A Price to Pay

Published: September 30, 2004, By George M. Spilka, George Spilka and Assoc.

Selling your business? Be sure to avoid these 7 common pitfalls.

For many owners, the sale of their company is the largest, most complex transaction of their careers. Due to its magnitude and impact on the future, it also is one of the most stressful. Sellers often find solace and security if they have an experienced acquisition advisor to provide guidance during this process.

There is very little information available on middle-market transactions — defined as deals valued between $2 million and $250 million — to inform a potential selling owner what is involved in the sale process. Correspondingly, prospective sellers often are under numerous misconceptions that can be harmful.

The following seven pitfalls are the most common erroneous beliefs of middle-market owners. The answers to these questions should correct these misconceptions.

1. Is a valuation basically a “numbers-crunching” process?

   Nothing could be further from the truth. A properly conducted valuation involves the complete investigation of a company's business foundation. It includes defining the company's future opportunities and major risks along with their projected impact. The following factors must be evaluated during this process:

   • The strength of the company's marketing program, including the diversity and control of its customer base;
   • For manufacturing companies, the ability to produce a high quality, low-cost product, and the caliber and productivity of its research and development function;
   • For distribution or service businesses, the demographics of its trading area, the quality of its product and/or service line, the attractiveness of its locations, and the ability to run its operation on a cost-effective basis;
   • The quality of the management team and the presence of a reasonably paid, well-motivated work force.

   These factors combine to become a prime determinant of the multiple to apply to the company's expected future earnings.

2. Will planning and timing the sale increase the transaction price?

   Prudence dictates that a selling owner plan and time the sale to maximize the transaction price. As part of the planning process, all factors defined in Question 1 are evaluated and suggestions are made to strengthen the business foundation. Solidifying the business foundation will increase the transaction price. In addition, planning the sale will enable a company to be prepared to “go to market” at the appropriate time to generate the maximum price. It also enables an owner to respond intelligently to the unsolicited interest of a prospective acquirer.

3. Is the deal fundamentally completed when a preliminary price is established at the letter of intent (LOI)?

   In fact, the execution of an LOI is merely the start of the negotiating process. Unless you have a sophisticated, experienced advisory firm that has a strong position and the ability to control the deal, it is not unusual for an acquirer to demand a price reduction between the LOI and the closing. You must make sure an acquirer knows that tactic will never be productive. Negotiation of the definitive purchase agreement (DPA) is a difficult, confrontational, time-consuming process. The DPA includes all the critical representations, warranties, and indemnifications that are of potentially equal financial importance to the deal price itself. If they are not negotiated to provide the seller maximum protection, the result can be a post-closing opportunity for the acquirer to recover a considerable portion of a seller's deal proceeds.

4. Should owners only sell their companies when they are at or near the end of their business careers?

   The answer is definitely no. Most owners don't understand many of the benefits that can arise from a sale. Usually owners of closely held corporations have a vast majority of their personal wealth concentrated in the business. In and of itself, this is poor financial planning, but it is a typical by-product of owning a closely held corporation. By selling all or part of the company, owners can reduce their concentration of wealth in the business. Many younger owners want to put their financial condition in that shape. They also want to enjoy the finer things in life for a few years, while still in prime health. After their covenant-not-to-compete expires, which could occur after a five-year period, they can get back in business. However, they will commit only a small portion of their sale proceeds to the new business endeavor. This will assure they have lifetime financial security. They will be refreshed and might be eager to pursue a new business endeavor. From a personal standpoint, this is a very attractive alternative for a number of owners.

   When owners merely want to reduce their concentration of wealth in the business but still want to run the company, a recapitalization with a private equity firm might be the answer.

   In this situation, a selling owner can get approximately 90% of the deal value while still retaining a 30% interest in the recapitalized company. As most private equity firms strongly prefer management to stay, the selling owner should be able to continue to run his business in basically an unfettered manner. The only thing likely to change is that the owner now will report to a board of directors. However, the owner still will determine the company's strategic course.

   For an owner who wants to pursue this alternative, it is essential to find the right private equity firm. Only a few private equity firms are price-aggressive and pay a price comparable to a strategic acquirer. Certain firms might have companies in their portfolio that are a strategic fit with the seller. This should enable them to pay a price comparable to a strategic acquirer.

5. Do private equity firms usually pay a fair price for a company?

   Most, but not all, private equity firms pay substandard prices for companies. These firms typically pay a price 15%-30% below a strategic acquirer's. Therefore, your advisor should only deal with the few private equity firms that historically have paid prices comparable to a strategic acquirer. In general, if an owner primarily wants to sell the company to get out of the business, the most logical buyer is the pure strategic acquirer.

6. Should selling owners have to accept notes as part of their transaction proceeds?

   Many unsophisticated people, as well as advisory firms that are not overly concerned with maximizing their client's interests, believe acquires will always want a seller to take back a significant portion of the purchase price in notes. They rationalize that an acquirer needs this as protection against legitimate hidden problems that might be uncovered after the business is sold and because growth-oriented companies must use all available leverage to fund future expansion. This is nonsense. When individuals sell their companies, they have the right to receive the proceeds in cash except for the equity portion retained in a recapitalization.

7. Should selling owners employ special legal counsel to handle their transactions?

It all depends on the sophistication of the seller's present law firm. If it is a large firm that has specialists in the critical areas of environmental law, human resources, intellectual property, corporate finance, and certain other areas, it might be appropriate to retain current counsel for the transaction. However, if the seller presently utilizes a smaller law firm of fundamentally generalist attorneys, they want to employ new counsel that has specialists in the numerous functional areas to advise them in the transaction. If the seller employs a sophisticated advisory firm that will direct the deal negotiations, it is often advisable to allow the advisory firm to bring in a large, experienced law firm with whom they are familiar. This will ensure a blending of compatible negotiating styles with people familiar with each other's negotiating style and skills. This will be a significant asset to the seller during negotiations.

Owners that avoid these pitfalls should be able to sell their companies at an aggressive premium price with only limited, if any, exposure to post-closing issues.

George M. Spilka is president of George Spilka & Assoc, Allison Park, PA, USA, a national acquisition consulting firm based near Pittsburgh that specializes in middle-market, closely held corporations. A broad-based service, the company has been advising clients on the sale of their firms for more than 25 years. Its client base has included a diverse group of converters, manufacturers, and distributors. Contact Spilka at 412/486-8189; This email address is being protected from spambots. You need JavaScript enabled to view it.; georgespilka.com.