Have you heard the term “You set the price, I’ll set the terms”? The crux of this quote is simply reinforcement that when negotiating a deal, the two elements are inseparably connected. For this article, we will be referring to business transactions between $500K and $10M in selling price.
It is a compelling idea for a business owner selling his or her business to ask for the best of both worlds, which would be highest price at best terms. However, in practice, it is common that you will need to flexible on one to achieve the other. What we have discovered in our years of helping small business owners through the complex selling process, is the idea that business owners seem to be more focused on the price while the buyers are typically more concerned with the terms. I would not say that either party necessarily verbalizes this, or even consciously acknowledges it, however by our own empirical observations; it seems to be the case. Albeit an interesting concept, this begs the question; “what do we learn from this?”
Below are five nuggets of value that every business owner should have before going to the table with a buyer.
- There is no typical deal structure:
There are a million ways to skin the cat and structuring business transactions is no different. However, there are some very common starting points; that every seller should understand. A common starting point for most buyers would most likely constitute some portion of cash at closing and some portion of a seller’s note or “carry back”. It is not uncommon to hold a note of 30% to 50%. Seller financing is typically used to widen the number of interested buyers as well as increase the overall selling price of the business. If you are not willing to finance at least some of the price, the result will either be a lower selling price or a reduced chance of selling your company. Other components that are used in deal making include an earn-out, equity rollover, consulting agreement, transition period among others.
- Risk can be shifted:
Most deal terms are used to either enable a buyer to reach the price of the seller or to shift risk from the buyer to the seller. An all cash offer is the least risky offer to a seller, but the most risky offer to the buyer. As price gets higher a buyer will typically try to lengthen the time to pay the seller, or make the price contingent on the performance of the business. Keeping the seller involved is another way to lower the risk. The basic rule of thumb is that as the perceived risk by the buyer and price are on opposite ends of the teeter totter. As one goes up, the other goes down.
- Not all buyers are created equal:
It is always the best option to take the highest bidder. In fact, sometimes the highest bidder is the weakest buyer. A vetting out process of the buyer is pertinent before an offer is accepted. According to Diomo Corporation, 90% of all buyers never complete a transaction, and 50% of deals that have agreed upon price and terms fail to close. It is important to note that there are numerous strategies that we use to improve upon these dismal numbers; one of which to comprehensively evaluate the factors that make a buyer credible before spending the time evaluating their offer. Examples include assessing direct industry experience, access to funds, net worth, post-closing synergies etc.
- Financing matters:
Keep in mind that valuation is ultimately determined by the buyer and accepted by the seller, thus it is important to step into the buyer’s shoes to understand their offer. That being said, financing plays an important role in how the offer is structured. According to BizBuySell statistics, 80% of all transactions involve some financing, while only 10% are all-cash deals. A seller should reduce his or her risk by performing adequate due diligence on the buyer as well as possibly obtaining a personal guarantee on the note as well as a UCC1 lien on the business assets.
- The cash received at the end of the deal may change after agreed upon price and terms:
Nobody likes to renege on a deal, and there are three common reasons why the price and terms may change after the deal has been struck. It is important to understand each of these three and how to avoid them. The first is lack of preparation and bad information from the seller. Most of the time this will kill a deal, but adequate preparation will help avoid this. The second is a strategy that some unscrupulous buyers take to lock into a deal and then point out the negatives and why the deal should be modified or price lowered. Adequate vetting process will take care of this and help avoid. The third reason is a change in working capital. Virtually all deals will call out the assets being purchased which will more than likely contain some sort of working capital. If working capital is included, the number should be well understood by the seller before going to market. Any change in working capital will cause an adjustment to be made on the day of closing.
A strong understanding of these five points will not only help construct the most optimal deal terms it will help get the deal done in a way that maximizes value and reduces risk on post-close payouts. If you have questions or comments, please feel free to reach out to us.