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Selling a business can be one of the biggest financial decisions of a business owner’s life. Unless you happen to be a serial entrepreneur, you will likely only make the decision once. As such, it pays to get it right. Literally. While many resources focus on how a business owner should prepare for selling their business (e.g., when to sell, determining the value of the company, aggregating important financial documents), few cover the actual sales process. To help prepare business owners for what to expect when selling a small to medium-sized private business, I’ve broken down the sales process into 11 key steps.
Step 1: Introduction
It is not unusual for a prospective buyer to contact an owner directly by phone, email, or letter to inquire about whether their business is for sale. A buyer and seller can also be introduced through a business broker or investment bank. The types of buyers vary and include private equity funds, corporations (i.e., strategic buyers), private investment companies, and individuals. Each has a different source of capital, investment horizon, and reason for inquiring about the business. For example, private equity funds have large amounts of capital but short-term investment horizons and usually sell the company after three to five years. In contrast, private investment companies and individuals may have less disposable capital, but the ability to own companies for ten years or longer. The ability and motive of each buyer type will become clearer in step 2 and as the sales process progresses.
Step 2: “First Pass”
A prospective buyer will know relatively little about the owner and their business (assuming it’s a private company) other than what is publicly available. Similarly, the business owner will have limited knowledge on the buyer. To get acquainted, a buyer will want to setup an introductory call (usually 30 minutes). These calls are very high level and act as a quick screen for each party to determine if it makes sense to explore a sales opportunity in more depth.
It is customary that the buyer will provide a quick overview of who they are, their investment focus, and their interest in the company. The buyer will also ask the owner to share a high-level overview of the business, their future plans, and interest in selling.
This is a great time for the owner to ask the buyer questions. Some typical questions include (1):
Where does your money come from to buy my company?
How much do you typically purchase companies for?
How do you structure transactions (e.g., stock or asset sale, minority or control ownership)?
How long do you typically hold the companies you purchase for?
Do you have your own management team to run the business, or do you partner with existing management?
Some common questions that can be expected from a prospective buyer include:
How long have you owned the company?
Can you tell me a little more about your business?
What are your reasons for selling the company?
What is important to you in a sale?
At this point a Non-Disclosure Agreement (NDA) has not been signed and therefore the business owner will typically only want to share very high-level information. It is perfectly acceptable for an owner to ask that an NDA be signed prior to answering any questions and/or sharing any information.
Step 3: Sign NDA
In order to sell a business, the owners will need to disclose sensitive information to the buyer. Prior to sharing any material information, an NDA should be signed. An NDA (sometimes referred to as a confidentiality agreement) is a legally binding contract between a seller and potential buyer that covers the following three key elements:
Defines what information the seller will be disclosing that is considered proprietary, a trade secret, and/or confidential
Restricts the potential buyer from using the aforementioned information for any other purpose than evaluating a transaction between the parties
Restricts the potential buyer from disclosing the aforementioned information to third-parties (except to representatives and affiliates for the purpose of evaluating a transaction)
The NDA can be provided by the seller or buyer – it is the seller’s choice. NDAs can vary in scope depending on the situation. For example, when sharing information with a prospective strategic buyer or private equity fund that owns and operates a competing business, the NDA will also contain a clause prohibiting the buyer from soliciting and hiring the seller’s employees. NDAs also vary in duration, though most agreements have a two-year term. As with any legal document, an NDA should be customized to fit the specific situation.
Step 4 through 6: Preliminary Due Diligence (Business Overview, Financial Overview, and Q&A)
The goal of preliminary due diligence from the buyer’s perspective is to learn enough about the company to make an informed decision as to whether they are seriously interested in buying the business and at what price. The goal of the seller is to provide just enough information for the buyer to accomplish their goal. The typical format involves the buyer providing the seller with an information request list of five to ten items they’d like to review. This should be thought of as a wish list. Upon review, the prospective buyer will ask to setup a call with the owner and/or management team to discuss the business in more detail. These calls typically last an hour or two. An overview of each of the steps is below.
Step 4: Business Overview – A prospective buyer will want to discuss the following topics:
History of the business
Main product or service lines
Roles and responsibilities of key management members
Top customers and suppliers
Existing business challenges and/or opportunities
Future growth areas of the business
Step 5: Financial Overview – A prospective buyer’s information request list will likely include the following items:
Financial information for the past three to five years, including income statements, balance sheets, cash flow statements
Projections and/or budget for the next year
Accounts receivable, accounts payable, and inventory aging
Management org chart and employee census
Copies of any business description documents (e.g., marketing materials, board presentations)
Breakout of sales by division, channel, product, and/or customer for the past three to five years
Step 6: Q&A – This is a “catch-all” for any remaining questions that the buyer may have prior to submitting an Indication of Interest (Step 7).
