Mergers & Acquisitions (M&A) 101: 7 Key Steps to Selling Your Business
When is the right time to begin preparing to sell your business? For some business owners, it’s before they even create the business. They structure all operations, contracts, systems, and processes so that there are quick, attractive exit options. For other business owners, it is after they decide to retire. Still for others, it is only after they have been approached by a buyer. Sometimes the market pushes people into a sales posture. Other times their internal clock drives the decision.
Regardless of what is prompting you to consider selling your business, there are things you can do to help boost your company’s potential for a successful M&A event even before you are approached by or reach out to possible buyers. The journey to a successful M&A deal can be a long path that begins with making adequate preparations. If the time has come for you to sell your business, a division of your business, or a product your team has developed, here are six key steps you should take to make your business more attractive to prospective acquirers.
For a whole overview of the M&A process (e.g., the players and terminology), watch Mergers and Acquisitions Explained: A Crash Course on M&A.
1) Eliminate Unknowns and Tidy Up the Back Office
Before launching the M&A sale process, you want to be certain that your company has no major, unresolved issues. Larger companies will have ongoing litigation—that is normal. However, a dispute with a fellow owner over buyout terms is the type of issue that is likely to slow down an M&A transaction. The buyer’s lawyers will be very concerned about issues that affect equity ownership. In my years of corporate law and experience on the business side of M&A deals, concerns about who owns the company are one of the primary reasons buyers walk away from, or renegotiate, deals.
A governmental tax audit or investigation of some sort is also the type of thing that is likely to give buyers reservations about going through with a deal. The major areas where unknown or unresolved governmental investigations are likely to impact your ability to close a transaction are tax audits, environmental cleanup issues, and claims of truth in lending or other regulatory violations.
What these things all have in common is that it is often challenging to estimate the extent of the risk they present. If you have a minor dispute with a customer over service fees, for example, that type of dispute can generally be framed easily, the potential risk quantified and capped. There isn’t much uncertainty. When the government is conducting an audit, one that is not routine, it’s tough to know just how much exposure the company faces. M&A buyers, like most people in the world, tend to be risk averse. Even if they’re not, their M&A attorneys, investment bankers, and other advisors are likely to advise them to be cautious – no one wants to make a major mistake in the M&A game, especially as an advisor to an acquiring company.
While certain types of M&A deal structures – asset purchases rather than stock acquisitions – mitigate the risk to buyers of pre-closing issues, they rarely give buyers all the comfort they need around large, unknown risks. Consequently, unresolved or ambiguous issues relating to your company, if you are selling your business, may not only forestall the process of merger or acquisition, but this forestalling can cause potential merger partners or potential buyers of your business to decide that the merger or acquisition will cost a prohibitive amount of time and effort, and that the resources and capital associated with getting the deal done will be, in layman’s terms, “more trouble than it’s worth.”
Your legal documents (e.g., option and restricted stock incentive plans, board meeting minutes and resolutions, NDAs, employment, consulting, non-competition and partnership agreements, etc.) should be organized and ready for review by outside parties, prospective buyers and their M&A lawyers, accountants, and other advisors. Required government filings must be in order. You need to have adequate product and marketing documentation. And make sure your financial records are correct, clean, and–unless you are a very small company–audited by a legitimate third-party. Remember that just because your inter-organizational processes are comfortable and familiar within your company, your processes may appear foreign to outside eyes, which is why retaining the services of outside advisors to assess your readiness to market your business for sale is valuable.
Another area of huge concern for prospective buyers of your business is intellectual property. Do you own the important IP in your business? General IP law in the US says that the work product of W2 employees belongs to the business. That’s not how it works typically when it comes to independent contractors. Just because you paid a developer to create your company’s application or website, doesn’t mean you have the intellectual property rights to those creations. You need clear, strong development agreements. If you haven’t spent any time on this issue, get with a good corporate lawyer or IP attorney to talk through and clean up these issues before the buyer raises them.
Lack of adequate and objective pre-negotiation preparation is a handicap, which may later derail the M&A process. Take the time to prepare and go through the exercise of having your own advisors kick the tires on your business. This will help ensure a smooth process with actual buyers. Your advisors will have an objective eye for problems you cannot recognize so easily.
Systematize Business Processes Before Selling Your Business
- Reduce Human Capital
- Another thing you can do to drive value and make your business a more attractive target for purchasers is to systematize and automate business processes. The less human capital required to maintain books, handle client relations, and more, the better. Look for ways to reduce the amount of time it takes for your employees to handle different business processes. By working through these kinks to systematize and automate your business processes, you’ll not only present your business as a better acquisition prospect, you’ll also help increase the amount a buyer is likely to be willing to pay to get the deal done.
- Build Your Business to Run Independently
- Relatedly, as a business owner, you should be doing everything you can to make your business run smoothly without you. Buyers will be much more apprehensive to acquire a business whose owner(s) are critical to making it run on a day-to-day basis. John Warrillow, founder of the Value Builder System, calls owners who are stuck smack in the middle of their businesses “hub-and-spoke owners.” If you’re an owner who is the hub of your business and all the action moves through you, a new buyer will be nervous that they won’t be able to transition the business to operate without you if you leave. That represents a significant risk. If you sign all the checks, know all your customers by name, and never have a day off, start right now working on replacing yourself in your business. Start working “on” your business, not “in” it. Prospective acquirers will reward you with higher offers if when they get comfortable that your business can survive, and even thrive, without you.
