We’ve finally come to the end of this series on business acquisitions after previously exploring an overview of the buying process, drafting a letter of intent, and questions to ask during the due diligence process. You can find the previous articles online at cleanfax.com/acquisition. While there is no magic-bullet approach to completely smooth out the overall process, I’ve attempted to provide guidance to make buying a business easier based on my own experiences.

I wish I had been given a list of tips before I made my first investment because it would have saved me a significant amount of time, energy, and money. What follows is by no means an exhaustive list, nor is each item pertinent to every situation; it is merely an attempt to shed light on a few issues—and maybe help you in at least a small way as you look to buy a business, whether it is your first company or your fifth.

1

Ask the key question, “Why are you selling?” Then ask it again and again until you feel certain the explanation is consistent and the motivations are clear and real. The two most cited reasons are retirement and inability of management to scale with the business. Make sure the owner’s story checks out and she isn’t hiding another reason that could negatively affect your ability to succeed with the company.

For example, while a 60-year-old owner looking to retire may feel credible, that reason might warrant further explanation if she has working-age children who traditionally might take over the company. I cannot tell you how many times I have been told by a seller, “I lack the energy and knowhow to roll up my sleeves and do what needs to be done, but a young guy like you with piss and vinegar can really take this business to the next level.”

There may be truth to that statement, but it also might be masking something troubling like an adverse change in the marketplace. The point is not that any single rationale for wanting to sell is better than another, per se, but some might require further probing.

��2

The seller is almost always less financially sophisticated than the buyer. Having spent most of her time focused on sales, marketing, and operations, there was likely little focus on financial issues. Compiling financial statements and understanding the intricacies of structuring a sale of a business may involve treading into unchartered water. After all, a common reason for an exit is that the company has outgrown the managerial capabilities of the current owner.

It is helpful to speak on the same level as the seller to effectively communicate and not come off as intimidating. The sale process may progress slower than desired because of a seller’s lack of sophistication, and she might have less information available on her business than desired since the need for detailed financial statements as a management tool may be a low priority.

3

Emotion frequently is a major factor in the seller’s behavior, so honesty and objectivity are critical. As the cliché goes, often the best deal is the non-deal, and you should be just as prepared to walk away from a sale as to close the transaction. It is important not to fall in love with the business until after the deal is consummated.

Putting emotion aside will lead to clearer decisionmaking. Objectivity is important for both deciding whether to continue going forward—as you learn more about the business throughout the due diligence process—and negotiating purchase terms. Don’t be too accommodating in an effort to close the deal at any cost.

4

Play the political angle with any intermediary, also known as a “business broker,” representing the owner of the target company. While this individual is compensated almost entirely only if the deal closes, he is often more aligned with the seller since she is the one who both hired him and pays him.

The broker will have known the seller for a longer period than you and likely had several conversations with her regarding the value of her business. He also typically serves as an adviser to the seller. By gaining the respect and attention of the broker, you may be able to obtain an understanding of the seller’s expectations and concerns.

5

Don’t take the seller’s financial statements at face value. Very infrequently will you encounter a target company that has undergone annual audits by a top-tier CPA firm. More commonly, the numbers are compiled by a small, local accountant or possibly only reviewed by one. Thus, you may want to consider performing your own forensic audit in which you track random invoices and bills and reconcile revenues to monthly bank statements.

It may be helpful to hire a financial consultant or an accountant. (Note that you may be able to cut a low rate for this work in exchange for hiring the firm as your company’s CPA should the deal go forward.) If you discover that the business is less attractive than the seller boasted, then a renegotiation of price is warranted.

6

Do not assume costs can be cut. Unless you are a strategic buyer and will combine the business with a pre-existing, similar one, there is typically little room for expense reduction. In fact, more frequently than not, I find that expenses will need to be increased, especially for marketing.

Conversely, the apple may be tastier than it appears. Be sure to back out from cash flow the owner “benefits.” Without claiming any unacceptable activity, it is likely a portion of the seller’s business expenses would more accurately be classified as personal items. Areas to examine include auto expenses, travel and entertainment, professional fees, rent, and salary. Changes should be made to:

• Adjust the salary to a market-based compensation package for an active owner/president—$100,000 to $150,000 for a small business.
• Include a realistic rent. If the seller also owns the real estate, the rent paid may not be the fair market value.
• Take out personal expenditures such as non-business auto and travel costs.

