Exit Strategy; By Sun Mergers & Acquisitions.
Letter of Intent ("LOI") is a preliminary agreement entered into between a buyer and a seller
summarizing the negotiated and agreed upon transaction terms & conditions. Most LOI's clearly state that the document is non-binding on the parties and is intended to serve as an outline of the key business terms to be incorporated into a Definitive Purchase Agreement and other ancillary documents. LOI's are also sometimes referred to as term sheets, non-binding term sheets, deal points, etc. The LOI should spell out the key business agreement points and contingencies, without going into unnecessary specific detail or legal specifics. It
enables the parties to determine if they can reach agreement on the "broad strokes" of a transaction, knowing that the finer points will fall into place during the drafting and negotiation of the definitive agreements. There are multiple reasons for the parties
to use a LOI: It can be used as a working document during the initial negotiation process, providing a written account of the areas of agreement as well as the evolution of proposals and counter proposals of the parties. It memorializes the key terms and conditions of a transaction, thereby minimizing any future misunderstanding during drafting and negotiation of the definitive transaction documents. A well-prepared LOI serves as a blueprint for the transactional attorneys when preparing their documents. It can identify problems or deal breakers in the early stage of negotiations prior to investing a significant amount of time and money on due diligence, comprehensive contracts and other areas. It minimizes wasted time and money because if the parties cannot summarize the key terms and conditions in a letter of intent, there is no probability that they will be able to negotiate more comprehensive transaction documents. "The LOI should spell out the key business points without going into unnecessary levels of detail or legal specifics." Governance of the parties' relationship in the period from signing of the document through the time of the closing and define timeframes and deadlines that must be adhered to. Transactions may encounter unexpected delays or extensions for a variety of reasons, such as hold ups in securing third party consents, prolonged contract negotiations, parties seeking to renegotiate, etc. * An LOI may be required by a lender as part of the loan package needed to obtain financing for the acquisition. * LOI establishes a "No Shop Provision" or standstill period in which the parties are committed to finalizing the transaction and precluded from negotiating with other parties. The LOI can contain any information that the parties wish to address and clarify relative to the transaction. The following are the components most commonly addressed in Letters of Intent based upon our daily experience with middle market transactions: Structure of transaction. It includes a description of the transaction (i.e. is the transaction a stock purchase or an asset purchase?). It should also clearly set forth the parties involved and whether an individual or a corporate entity is making the purchase. Price and terms. It is important to clearly define the purchase price or method of determining the purchase price, along with any potential price adjustments (i.e. based on Y-T-D performance, closing balance sheet, etc.). It should address payment terms of all component parts, including cash, notes, assumption of liabilities, earnouts, etc. Included Assets and Liabilities. It should clearly state what assets are included and excluded as part of the transaction. Common questions that LOI's address include: Are the accounts receivable included or will they remain the property of the seller? Will the seller retain the cash on the balance sheet? How much inventory is included in the transaction and what happens if the level of inventory level at closing deviates from the included amount? Will the seller be retaining certain vehicles i.e. personal vehicles? If the acquirer will be
assuming equipment leases and/or any other liabilities of the company, it must be clearly stated. All of these items have a significant impact on the total pre-tax and after tax yield of the transaction. Transition/Employment Period. LOI's usually also spell out the intentions of the parties with respect to the transition, setting forth how long the seller will remain with the buyer in an employment or consulting capacity, following the closing. It may or may not include the specific compensation arrangements between the parties. Contingencies or Conditions. The parties should also document any contingencies that must be met in order for the transaction to proceed to closing. Common contingencies include financing, environmental clearance, the ability to transfer or obtain licensing or approvals from regulatory agencies, due diligence (financial and legal), lease transfer, etc. Due Diligence. The LOI will