3) Focus on Value Drivers for Business Sales: Recurring Revenue and Growth Potential
When gearing up to sell your business, create a plan to boost your value drivers. Determine how you can improve the characteristics of your business that buyers value highly. Two common characteristics buyers value in M&A targets are recurring revenue and growth potential.
Recurring revenue is predictable and requires less sales effort and investment. Over the years, I have represented buyers and sellers of all sorts of businesses (as an M&A lawyer and an M&A corporate development “deal guy”), including plenty that have no recurring (already booked, contracted) revenue. However, without a doubt, businesses with recurring revenue sell for higher multiples. If you build websites, sell an ongoing maintenance package. If you’re a law firm, offer “on-call’ retainers, bi-annual audits, etc. In those businesses, you’ll never transition to primarily recurring revenue, although any little bit will help when it comes to marketing your business for sale through the M&A process. Businesses don’t need recurring revenue to thrive, although trust me – M&A buyers, business lawyers, investment bankers, and M&A consultants love recurring revenue!
When it comes to attracting buyers and commanding high sales multiples, the name of the game is growth. Buyers don’t care about what you’ve done; they care about your growth potential – what can your business do in the future? Being able to show some traction moving into new markets, including other geographic areas or other product or service lines, is super valuable. If you haven’t actually made any inroads into the new markets, your business broker or investment bankers will still spin the story of opportunity, although it’s unlikely to move the needle too much unless the buyer is a perfect complement to the new market strategy (e.g., the buyer already has great contacts or sales pipelines into those new markets).
Ideally, you’ll have laid some groundwork or shown some ability to enter the new market, which means you need to start planning this well in advance of a sale. The great news about that is that your company will be growing along the way, so not only will you hopefully have more revenue and earnings, which will raise the price buyers will offer to buy your business, but you will also command higher multiples if you do this right.
4) Trim Costs to Improve Your Financials
Part of cleaning up your balance sheet and financial reports includes trimming costs. Granted, your investment bankers or business broker will generally recast your financials to show what your checkbook would look like if you eliminated seller discretionary expenses. Things like optional travel, conference attendance fees, entertainment, club memberships, cell phone bills, periodical subscriptions, etc., all count as “discretionary expenses”. These can be eliminated. I realize there’s benefit to running all expenses through your company; however, wisely consider scaling back on these in the year leading up to the time when you’ll market your business for sale. Or, move the expenses somewhere else (e.g. other businesses, etc).
Debt may be tougher to clean up, although if you can restructure your debt as equity or push out your repayment schedule on short-term loans that are depressing your net earnings, these may help portray your business in a more favorable light. Some of that depends on the particular buyer and how they look at businesses. Private equity (PE) buyers are financially-savvy and inclined to immediately see through your financial structure and apply their lens of how they’ll choose to financially capitalize the business. This is why PE firms focus on EBITDA – earnings before interest, etc. They may use zero debt, lots of debt – these are their choices and they’ll very widely from firm to firm and deal to deal. Other buyers won’t be as readily able to look past low earnings due to heavy debt.
5) Deal with Personnel Issues Related to Selling a Business
A big reason why your company will be valuable to buyers is the human capital in it – your people. Your team has worked hard to build your company, and many employees and members of management are going to continue working for the company after it is sold. Thus, the buyer has a big incentive to find companies with successful management and employees. So, hire well. Promote people into leadership positions. Make sure you cross train people in different departments or specialties, though, because sometimes with M&A deals come layoffs. You want to be as prepared as possible to convince a buyer that the business can survive without any particular person. Hopefully the buyer keeps all your people, although a little friction in the form of layoffs is a reality, especially in larger M&A deals that are driven by cost savings. This is okay. Good, well-trained employees will find other opportunities.
Even if you elect to not tell most employees that the company is for sale, you need to tell management. Buyers will want to talk to management. They may want to know whether they are willing to stay on with the buyer after closing. Or, even if the buyer doesn’t want to employ any of your company’s management after closing, the buyer is nearly certain to have questions about issues to which only specific management members.
6) Resolve Any Minority Owner Issues
Purchase and consolidate available minority shareholder interests, or ensure they’re interested in the possibility of selling. Minority shareholders may demand a considerably larger amount for their shares (or LLC membership interests or other equity interests) if they think the buyer is very committed to the deal.
It’s always a good idea to have “drag-along rights” in minority owner stock and other equity agreements. These rights force a minority owner to sell if the majority of the owners want to sell. You can usually outvote a minority owner anyway, although they may be entitled to something called “appraisal rights,” which can slow down getting a deal done.
7) Connect with Brokers, Investment Bankers, and M&A Lawyers
Whether the business you are selling is a “main street” business (i.e., selling for $2 million or less) or in the lower middle market ($2 million – $50 million), there are business advisors who can help prepare your company for sale – business brokers and investment bankers. Contact them sooner than later. Explore what steps you can take early on in the process – think years out from the date you want to sell or begin exploring the market – so you can begin laying the groundwork now for a successful exit later.
If you want to speak to an M&A adviser, reach out to me at (512) 910-2700. I have offices in Austin and Houston, although I help buyers and sellers all over Texas. I look forward to connecting with you!