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Accurate Financial Records When Selling Your Business

8/14/2015

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A big issue we experience with many small businesses is the lack of financial integrity.  This causes issues with the business valuation and sometimes trustworthiness from a buyer’s standpoint.  What is being bought or sold are instant cash flow and a future stream of income.  Without knowing the correct numbers it is hard for a buyer to predict what this future stream of income might be. 

Since future income is impossible to definitively compute and hard to estimate, the company's financial history, at least, provides concrete facts and insight to future performance. So, reliable financial records are not only a critical element of business management but also support the business' historic profitability, operational efficiency, and its solvency.

Most importantly, however, reliable financial data is the impetus for two critical events to occur in successful small business acquisitions:

  1. the ability for a prospective buyer to forecast the future probability of growth and prosperity of the company
  2. the likelihood that a bank will provide financing for the acquisition
Many sellers say they are making X number of dollars a year, but without proving it this income carries no weight in the value of a business.  The phrase we like to use in these cases is “You can only steal money once”.   You can not steal from Uncle Sam and then expect the buyer to pay for it. 

Therefore, a review of your business financials is critical prior to putting it on the market.  This will help your Business Advisor prepare a more accurate valuation and avoid surprises later when a buyer is performing due diligence.

To make sure your company remains attractive and to avoid the deal falling apart during due diligence business owners should consider these tips for keeping accurate financial records:

  1. Understand your financials and be able to explain them if the buyer has questions about them.  This includes revenue, expenses, and net income. 
  2. Produce cash flow statements with future projections.
  3. Have detailed documentation showing any “cash” payments.
  4. Be able to defend non-business essential expenses.  For example, travel expenses for a restaurant that does not deliver or cater.
  5. One-time expenses and expenses a new owner would not incur.
  6. Compare each year's performance to the prior years and be able to explain the reason for any variances.
Following these steps will help sellers drastically decrease the probability of deals falling apart and will help the business sell for its true value.  

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What is an Earn-out in a Business Acquisition?

8/4/2015

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Despite months of negotiation, buyers and sellers often have trouble agreeing on a specific purchase price. But this disagreement does not need to end the entire process. Rather than scrapping the transaction, one strategy to bridge the gap between the buyer and the seller is to use an earn-out.

With an earn-out, the buyer makes additional payments to the seller, after the sale, dependent on the performance of the business and the owner’s involvement in the business. Earn-outs can be essential to closing deals. They are designed to protect both parties and ensure that everyone receives fair value for the business.

Let’s take a deeper dive into some of the specific advantages of an earn-out agreement to business owners:

    • Shorten the negotiation time. Rather than haggling over price for months (and potentially never reaching an agreement), an earn-out can speed up the process of selling your business. This can drastically reduce the efforts and headaches associated with selling your business and lead to a better relationship with your acquirer. However, earn-outs do require some additional negotiation themselves.
    • Get full value for your business. An earn-out allows you to receive the full price for your business post-acquisition, because you don’t rush to sell in one payout. Instead, earn-outs can act as a form of dividend payment. If the business performs stronger than the buyer anticipated, there is a likelihood that the sum of the earn-out will exceed the one-time payout you would have received at the time of the negotiation. This is particularly true if you are selling a strong business in a down market. The earn-out can get you closer to what your business might be worth in a strong market.
    • Ensure a seamless transition. During an acquisition, an abrupt departure by the owner can create some cultural uncertainty. Employees are uncertain about the future of their roles, the company, and their future. In an earn-out, the seller will typically remain involved in the company during the transition and have the ability to include key employees at your company in the loop. Rather than leaving your top workers shocked and disgruntled, you should include the smooth and successful transition of your most loyal people that have been with you from the start.
    • Demonstrate confidence to the investor. Earn-outs are appealing to an investor because they prevent the firm from overpaying for the company since the earn-out is only paid when the company exceeds pre-defined performance thresholds. By agreeing to an earn-out, you demonstrate you are very confident your business will outperform their conservative estimate. This confidence can be a good sign to the potential investor, indicating you are not hurrying to jump from a sinking ship.
The exact terms of an earnout can vary depending on type of company being acquired, seller’s expected involvement, and length of transition.  On average the payouts last for 24 to 36 months on small to medium size acquisitions.  For larger acquisitions the payout can last for five to seven years.  

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    Jeremy Hovater

    President, Sunset Business Advisors

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