As we discussed in the first part of this post, exiting your business is as inevitable as taxes. In this post, we go into other items you need to consider when exiting your business. From the structure of the deal to the effects of debt, we will review key elements that can trip up sellers.
Structure of the Deal
Are you selling your stock or your assets? This distinction makes a huge difference in terms of taxes and future liabilities. When exiting your business there are two acquisition structures, stock deals or asset deals.
Stock deals sell your stock in the company to the buyers. The company remains the same, and the full company moves to the buyers. Asset deals create a new company, often called newco, that buys the assets of the company, leaving the ownership of the old company with the sellers.
The type of deal has tax consequences. From the seller’s standpoint in asset deals, the valuation of the assets can make a big difference in your tax bill. The asset value gets taxed at the ordinary income rate, and only the difference between the purchase price and the asset value gets taxed at the lower capital gains rate. In stock deals, you get taxed at the capital gains rate. From the buyer’s perspective in asset deals, they can increase the value of the assets from their value on the balance sheet to their current value. This difference allows them to depreciate the higher amount of the assets going forward, lowering their future tax bills. In equity deals, they receive the balance sheet as is, and can not increase the value of the assets.
There are liability concerns as well. In asset deals, the liabilities stay with the seller. However, the buyer assumes all liabilities in a stock deal. This feature is attractive to buyers who don’t know what risks they are receiving. For example, if there were a dispute with a vendor before the transaction that leads to a lawsuit. The vendor would sue the seller in an asset deal and the buyer in a stock deal.
There are also implications for employees. In an equity deal, the employees maintain their employment with the same company before and after the transaction. In an asset deal, the employee must get fired from the old company and rehired by the new company. This process can be cumbersome for companies with a large number of employees. It can also be challenging to explain why it needs to happen. Also, you must follow all hiring processes for the process. That includes new offer letters, I-9 certifications, benefit sign-ups, and any other documentation needed for a new hire. The hire/fire process should not scare you away from an asset deal. But you need to manage the process well, or it can create issues for the new company.
Cash Free & Debt Free
Another term you hear a lot is a “cash-free and debt-free” transaction. This phrase means that the seller takes the cash in the bank at the time of the deal. But the seller is also responsible for paying the outstanding debt of the company. This standard helps to make sure the buyers do not receive a massive debt bill and that the sellers take the cash they earned but haven’t taken out of the company yet.
Working capital is the most often misunderstood part of the process for sellers. When exiting your business, there is a working capital adjustment done at the time of closing, and a true-up performed 60-90 days later. Understanding why this gets included in deals and how it gets done is key to understanding how much money you will take home from the transaction.
Working capital is the net value of the short-term financing that the company receives and gives out to operate the business. Working capital includes items like accounts receivable, inventory, accounts payable, accrued expenses, prepaid expenses, and credit cards. While running your business, you use working capital to buy items and to sell things.
Most customers can not pay you the moment you ship an item. So, you invoice them and carry their balance as an account receivable until they do pay you. You need to stock up on material so you are ready to make your goods when you receive an order, so you carry inventory. You want some flexibility to buy items you need, so so you use a credit card and pay the balance at the end of the month. All of these items are examples of how you need working capital to operate the business at its current level.
The working capital adjustment sets a normalized working capital level that represents how much working capital the company needs to operate normally. Then at the transaction, you measure the current value of the working capital, and the purchase price is adjusted up or down based on the difference.
Why is Working Capital Important?
The reason is that the buyer will need the average level of working capital available to it to run the business. If the working capital is too low, then the buyers will need to put an equivalent amount of money in to keep the business operating normally. For example, if the company just bought more than usual on their credit card. Then the buyers will need to put in more cash at the time of the transaction to pay the balance at the end of the month.
Alternatively, if the working capital is too high, then there is cash being left on the table by the seller. For example, if customers who would have typically paid their invoice before the transaction delay their payment a week until after the sale closes. Then that would have been cash in the bank for the seller to take home.
The sellers need to manage working capital close to the average level so the business can operate as usual throughout the deal process. So the working capital adjustment protects both sides from any variability from the needs of the company. The later reconciliation gets done because the exact working capital at the time of the deal is difficult to know. So, the sellers are responsible for putting forth a best-effort estimate, and there is reconciliation done after the buyers can verify the exact amount.
What Happens Afterwards?
Exiting your business is not the end of the deal. After the sale date, the new owners need to operate the business. Some crucial questions are:
- Who is going to be in charge?
- What is their plan for serving your customers?
- How will they manage relationships with vendors?