outline the scope, procedures and the time frame that the buyer must abide by in conducting his due diligence and confirming approval. It should also provide for the level of access that the buyer will be given. Exclusivity. A buyer may desire a provision requiring the seller to deal exclusively with the buyer for an agreed upon period of time. This is also referred to as a "No-Shop" Provision or a "Standstill" Agreement. The purpose of LOI's can vary, however in our experience it is a vital component of the business sale process. Done correctly, it maximizes the probability of a successful transaction and also tends to "smoke out" situations that are not likely to lead to a closing, thereby saving time, money and protecting confidentiality in the process. "The LOI can identify problems or deal breakers in the early stages, prior to investing a significant amount of time and money." Bonusing Key Employees When Selling Your Company: When owners sell their businesses and realize a significant economic gain, it is not unusual to reward or thank key employees by giving them well-deserved bonuses out of the business sale proceeds. Many owners recognize and appreciate that without the dedication, contributions and years of service of their loyal employees, the business would not be in a position to yield the current level of purchase price. There are important considerations when determining how best to handle a post sale employee bonus: (1) Which employees deserve to be compensated? (2) How much money to allocate to bonuses? (3) What is the most tax advantageous way of paying these bonuses? (4) How can these bonuses be used to create a smoother transition for the acquirer? Determining which employees are worthy and how much money should be allocated to post sale bonuses are personal decisions and as such are not subject to any rule of thumb or formula. Factors to take into account are: How long has the employee been with you? How dedicated were they? How much did their efforts contribute to getting the company to where it is today? These are all subjective questions, which typically can only be evaluated by the business owner. Your tax advisor is in the best position to review the most tax efficient manner of issuing a bonus and discuss the various options and consequences of each. Alternatives include issuing the bonus just prior to the closing and paying the bonus from the Company immediately preceding the transaction. In this scenario the bonus expense will offset income earned during the current tax period and will reduce your tax burden by providing a significant write-off. This, as well as other creative ideas should be explored with your tax advisor. An often overlooked or minimized aspect of the decision to provide employees with loyalty bonuses is how they can be used as an incentive to affect a smooth transition for the
acquirer. In this manner your altruistic act results in a tangible benefit to you, the Seller. Key employees in small and mid-size businesses are a significant component of a company's value. If the acquirer achieves an increased comfort level that the key employees will support the transition of ownership, it will eliminate much of the acquirer's perceived risk. Alleviating this transitional risk increases the likelihood that a buyer will move forward in an expeditious manner and perhaps consider a higher purchase price given the reduced risk. A stepped bonus program is one method that rewards the employees and simultaneously secures their retention and commitment to an acquirer following the closing. In this scenario the employee will receive a portion at the closing and the remainder at specified future intervals, contingent solely upon their continued employment under new ownership. For example, assume you are selling your Company for $4 million. Further assume that you opt to pay your general manager a bonus of 5% or $200,0000 of the proceeds to reward his or her loyalty and dedication to the company for the past 12 years and the major contribution they made toward building the Company's value. Instead of disbursing the entire amount at the closing, it might better
serve you to pay $50,000 at the closing and $50,000 in each of the following 3-years, contingent upon the key employee's continued involvement with the new ownership. If you were to bonus the entire $200,000 to the employee as a lump sum there would be no incentive to remain. You may even be providing the initial funding for the employee to go into competition with the company you are selling. The value of your company will increase or decrease in proportion to the acquirer's level of perceived risk regarding its ongoing performance. Employee continuity is often a major concern of prospective acquirers. This tool can be a win/win for Seller, Acquirer and employees. When properly implemented, it can serve to avoid unnecessary headaches, due to employee defections and create more goodwill valuation for your firm. Seller Financing in a Business Sale: The he majority of privately held midmarket business sale transactions have at least two purchase price components: The initial investment or down payment paid to the