Step 7: Indication of Interest
Typically, a buyer expresses interest at three points in the sale process - Indication of Interest (Step 7), Letter of Intent (Step 9), and Purchase Agreement (Step 11). The Indication of Interest (IOI) is the first expression and happens early in the sales process after the prospective buyer has had a chance to review limited financial information and to speak to the owner.
The primary purpose of the IOI is for the prospective buyer to provide the seller with a valuation range for the business. It can be viewed as an early litmus test for the seller and buyer to gauge the viability of reaching an agreement.
It is quite common for a prospective buyer to determine the value of a company based on a multiple of the historical and/or prospective earnings level of the business as measured by EBITDA or Seller’s Discretionary Earnings.
In addition to offering a valuation range, the IOI will include other important deal terms, some of which are highlighted below.
Proposed Transaction Structure – Is the deal an asset or stock purchase? Will the deal be in all-cash at closing, require a seller’s note, or include a performance-based payment (e.g., earn-out)? Each of these structures can have very different and important tax consequences.
Included and Excluded Assets and Liabilities – If structured as an asset purchase, does the offer include or exclude cash on the books, real estate, and/or assumption of any debt?
Working Capital Target – Will the deal include a working capital target? What is included in working capital (e.g., accounts receivable, inventory, accounts payable)? For more on working capital, click here.
Management – What is the expected role of the business owner after the sale occurs? How long will this role be? What consideration will be provided?
Due Diligence – What due diligence does the buyer need to conduct (e.g., business, legal, accounting, insurance)? See step 10 for details.
Time to Close – When does the buyer expect to close?
The IOI is typically presented as a two to three-page document written in plain English. It represents a “non-binding” offer and many of the terms will be refined at a later stage of the sales process (2). Many sales processes never move past step 7 as the buyer and seller are unable to come to a general agreement on price and structure.
Step 8: On-Site Visits
The on-site visit presents an opportunity for the buyer and seller to meet in person and the buyer to see the business first hand. It also presents an opportunity for the buyer and seller to continue their discussion about the business, review additional financial information, and discuss what is important in the transaction.
Each buyer and seller have their own preference for how these meetings go and who should attend. To keep things discrete and confidential, a seller may want to first meet off-site and/or to only meet on-site before or after normal business hours. Some sellers may be okay with the prospective buyer visiting during normal business hours under the guise that they are prospective customers, vendors, auditors, or consultants. It is not uncommon for the seller to invite other key members of their management team and for the buyer to bring their business partner(s).
On-site visits typically occur over the course of a day or two. At the conclusion, the prospective buyer may ask for any remaining information they need in order to submit a Letter of Intent.
Step 9: Letter of Intent
The Letter of Intent (LOI) is a more formal and detailed document than an IOI and will define the buyer’s offer in much greater detail. An estimated ten percent of investment opportunities that buyers and investors review get to this stage of the sales process. While an LOI is not necessarily a binding legal document, there is precedent of courts awarding damages when one of the parties has not acted in good faith and backs away from the deal (3). In that regard, the LOI should be thought of as an integral document in the sales process that addresses all of the key aspects of the proposed transaction.
It is very common for the LOI to be heavily negotiated and to go through multiple iterations of a draft before a final, executable version emerges. The goal of this back-and-forth is to iron out any important details of the transaction in advance so that there are no surprises when the lawyers draft the Purchase Agreement (step 11).
Although this article is not intended to cover LOIs in their entirety, an overview of some of the main sections are included below. In addition to these sections, the LOI will also address many of the same topics already covered in the IOI.
Purchase Price – Unlike an IOI which provides a price range for the business, the LOI will state a definitive price for the business.
Management and Employees – Defines the business owner’s role post-transaction. It may also identify other key management members and employees that will be retained, define compensation (salary, benefits, and stock compensation/co-investment opportunities) and define any employment agreement requirements.
Exclusivity Period – Prohibits the seller from soliciting or communicating with other prospective buyers and/or investors for a defined period of time – usually 30 to 90 days.
Non-Competition / Non-Solicitation – Requirement that the seller and other key management enter into a non-solicitation agreement with respect to any employees hired by the buyer and into a non-compete agreement with respect to the industry, customer, or geography. The non-competition and non-solicitation clause can each range in duration from one to five years.
Closing Conditions / Representations and Warranties – List of requirements each party must satisfy prior to the sale closing and provisions that each party will warrant and represent are valid as of the closing date. An exhaustive discussion is beyond the scope of this article.
