not making unrecorded sales for cash, keeping two sets of books, etc.
From the buyer's perspective, an earnout is a good solution to uncertainty about the business's future since the payments can often be internally financed. The buyer will want to place a cap on the total earnout payments to limit the risks. Particularly if the seller remains active with the business, the buyer will want to be sure the seller isn't making lots of sales that will never be collected on or that will hurt the business's profit margin.
Escrows Help When Business Has Liabilities
If it seems likely that there are significant unknown liabilities associated with your business, the buyer may be willing to assume them if some part of the purchase price is placed in escrow. In an escrow arrangement, funds are placed in the hands of a neutral third party such as a bank, to be released to either party upon the happening of certain events. If problems surface within a specified time period, the buyer will get some or all of the money back. On the other hand, if nothing goes wrong, the money will be released to you at the end of the escrow period.
Indemnification clauses. Another possible solution is to include an indemnification clause into the contract. Under an indemnification clause, if the buyer becomes subject to a lawsuit by a customer, employee, supplier, etc., the seller agrees to pay for the buyer's costs of defending the suit and also to pay any damages. The problem with such clauses, obviously, is enforcing them. As the seller, you'd typically prefer an indemnification clause over an escrow, but the buyer may be concerned that he won't be able to find you if the need arises. He'd much rather have some of your cash available, if he meets the terms of the escrow agreement.
Stock Can Finance Corporate-to-Corporate Deals
If one corporation sells out to another, it's often possible to structure the deal as a tax-free reorganization. If properly structures, there will be no capital gains tax is due at the time of the sale, because each party is merely exchanging one type of security for another. The big catch is that you must agree to accept stock in the other company as virtually the only consideration for the sale. This is risky, but aside from structuring the deal as an installment sale, a reorganization is really the only way to defer the capital gains on the sale of your company into the future.
While these types of deals are most attractive with large public companies whose stock is highly liquid, it's also possible to do a merger between two private companies. You will, however, need expert tax and legal representation.
Negotiate Price After Deciding on Terms
Once you've established what the major terms of your deal are going to be, you can begin to negotiate on what's probably the most important aspect of the sale of your business: the price.
Whenever you negotiate price, in any type of sale, it's almost always best to let the other party make the first offer. When someone names their price, you have a fix on at least the minimum they will accept. However, as a practical matter, you will often have to make the first price move because you will have to give a ball-park asking price to your business broker. The broker will need a figure in order to advertise your business, or to contact buyers and see whether they might be interested in purchasing. You might also have listed an asking price for your business in your selling memorandum.
Of course, the buyer knows that your asking price is not the lowest amount that you will take. What he doesn't know is how low you'll go. If your buyer knows that your asking price is based on a formal appraisal using recognized valuation formulas, he or she may take your asking price more seriously, and make an offer that is fairly close (i.e., within 20 percent or so) to it.
However, don't be shocked if you get low-ball offers at around 50 percent of your asking price, or even less. There are a lot of bottom-feeders out there looking to buy businesses from desperate owners, but there are also legitimate buyers who just want to test your stamina by starting with a small bid. You should always respond to each offer on its own merits, and don't allow yourself to feel insulted or angry at an offer that you think is far too low.
On the other hand, if the buyer names a price that's more than you anticipated, don't automatically accept the first offer. Buyers will expect you to bargain hard on this issue. If you give in too soon, they will think something is wrong with the business, or with you (which in turn reflects on your business). An exception to this rule applies to large corporate buyers — they sometimes bid on a lot of small companies, and if you don't bite, they'll simply move on to the next likely prospect.
Strategies to off-set a low price. Our general advice is that you try not to get too hung up on any particular price. If you feel that the buyer won't budge, you can go back and change some of the terms you've tentatively agreed on, to make them more favorable to you. Your broker or attorney may have some creative ways of bridging a price gap between you and the buyer.
For example, the buyer might agree to purchase some zero-coupon treasury bonds (commonly known as "strips") for you, at a discount that allows you to get your desired price when the bonds mature, but at a present cost to the buyer that's much lower. Or the buyer might purchase a single-payment annuity product from an insurance company that will pay out enough each year to give you a comfortable retirement, at a price that's much lower to the buyer.
In family transactions where the buyer is the owner's child, the child may be able to set up a nonqualified pension program for you that will give you the desired price, but create tax deductions for the child (the groundwork for this type of solution needs to be set up several years before the sale, though).
You can also decide to keep some of the business assets yourself, and lease them back to the buyer (or anyone else) to reduce the business's price. The point is, there are almost infinite possibilities, if you are willing to be flexible.
Firm Offers Should Include an Expiration Date
Under contract law, when someone makes a firm offer they can theoretically be forced to complete the deal at that price (though if they are smart they will hold back some reservations in the form of contingencies, such as "this offer is contingent on my attorney's approval of the purchase contract"). Therefore, every time you make an offer or counter offer as to price, make sure that you have attached an expiration date to it. If the other party does not accept before the expiration date, the offer goes up in smoke and you can't be held to it.
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