- Are employees going to be in the same role?
- What systems are you going to use?
- What reporting requirements will you have?
All of these need answers. If any changes are happening, then there needs to be a clear plan for how to implement them. Often during a deal, both sides focus on the transaction and forget that the buyers will need to do the things they are planning. If there aren’t stepwise plans in place, the team will often become overwhelmed with too much change at one time. Building out an operating procedure during the due diligence process that prioritizes changes helps the team stay focused on their essential goals. A concentrated plan also prevents from overwhelming employees. Employees are already dealing with the shock of the sale. So, make sure the buyers don’t plan on doing too much too quickly.
Any leadership transition has two parts to it. The first is what support does the new leader need to take on the role. The second is what is the old leader going to do with their time.
New Leader Needs
The new leader will need a balance of support and space after the transition. They will need help establishing relationships with clients and employees in their new role. If they are a current employee, then they usually have a deep understanding of one part of the business. They will need help filling out their knowledge of the entire industry and what it takes to run the company. If it is an external hire, then it will take time for them to get to know the team and its strengths and weaknesses.
It is essential to take time before the deal to evaluate the strengths and weaknesses of the new leader and build a plan to help fill their gaps. That plan needs to balance the fact that the leader needs space to put their stamp on the company. They need to manage the company authentically, not as a replica of the old leader. This balance is often delicate for the former leader to handle during the transition. Both leaders need to develop open communication so they can say what they need and when they need space.
Former Leader Needs
What are you going to do after exiting your business? Owners often underestimate how disorientating it can be when they don’t go into the office every day. An essential part of preparing for your exit is planning for your life after the company. Are you going to travel? Is there a hobby you’ve always wanted to pick up? Are you going to spend more time with your family? Are you going to start another company? Figuring out what you wish this to look like after the sale helps you have a positive experience throughout and after the transaction.
Real estate can complicate a deal. If you are selling to an investment group, they will not want the real estate included. If they are buying your business, then they usually don’t also invest in real estate. They will want a clear separation between the two. That means typically agreeing to a long-term lease as part of the transaction to provide stability for the business.
If you are selling to an individual who is using an SBA loan, they might want the real estate included in the deal. They want it included because it can be rolled into the SBA loan and extend the term of the loan from 10 years to 20 years, or a weighted average of the two. Often the SBA is more willing to sign off on loans that include real estate because it provides an asset to back the loan.
Another option is to do a sale-leaseback agreement as a different transaction from exiting your business. There are investment groups that specialize in buying real estate and then leasing that real estate back to its current tenants with a long-term lease. This option is an excellent idea if you don’t want to hold onto your real estate after the transaction, and the buyer of the company doesn’t want to buy it either.
The Role of Debt
Most transactions contain some level of debt. You need to understand how much debt gets added to the company and evaluate if that is reasonable for exiting your business. I have seen several great companies drown under the debt load of a transaction.
The companies either had sales growth projections were unrealistic, or their valuations were too high. The companies came under pressure from their debt providers to change their operations to service their debt. They needed to lay off workers and were under constant surveillance of the bank. These companies would have been generating plenty of cash if they had half of their debt load. But with their debt load, they were drowning.
When exiting your business, seller financing can be a great option to finance a deal. It can also provide the seller with a higher return than just the sale price. If the buyer is struggling to finance the last piece of a transaction, they will ask for seller financing. Seller financing gets outlined in the LOI, including the maximum amount they would include and its terms. Seller financing is widespread in 100% ESOP transactions. Since you are adding 100% of debt to the company, and it is often challenging to find debt providers for the last piece of financing.
These are the considerations you want to make before including seller financing in your deal:
What is the level of seniority? You won’t be above bank debt in the seniority table, but you will want to be ahead of any mezzanine debt.
What is the interest rate? Do you think you could invest the proceeds of the sale at a higher rate of return?
How is the interest calculated? Most bank loans have an Actual/360 basis, which means daily interest gets calculated by taking the annual interest rate divided by 360. Then interest gets paid for each day during the year. This process is different from 30/360 when you get paid 30 days of interest every month, no matter how many days were in the month. If you use 30/360, then you will be leaving 5-6 days of interest on the table each year of the loan.
When is the maturity? Don’t let it string out for too long. Also, is the principal paid in installments or all at once at the end of the loan?
All of this combines to the critical question, will the company be able to make the payments?
Excellent Resources to Check Out
Finish Big – Bo Burlingham’s book about how to prepare for your exit.
Darby Creek Consulting’s Consulting Services – How we can help you manage your exit.
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