Step 10: Due Diligence
Due diligence can be one of the most grueling portions of a sales process. A seller should expect a rigorous inspection of every aspect of their business, including operational, legal, and financial (4).
Broadly there are two categories of due diligence – document production and business meetings. Serious buyers will usually have long due diligence checklists that they will provide and follow to ensure all aspects are covered in document production. These checklists cover producing copies of corporate and organization documents, material contracts, insurance policies, tax records, and other highly sensitive business information. Certain buyers may work with third party accounting, insurance, and legal specialists who focus on various facets of the diligence process to document and verify information. During the course or producing documents, the seller and buyer will be in constant communication. Expect several more business meetings to review info, answer questions, and finalize any remaining transaction details.
The due diligence process can make or break a deal. Not only is the buyer looking to confirm what they already know about your business, but they are looking for new information and any indications of previously unknown risks that might give them pause for concern (e.g., undisclosed liabilities, potential lawsuits, misrepresented facts). In my experience, honesty pays off.
A thorough due diligence process is designed to uncover any skeletons in the closet. As such, there is no sense in trying to hide a material fact about the business. Once uncovered in due diligence, any undisclosed information will cause the buyer to classify the seller as untrustworthy and walk away from the deal and/or significantly reduce the purchase price.
It is estimated that fifty percent of all business sales fall apart in due diligence, and one of the most common reasons this happens is due to the buyer uncovering an issue which the seller did not disclose earlier (5). By being forthright with information, the buyer and seller build trust, the seller avoids the risk of the buyer materially changing their offer price late in the sales process, and the seller increases the likelihood of successfully selling their business.
The entire due diligence process can last three to four weeks depending on how quickly the seller is able to respond to the requisite information request and answer any of the buyer’s outstanding questions.
Step 11: Closing
The closing process primarily consists of drafting and negotiating a Purchase Agreement. The Purchase Agreement is a binding legal document drafted by lawyers that covers all aspects of the sale of the business. Including schedules, the Purchase Agreement can be over 100 pages. In addition to the purchase price, the Purchase Agreement includes information on indemnification and other methods of recourse should either party violate an aspect of the Purchase Agreement. Once executed by the buyer and seller, the Purchase Agreement is binding and supersedes any previous IOI and LOI. The Purchase Agreement can be drafted by either the buyer’s or the seller’s lawyers and can often be drafted simultaneously as the buyer completes due diligence. If the LOI was properly negotiated, drafting the Purchase Agreement is more of a formality than a negotiation.
Conclusion
The sales process can be one of the hardest things a business owner ever does and can create an enormous distraction to running the day-to-day operations. From start to finish, the process can take between three to six months. However, not every sales process is the same. Sometimes the steps above run in parallel and/or come in slightly different orders. But the main steps and key components of each don’t change. Knowing what to expect in the process can help a business owner navigate the sales process more efficiently and effectively and increase the likelihood of a successful outcome.
The partners at Cronkhite Capital have over 10 years of experience buying and selling small to medium sized businesses across industries. If you are interested in learning more about the types of companies Cronkhite Capital buys or have questions about the typical sales process, please reach out directly to Ryan Hammon. Email - rhammon@cronkhitecapital.com Phone - (415) 847-8103.
Disclaimer: Nothing in this article should be construed as advice with regard to legal, regulatory, tax, or investment advice, and should not be relied upon for such purposes. The parties involved in a business acquisition should seek the advice of their attorneys, accounts, tax, and financial advisors with requisite acquisition experience.
Sources: 1 - Frequently Asked Questions. Adventures.es. Retrieved (2019, February 12) from https://www.adventur.es/frequently-asked-questions. 2 - Indications of Interest, Letters of Intent, Sale/Purchase Agreements. Cafa Corporate Finance. Retrieved (2019, February 12) from http://cafa.ca/pdf/cafa_news_17_en.pdf. 3 - Ibid. 4 - 8 Line Items to Expect in Any Due Diligence Checklist. (April 2014). Offit Kurman. Retrieved (2019, February 12) from https://www.offitkurman.com/blog/2014/04/30/8-line-items-to-expect-in-any-due-diligence-checklist/. 5 - Half of All Business Sales Fall Apart in Due Diligence, Here’s What to Do. (September 2016). Forbes. Retrieved (2019, February 15) from https://www.forbes.com/sites/richardparker/2016/09/16/surprises-are-great-for-parties-but-they-can-kill-the-sale-of-a-business/#217b77cc16a3. Diagram inspired by Adventures.es from https://www.adventur.es/process