seller at the closing; and the deferred portion, generally in the form of a Promissory Note made payable to the seller with a defined interest rate and duration. Although third party bank financing is an option, a seller should be prepared to finance a portion of the transaction. This article addresses common transaction structures, issues to be aware of and points to be negotiated relative to seller financing. Positions are presented from the perspective of both the buyer and seller. There are a myriad of reasons why an acquirer believes that seller financing should be a part of a transaction: (1) Business acquirers believe it is crucial that the seller have a financial stake in providing the proper ownership transition following the closing; (2) It demonstrates the seller's confidence in the ongoing success of the business; (3) The buyer can leverage financial resources to acquire a more significant business (i.e., if someone had one million dollars to invest, they would rather utilize that equity to acquire a $2 million company, rather than to buy a $1 million company for cash; (4) an acquirer's cash on cash return is greater when financing a portion of the transaction; (5) Bank financing is not always an option for small or mid-market companies due to the lack of assets, quality of financial reporting, etc. From the seller's perspective, some of the reasons to provide seller financing include: (1) Price and terms generally have a dependent relationship. Providing seller financing, will generally enable the seller to realize a
greater total sale price; (2) The seller can receive an interest rate well in excess of what would be available from a financial institution; (3) it demonstrates a confidence in the ongoing business (i.e. a reticence to finance any part of the deal may be a negative indication of the future; (4) the seller is only taxed on proceeds as received rather than being taxed on all proceeds at the time of closing. Financing Amount. A typical promissory note for business transactions below $5 million in purchase price will range from 35% to 50% of the purchase price. This can vary significantly from transaction to transaction depending on a variety of factors. Interest. Interest rates on seller-financed notes have varied significantly throughout the years, similar to variations in prime interest rates. While we have witnessed seller interest rates from 5% to 12% over the years, it is common for these promissory notes to be 2% to 3% above the prime rate. Term. The term of the note varies significantly from deal to deal though the most common range is between 3 years and 7 years. It is not unusual to see structures that provide longer term amortization at the earlier period of the note with a balloon payment at the end. These structures are often used to bridge "valuation gaps" between the buyer and seller. "Bank financing is not always an option for small and mid-market companies due to lack of assets and quality of financial reporting." Security. The most commonly contested point is the securing of the note. The buyer ideally prefers that only the assets and/or the stock of the company that is being acquired secure the note. The seller would ideally like to see the note collatorized by something outside the business as well as secured by the business and its assets. The negotiated result is commonly somewhere in the middle. It is customary: for the buyer to provide the assets of the company as security: for shares of the company to be held in escrow until completion of payment: and for the acquirer to provide a personal guarantee. When the acquirer invests greater than 50% in cash at closing or in cases involving significant risk factors that the acquirer is inheriting from the seller, the buyer may object to providing a personal guarantee of the note. For example, if there is serious pending legislation that could significantly damage the business, or there is a customer concentration concern due to one or a few customers accounting for major percentages of the business, the buyer could want the seller to share in these inherited risk factors. Certain types of acquirers, such as Private Equity Group buyers, will not provide a personal guarantee. Strategic buyers (other firms) may not provide the personal guarantee of the principals however this may be handled by having the acquiring company stand behind the note in addition to pledging the assets and stock of the company being acquired. It is a fact that seller financing plays a role in most transactions involving small and midmarket firms, with potential benefits to both the buyer and the seller. The key is being aware of the realities of the market place and the options that exist.
Common Questions Relating to the Business Sales Process:
1. Does a well-constructed confidentiality agreement assure confidentiality in the selling process?
Confidentiality agreements, also referred to as NDA (non-disclosure agreements), are crucial documents to have executed by a potential acquirer prior to entering into transactional discussions and exchanging sensitive information. These agreements serve as deterrents to the disclosure of sensitive information, but should not be viewed as an absolute assurance that confidentiality will be protected. The best way to protect confidentiality throughout the process is to work with a qualified business intermediary who
is experienced in managing the flow of information from seller to buyer. This allows you to remain at arms length from the initial point of contact and shields the most sensitive information until it is absolutely required. It is typical for buyers to initially request most of the information they are interested in, the reality is that many items can - and should - be deferred until a more appropriate time. A professional business intermediary is well versed with the varioustechniques utilized to maximize confidentiality throughout the business sale process so your employees, competitors, customers and vendors do not become aware of a pending sale of the business. As a professional business intermediary, we interact daily with business owners and understand many of their concerns. In each issue, we will address common questions of business owners relating to the business sale process. Acquirers will always have more confidence in the accuracy and credibility of audited financial statements compared to compiled or reviewed statements. Certified or audited statements reduce the perceived risk that a buyer associates with the accuracy of financial reporting since the CPA firm preparing the audited statement is certifying as to its accuracy, that financial records have been maintained in form and substance adequate for preparing audited statements in accordance with GAAP (Generally Accepted Accounting Principals) and it has conducted a certain level of due diligence. Reducing perceived risk to the buyer can translate to a higher value that a buyer is willing to pay for a business. Smaller firms rarely have certified statements and as a rule, buyers of smaller businesses do not expect audited statements to be available. Our opinion is that if your firm generates over $10 million in sales, we would recommend that your financial statements be certified. If public companies are to be the target group of potential acquirers, they normally require certified statements as a prerequisite to completing the process. It typically requires 90-120 days to secure SBA financing from the time all application documents are presented to a financial institution. SBA financing is a federally guaranteed program that adds an additional level of scrutiny in addition to the financial institution that is providing the financing. Significantly increased paperwork and legal requirements associated with SBA loans, as compared to conventional financing, tends to slow down the process. When SBA financing is needed as an aspect of a business sale, it is strongly recommended that the Buyer use professionals (attorney and/or CPA) who have first hand experience in preparing and submitting SBA documents.
2. What is the "learning curve" associated with the sale of a Company? ISRA refers to the Industrial Site Recovery Act. When a business is sold, regardless of whether the facility is owned or leased, ISRA approval is required to consummate the transaction. You may be able to receive an exemption from having to go through an involved ISRA approval process, even though you are utilizing hazardous chemicals in your production process. If you are utilizing a limited amount of these hazardous chemicals, you may be eligible to receive a "Diminimus Quantity Exemption." This would provide an exemption from being subject to a more involved and rigorous environmental clearance process, provided that you can certify that the amount of hazardous materials utilized over the course of a year and the amount of hazardous materials stored at any point in time, do not exceed certain thresholds. 3. How long does it take to secure SBA financing in a business acquisition: It typically requires 90-120 days to secure SBA financing from the time all application documents are presented to a financial institution. SBA financing is a federally guaranteed program that adds an additional level of scrutiny in addition to the financial institution that is providing the financing. Significantly increased paperwork and legal requirements associated with SBA loans, as compared to conventional financing, tends to slow down the process. When SBA financing is needed as an aspect of a business sale, it is strongly recommended that the Buyer use professionals (attorney and/or CPA) who have first hand experience in preparing and submitting SBA documents. 4. Should I have my financial statements audited if I am thinking about selling the business? Acquirers will always have more confidence in the accuracy and credibility of audited financial statements compared to compiled or reviewed statements. Certified or audited statements reduce the perceived risk that a buyer associates with the accuracy of financial reporting since the CPA firm preparing the audited statement is certifying as to its accuracy, that financial records have been maintained in form and substance adequate for preparing audited statements in accordance with GAAP (Generally Accepted Accounting Principals) and it has conducted a
certain level of due diligence. Reducing perceived risk to the buyer can translate to a higher value that a buyer is willing to pay for a business. Smaller firms rarely have certified statements and as a rule, buyers of smaller businesses do not expect audited statements to be available. Our opinion is that if your firm generates over $10 million in sales, we would recommend that your financial statements be certified. If public companies are to be the target group of potential acquirers, they normally require certified statements as a prerequisite to completing the process.
Copypright Sun Mergers & Acquisitions:
Sun Mergers & Acquisitions is a professional business intermediary firm specializing in the confidential sale, merger and valuation of privately held businesses. Stephen Goldberg, the Managing Partner of Sun M&A, is a Certified Business Intermediary, engaged in sales and merger transactions since 1985. He is a frequent speaker and writer on the sale of privately-held companies. "Exit Strategy" is distributed quarterly, compliments of Sun M&A, to advise business owners and their advisors on topics involving valuing privately held companies, building market value and preparing for an eventual exit strategy. 411 Route 17, Hasbrouck Heights, NJ 07604 800-232-0180 * 201-727-1300.
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|Date:||Aug 3, 2011|
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