Putting All the Ducks in a Row: Advising Clients on Selling a Business
by Paula Barrett, CPA, RKL LLP, and Ryan P. Hurst, RKL LLP. –
April 9, 2018
The commercial landscape is on the cusp of a seismic generational shift, with about two-thirds of U.S. businesses expected to change hands within the next decade, according to 2017 Pepperdine University research. As baby-boomer entrepreneurs move toward retirement, many will look to transfer both their ownership interests and management roles in their companies.
This demographic shift, however, is not occurring in a vacuum. As with most business transactions, market factors will significantly impact the outcome of an ownership transfer or business sale. The ebb and flow of supply and demand play a key role. On the demand side, several factors have aligned to drive up interest and price. Corporations are holding onto a record amount of cash since the 2008 recession ended, much of which has been pegged for acquisitions. Recently passed tax legislation is expected to reduce the burden of repatriating much of the corporate cash and earnings held overseas, which Bank of America Merrill Lynch estimates may bring stateside as much as $400 billion. Additionally, according to financial data and software company PitchBook, U.S.-based private equity firms are sitting on $550 billion in capital to be invested in buyouts. Factor in easy access to debt from lenders, and many buyers will be well funded to act upon acquisition ambitions.
On the supply side, however, there continues to be a limited number of quality buyout targets. Owners with a company in pristine condition are rewarded with a top-dollar offer, while businesses that need improvement or lack a key component are more likely to be passed over, garnering few – if any – offers. This climate demonstrates the importance of encouraging clients to invest the time and energy into optimizing their companies to become a more attractive acquisition candidate.
CPAs rank as the most trusted financial and business professionals according to a 2015 AICPA study, and accounting professionals are uniquely positioned to guide clients through the sale of their businesses. As more owners elect to transition their business interests, it is essential that CPAs walk them through the critical stages of preparing them financially, accelerating business value, and executing the optimal deal for their unique goals.
Personal and Business Preparation
As with most business and financial endeavors, the time and energy initially invested to prepare for a sale pays dividends down the road. Preparation runs counter to human nature, and owners often become impatient in the first stage of the sale process or feel overwhelmed by the entire process and try to jump ahead. Skimping on this phase, or skipping it entirely, may cause problems later, when the seller winds up in a deal that does not reflect his or her priorities or financial best interest.
Advisers should facilitate a discussion with their sale-minded clients, and clearly define the goals for a transaction. The goals may include considerations such as the importance of family legacy, a desire to provide a continued place of work for valued employees, or to get the most financial worth out of a transaction. It is equally important to identify their “no gives.” These are non-negotiable areas for the client. Once the “no gives” are identified, whether it is location, workforce, or financial, the adviser can cordon those topics off so they are not traded away during negotiations.
Defined goals will help mold the direction and form of the deal, which is also underpinned by a financial assessment on two levels: personal wealth and business value.
To assess personal financial standing, a CPA should connect clients with a wealth adviser if they are not already working with one. A professional wealth adviser can help the owner develop a thorough understanding of what their lifestyle needs will be in retirement and assess whether the business value will help fill those financial needs.
Three keys to personal financial planning – Many clients are hesitant to undertake a comprehensive financial assessment on a personal level because they fear exposing gaps or shortcomings. Often, though, the process can help settle angst by demonstrating the absence of gaps. But if shortcomings are detected, the process allows time to fill them. Personal financial planning is driven by three key inputs:
- A realistic asset appraisal – Identify what the personal estate looks like and nail down solid estimates of values for those assets.
- Lifestyle needs – Figure out what spending habits exist today and what realistic spending expectations are moving into the future. This is a critical component that drives the entire financial plan. Flawed expense assumptions can cause trouble down the line.
- Income source projections – Determine your client’s retirement income sources. Are they investment income, Social Security, pensions, or other savings vehicles? Be sure to solidify what these income sources will look like in the next chapter of life. The outcome of a deal and the maintenance of a desired standard of living for the seller are largely contingent upon these three areas. It is well worth the investment of time to develop these financial estimates.
