Negotiating and Deal Structure – Part 1

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Every business transfer will involve some form of negotiating before the process is ultimately finalized. The negotiating phase can be difficult with the final results being radically different from the original deal. If a business owner is not prepared to properly negotiate, he could lose the deal or settle for a lesser deal and not even realize it. The best deal does not always constitute the highest sell price as will be explained below. The deal structure of any business transfer is always part of negotiations since it will ultimately affect price and terms. From all cash transactions to owner financed deals, remember that deal structure is a major area of negotiation. The following are points of negotiating beyond the sale price that can be used to obtain the best overall deal.

Allocation of Sale Price

Allocation of sale price is just as important as the sale price itself, since it is the determination of what areas the sale price will be divided. In fact, we have seen many owners spend weeks negotiating the sale price and not consider the tax implications of the allocation of that price. Minor concessions on sale price can be more than compensated for with the allocation process. An awareness and understanding of the allocation areas in their respective implications to both parties will give the seller an advantage in the negotiating process. It is a good idea to go over these allocation areas with your CPA and determine the potential tax implications from the beginning. Some allocation areas include fixed assets, goodwill, consulting, noncompete agreements, employment contracts and real estate. The allocation of sale price should be reviewed between the seller and his CPA before the process starts to determine the best mix of variables that constitute the sale price.

Taxes

Similar to allocation of sale price, another key area in which we see owners unprepared, is their ultimate tax implications of sale. Depending on the corporate structure (C-Corp, S-Corp, LLP, etc) there can be many tax advantages and disadvantages when selling. We have seen business owners attempt to change the deal structure after they are well into negotiations, they discover their tax liability, because they realize they could not handle the deal that had been negotiated. In fact, we have seen many promising deals that were ready to close ultimately fail because the seller had not prepared himself in this area. It is imperative to get a CPA involved early on to fully understand the tax liabilities in order to avoid paying a majority of the sale price to Uncle Sam.

Handling Assumable Assets and Liabilities

It is beneficial to determine which balance sheet items can be assumed by a new owner before beginning the business transfer process. Many sellers are concerned about bringing their creditors into the picture until they know that they have a firm deal. Since there is only a certain amount of liquidity that most buyers can bring to the table, assuming balance sheet items can allow a buyer to purchase your business with less cash out of pocket, therefore warranting a higher sale price. For example, regardless of the type of financing, you may or may not elect to sell the accounts receivable and or accounts payable. These are variables and negotiating points for any transaction. If it is decided to include both, the net balance between these two values will either add to or subtract from the overall sale price at closing.

Earn Out

And earn out provision is a negotiating tool that can handle a deadlock on sale price. An earn out basically says that in a specified number of years after the sale, if sales stay the same as at the time of sale, the seller gets 100% payment on the owner note. If sales drop by a certain percentage, the owner note is likewise reduced by the same percentage. Usually there is not a corresponding increase to the seller on note payment if the sales increase, since that increase will be the result of the buyers efforts. A seller can take the position that there is only downside risk to him, but the earn out is used to handle only the amount of sell price that is in contest, not the total sale price.

Asset vs. Stock

We have and will continually discuss the many consequences of selling assets or stock. Some deals never reach the negotiating stage because the seller wants to sell stock instead of assets. In many of these situations, the seller has received preliminary information that he has to sell stock or else it would be a bad deal for him. Assistance from a CPA and an attorney that specializes in business transfer will sort a seller through this area. Almost always, buyers will want to purchase the assets of the corporation because of tax liability issues.

Selling a company with an asset basis and still benefiting tax wise puts a seller in a strong negotiating position. There are many ways for a business owner to minimize his tax liabilities, and selling stock is just one of these methods. If you only consider selling the stock, and that’s it, you may be ending the deal before it starts. A seller needs to be aware of the tax implications of both sides of the deal. As mentioned, the key to successful negotiating is to obtain specialized help before starting the selling process.

Non-Compete Agreements

Though not a major negotiation point, noncompete agreements can be used in the negotiation process. Most buyers are concerned about a seller’s ability to return to the industry and compete against them. A noncompete agreement reduces a buyers concerns; conversely it disallows a seller’s ability to return to the industry. This agreement could have many points of negotiation surrounding the length of time, distance parameters, and range of industry positions.

Length of Training

Although training is not a major negotiating point, it can be used as one. One or two months of a seller training is normally all that is required in the sale, with phone consultation for a nominal period to follow. If you are close on sale price, you can always adjust the length of training and even charge for it to compensate.

Earnest Money

Some business owners falsely believe that earnest money is some form of guarantee; therefore an area for hard negotiation. Actually, the amount placed on deposit by the buyer is only a gesture of good faith. As a seller, time and expense will usually far outweigh the escrow monies received if the deal does not close. If the earnest deposit is viewed as a good faith gesture rather than a negotiating point, it will not be an issue in the deal.

There is no set formula to determine the optimum amount of escrow money that accompanies a purchase contract. Escrow deposits are not a guarantee that a transaction will close. The deposit is refunded to the buyer if he withdraws before the due diligence period. Conversely, after the buyer has completed his due diligence, the escrow money would be forfeited if the buyer does not go through with the deal.

Deal Structure

Conventional Financing – this type of financing is commonly referred to as asset based lending. Conventional financing institutions rarely look beyond asset value; therefore do not consider one of the biggest assets you have to sale, goodwill, as part of their calculations. With conventional financing, lenders do not place a value on goodwill and even worse, place a deeply discounted value on assets. Anyone who has tried to obtain a conventional bank loan with a major of the value in goodwill can recall the stringent policies they have in place.

Conventional banks are excellent sources of funds for lines of credit, real estate and asset-based financing. In the small business arena conventional financing is not normally available to a buyer unless he has personal assets to collateralize the loan for the sale price is made entirely of asset value. Conventional banks have helped us all at times in our business ownership tenure and it is unfair to paint a negative picture, but chances are a buyer will not be able to use conventional financing as a vehicle to purchase a business if it is not heavily asset-based unless the buyer will have collateral to cover the loan.

In part two of negotiating and deal structuring, we will look at SBA financing, selling for all-cash, & owner financing.