Avoiding Sleepless Nights

As your advisor and professional business sellers, we are committed to being your advocate. However, we cannot make you do what we believe is best for you and your family’s future. And in that, you will see numbers do not lie! A sales process is full of cascading decisions and consequences. Today, we’re working backwards from post-closing to the purchase agreement to the LOI and how buy-sell negotiations and ultimately your decisions impact all consequences favorable and not. We know how you feel and felt the same way when we sold ours.

What we found out was one word every business owner expressed about their case – overwhelmed. The emotions experienced, the daily reactions and the overwhelming feelings have been demanding throughout the process. Overwhelm is everywhere; leading into, during and after selling life’s work. We’ve often shared how an owner’s mindset evolves from that of an entrepreneur to that of a business seller – two distinctly different perspectives and realities. Every business owner moving to the next stage of their business will experience sleepless nights before, during and after selling. How can you avoid or at the very least minimize these feelings?

The Uhh Ohs

Defining Clarity. There are three uhh ohs that can trigger potential disputes and WTF moments can commonly occur post-closing in how a business is transacted. Whether business is sold as a stock or asset sale, they’re typically sold cash-free, debt-free. A price is agreed between buyer and seller which represents the underlying value of the seller’s business. In addition to the sales proceeds, the seller keeps the cash in the bank and they also must pay off the debt, thus clearing both cash and debt. If the debt must be funded by the seller at closing, then it’s performed through a purchase price adjustment. Potential uhh oh #1.  All debt is both short- and long-term as it’s defined. However, it’s not intuitive these days. Within the past few years, debt-free has become predominant in cases for nearly every transaction we’re involved in has experienced a debate. The purchase agreement constitutes what debt is and we pay very close attention to its definition along with our financial and legal advisors on your team.

Working Capital is uhh oh #2 where we (seller, advisors and buyer) agree to set the peg or target based on a historic period and a methodology for a comparison made to closing working capital. The comp is to protect the buyer ensuring there’s enough coins in the piggybank to carry on business beginning Day One without having to go out and immediately secure additional funding. Where does it break? It’s subjective! We’ve seen owners accelerate collections by enticing customers with a special discount, others who’ve run off inventory which increases turnover and some who stretch out payables which helps maintain cash. We call these methods ‘not in the spirit of business integrity’. For instance…

A $50MM case includes $5MM working capital and the buyer performs the true-up and goes, “TIME OUT. We didn’t get $5MM.” They received $3.5MM working capital and now there’s a dispute for the $1.5MM remainder. Once the buyer has control of the books, they prepare what they believe is the WC delivered to them within a period, let’s say up to 90 days. The seller has let’s say up to 30 days to respond to the shortfall. The uhh oh continues when neither party can come to a mutual agreement which triggers a dispute resolution mechanism in the purchase agreement which can be resolved somewhere between arbitration and the courts.

“I will go to my grave wishing I was more prepared.” – Industrial client

Here’s the problem. Working capital is subjective. WC is to protect the buyer and what we are going to do at JSP is capture the true movement between LOI and closing. Read that again! The situation is always fluid. The negotiation required is to remove as much subjectivity in the methodology as possible. When there’s agreement on the methodology and you do your part in operating the business from LOI to closing with integrity, then there won’t be issues as above. In plain English, don’t change your inventory from FIFO to LIFO and other creativity. What matters most is to minimize any differences and maintain all pre-closing measures through post-closing measures. The differences matter and differences arise when dealing with reserves – reserves on A/R, inventory and what they are supposed to reflect under GAAP.

A seller might be thinking ‘I’m ready for GAAP.’ I will just sign off on an agreement that says that, and the true up for working capital will be done in accordance with GAAP. Here’s the problem, oftentimes sellers are using more of a buy item thought pattern. For example, they may write off an A/R or reserve it after they exhaust all collection efforts on that item. Or, if an inventory item is going to be liquidated, they may reserve that. The problem with that is the buyer may come in with their own expectation and their own methodology for setting up a reserve. Oftentimes, they may want to use a formulaic method, e.g., any account receivable that’s over 90 days past due is bad and should be reserved. Or any inventory on hand that’s in excess of six months usage should be reserved. And there’s your disconnect. It’s in the choice of estimation methodologies. Both of those estimation methodologies are acceptable under GAAP. GAAP isn’t the question – there’s degrees of subjectivity.

“Do your homework and listen to Scott and the team. Don’t and it will cost you 6-8 figures.” – Danny W., Cabinet Mfg. CEO

 

The moral is if you say we’re gonna measure working capital according to GAAP, then you’re giving the buyer blank check. We are going to be very specific about what methodology will be using particularly in areas involving estimates and reserves. How potential uhh ohs are resolved between parties to the satisfaction of each party is to deal with them before closing rather than after.  Understanding how disputes arise is understanding the parts of the purchase agreement that impact these elements. How these elements are tailored in the agreement to prevent disputes from happening are critical.

Earnouts. Uhh oh #3 would be the most common type of contentious compensation – earnouts. We come alongside you and your business to help you grow smart to sell smart. Part of that process before entering the market is ensuring your value is where potential buyers believe it is so there’s no variance, little or no gap. Unfortunately, too many business owner’s egos get the best of them and decide NOT to be adequately prepared. What happens as we negotiate deals is the seller values their business based on future EBITDA of what they believe is achievable. The buyer is purchasing your business on future potential and yet valuing the business focused on history. Check out a quick Valuation Gap Analysis here.

A gap between buyer and seller valuation oftentimes is filled with an uhh oh solution or earnout. If the seller believes the business will grow at 15-20% a year for the next few years, then the buyer may say, ‘sure prove it’ and thus a mechanism is set to compensate the seller IF those objectives are achieved. And if you don’t achieve that aggressive increase? Uhh oh! We don’t like earnouts, but in the right situation in the right case it might be a worthwhile gamble…but it’s a gamble. We’re seeing less earnouts over the past few years, because of how many times sellers have been burned and lessons learned with many factors out of their control.

It’s important to craft language ensuring you’re protected and that means different things to different parties for sellers. It means you want your past practices acknowledged and respected. Whereas the buyer wants to protect themselves from things unknown by not falling victim to undisclosed items. In the end, having these things resolved ahead of time and adequately documented in the agreement makes the difference between a happy post closing experience versus a miserable one. While our sample size was less than 1,000 respondents every business owner we’ve surveyed expressed the following:

62% feared selling their business for less than they wanted to
58% wish they had better prepared for a sales process
46% regret not following their advisor’s advice