Understand the business value – The next phase of the preparation stage focuses on the business. To ascertain a realistic picture of the business, a third-party valuation is recommended. There are numerous valuation products, but for the purpose of a routine business sale a valuation analysis is adequate. This tool provides a realistic run of the numbers and other unique business factors that can be used as the basis of a business sale as well as other estate planning efforts. Tapping a highly credentialed valuation expert who regularly helps clients buy and sell companies ensures the analysis will be conducted and produced in a format that is most beneficial to business transactions such as sales, mergers, or acquisitions.
When conducting a valuation, the analyst should start by gaining a thorough understanding of the business history, outlook, growth expectations, industry trends, and regulatory challenges the company faces or may face in the future. This information will be assimilated into a comprehensive risk profile and the business’s past, present, and projected financial results.
Many business owners believe they know what their companies are worth, but an independently prepared valuation is a valuable way to test those assumptions and spur an open, in-depth conversation about why an owner’s belief may not align with reality. It is an important opportunity to peel back the layers and discover what is driving or draining the value of the business.
Assemble a team of experts – As the business owner honestly evaluates his personal situation and assesses the true value of his company, it is important that he is supported by a team of experts for every phase and facet of the sale. Assembling this professional advisory group is a financial investment, but it more than pays for itself in advocacy, advice, and expert guidance. The ideal team should include a transaction attorney, an accountant, a business valuation expert, a wealth adviser, an estate planning attorney, and an investment banker or broker, in certain situations.
These advisers should be involved from the start in a joint conversation about the seller’s goals, which can save time and make the process more efficient. This comprehensive perspective also helps eliminate pitfalls, such as pursuing the wrong buyer class, and facilitates the liquidity transfer into an investment plan post-sale.
Maximize Business Value
Comparing a seller’s wants, needs, and goals with the independently developed value of the company allows the adviser and client to identify gaps between the two and to make plans that address them. Value gaps are the top cause of deal breakdowns, according to the Pepperdine’s 2017 Private Capital Markets Report. Future cash flow and risk are two primary influencers of a company’s value.
When it comes to cash flow, it is important to demonstrate consistency and a positive trend. Instead of touting a one-off year of success, sellers should compile a trends report over three to five years to provide potential buyers a sense of predictability moving forward. Even if each year’s performance is not perfect, it is beneficial to demonstrate a track record of solid performance instead of shorter windows of time that could be dismissed as an aberration.
For family-owned or closely held businesses, cash flow may be depressed due to discretionary owner expenses. Buyers will generally look past that fact, but it helps to reduce those competing interests once the decision to sell has been made and to compile a realistic track record that accurately represents a company’s cash flow. Additionally, earnings can be adjusted for revenue or expense anomalies that are unlikely to repeat.
It is equally important to identify and mitigate perceived risks to the business’s ongoing operations. Common examples of these risks are concentrated customers and suppliers, aging workforce, and outdated technology or equipment. Having one customer represent the majority of a company’s client base or one supplier contributing the bulk of materials each represent a risk should something impact those relationships. Developing a broader customer base or supplier network and strengthening multiple relationship points within the business are two approaches to mitigate these risks.
Investing in people, equipment, and technology sends a positive signal to potential buyers because they know important components will be updated and in place after the transaction, thus reducing large, up-front expenditures. Owners should evaluate the state of their workforce, equipment, and technology infrastructure to ensure that they will not be disrupted by a competitor who can do the same work in a more efficient and effective manner.
CPAs should also help their clients assess whether business value drivers are transferable. For instance, many companies rely on a small group of key individuals for relationships and technical expertise. If these people (often the selling owners) will not continue to be employed by the buyer, or if the buyer perceives a flight risk, the value that is evident pretransaction may not transfer without shifting technical roles or ensuring key employees remain satisfied before the deal closes.
Execute the Transaction
As the transaction enters the execution phase, the CPA can continue to play an integral role. Generally speaking, CPAs have the longest, deepest relationship with the seller when compared with other advisers. From years of routine client communication and comprehensive responsibilities, the CPA is uniquely positioned to lend historical insight and perspective to the transaction.
Heading into this phase, making sure clients have quality financial information is key. Buyers will often initially accept financial information on its face, but during subsequent confirmation the numbers can sometimes fall apart and the deal craters. Moving beyond routine preparation, CPAs can provide an opinion as to the quality of the financials. A switch from cash-based to accrual-based financials may elevate the information beyond compliance and capture the real nuances of the company’s financial situation.
CPAs can offer solid tax advice, helping sellers understand the tax consequences of any proposed deal structure and ensure that the most tax-efficient deal is crafted. Sellers focus so much on deal price that they are often blindsided by the diminishment of sale proceeds due to taxes. CPAs can prepare a pro forma analysis and thoroughly review a deal with the client to facilitate greater understanding and realistic expectations of after-tax sale proceeds. Discussing the tax impact before inking the deal also helps CPAs negotiate the most advantageous position for their clients. Moreover, with sufficient time prior to a sale, CPAs can guide their clients to make tax-efficient elections and understand the impact of tax decisions made now on the after-tax proceeds of a future sale.
Assisting the client through the due diligence stage, which opens the books to buyer scrutiny, is a natural role for the CPA. Due diligence generally occurs after the rigorous negotiation phase, so at this point in the process the seller can be worn down. Since due diligence involves a high level of detail and a significant amount of follow-up and information sharing, CPAs can relieve the burden on owners and management during this phase. Having a trusted adviser manage this process allows the seller to keep his or her eye on the business during a time when preventing a slip in financial results is critical. CPAs who are experienced in transactions can also guide their clients not only on what information to provide but when is the best time to provide it.
As due diligence is under way, attorneys for the seller and the buyer work to negotiate the purchase agreement. CPAs can play an important role in the purchase agreement review process, particularly with regard to the deal’s financial terms, including definitions of purchase price, contingent consideration, and potentially complicated formulas for additional purchase price and net working capital.
CPAs familiar with the intricacies of a client’s business are well-prepared to assist in the preparation of the purchase agreement disclosure schedules required from the seller, which can reduce the risk of breaching purchase-agreement representations and warranties.
Once the transaction has progressed through due diligence and a closing date is set, it is time to circle back to the wealth adviser and make sure there is an efficient plan for the disposition of the net sale proceeds. Ideally, the wealth adviser should be apprised throughout the entire transaction process to ensure all aspects are being addressed.
Common Business Sale Pitfalls
Throughout the business sale process, there are several pitfalls that CPAs should strive to avoid. Clients may often believe too much time is spent in the preparation phase. Becoming impatient, they may make an end run around their advisers to start dealing directly with potential buyers. This decision by a client can jeopardize the entire deal, sometimes beyond repair, or result in a significant loss of time and money.
The business sale process is rife with legal and financial complexities that require strong and experienced advisers. Direct and unaccompanied contact between seller and buyer can result in a lower purchase price that drains the value the seller worked hard to establish.
In these situations, it is critical for the CPA to maintain open and honest communication with the seller and stress the importance of patience and trust in the process.
Time, expertise, and deliberation are large components of starting and growing a business. Why shouldn’t owners dedicate that same attention when exiting the enterprise? When advising clients on the sale of a business, the entire process relies on a strong foundation of due diligence. Eliminating this step or underestimating its importance can cost time and money later in the process. From personal financial planning to maximizing business value ahead of a sale, it is critical that sellers and their advisers take a thorough and comprehensive view of the entire financial landscape to execute a truly beneficial transaction tailored to meet the seller’s unique needs and circumstances.
Paula K. Barrett, CPA, ABV, CEPA, is a partner in the business consulting group of RKL LLP in Wyomissing. She can be reached at firstname.lastname@example.org.
Ryan P. Hurst, ASA, is a manager in the business consulting services group of RKL LLP. He can be reached at email@example.com.
Reprinted with permission by the Pennsylvania CPA Journal