7

Strongly consider spending money to hire a lawyer to review documents such as supplier and customer agreements, a financial expert to perform an audit on the company’s financials, an industry veteran to recommend certain questions to ask, and an experienced buyer to help guide you through the process. A significant amount of the investigation into the company and its industry, employees, customers, and competitors can be done firsthand. Also, depending on how knowledgeable you are of the industry, attending an industry conference can provide a wealth of information in a short period of time. These expenses should be considered as the first part of your investment in the business regardless of whether the deal transpires.

8

Be creative in your due diligence. A lot can be learned about a business through some unorthodox investigative methods. I have two favorites:

1. The first involves asking a friend to approach the company, posing as a customer. Pay for her to receive their services, and you can see every step of the customer interaction process. Then ask her to do the same with key competitors and compare the experiences.
2. The other is to make phone calls to the large trade magazines covering the company’s industry. You would be surprised how much the typical ad salesperson and editor can disclose about the industry and the key players.

9

Frequently remind the seller she is selling the business. By this, I mean talk about what will happen after the sale. This will serve two purposes:

1. By observing the seller’s reactions, you will gain a sense of her comfort and desire to sell. It is helpful to know early on if the seller could, at some point, decide not to go forward.
2. By reinforcing the vision in her mind that she will soon have a great life lying on a faraway beach, you may be able to gain leverage in the final negotiation process.

10

It is never too early to plan for the transition. While you may be pre-occupied with—or overwhelmed by—closing, the due diligence process can be used to help plan for when you are in the driver’s seat. If done correctly, prior to the purchase you should have strong ideas on such topics as how to effectively grow the business, which employees are underperformers, the size of the investment needed in the following twelve months, and what areas you personally need to focus on. Furthermore, thinking hard about these issues will enable you to see yourself running the company and allow you to know if taking the plunge is right for you.

11

Remember the deal is not done until the final paperwork is signed and the check has cleared. Know second-guessing your thinking every step of the process is expected and even healthy. While you may end up having nothing to show from months of hard work except large legal and due diligence bills, there is no shame in walking away even at the very end. You should use every last moment to research and every interaction with the seller to learn more about her business. As the great Kenny Rogers says, “Know when to walk away, and know when to run.”

12

From my experience, whenever momentum is lost, even for legitimate reasons, the deal falls apart. While it is important to perform a thorough due diligence process, milestones need to be set and the process should move along. If a deadline will not be met, frequent and frank communication between the buyer and the seller will help mitigate the risk of the transaction tanking.

13

Push for the seller to have skin in the game. Tying part of the seller’s proceeds to actively working with you as you learn the business—and helping you succeed—post-close is critical. Including a large percentage of the sales price in the form of a multi-year note (as opposed to a 100% upfront cash payment) helps accomplish this.

While there is no set-in-stone formula, a buyer should strive for paying no more than 50-75% of the total purchase price in cash upon closing. The balance, referred to as a “seller’s note,” should be paid over the next two or more years. This note typically calls for a fixed, quarterly payment and a reasonable interest rate.

However, the post-closing payment can be variable and tied to several different metrics such as the future revenue of the business. If for some reason the seller is unable to remain with you, then the price should be lowered. For example, an individual purchases a company and is counting on the seller to stay around for several months to introduce him to the customers. Two weeks after the sale closes, the seller suffers a fatal heart attack—a tragic event, indeed, but one that leaves the business arguably less valuable. Unfortunately, the buyer has no recourse against the seller’s estate if this issue is not addressed in the contract.

14

Consider letting the seller pocket more money. While this may sound counterintuitive, you may want to incorporate a provision wherein the seller can reap additional money if the business grows over the next several years by a pre-determined amount. This is known as an “earn-out” and is intended to further align your interests with the seller’s. It is worth considering if the seller’s involvement could be particularly helpful in generating additional sales or profits.

In the past, I have proposed that the seller could make more money than she was looking to if the business had higher revenue than either of us anticipated. Of course, the trade-off is she would make less if it underperformed. In one situation, I was willing to pay to the seller 10% of all revenue above a set benchmark for the year following the sale. Given that gross margins were well in excess of 10%, both the seller and I benefited from the growth.

If the seller does not agree to this type of arrangement, then either she does not have faith in the business or she does not have faith in you. Either way, that is a serious red flag.

15

There are a few issues that, if addressed upfront, can save a significant amount in taxes. For example, in most circumstances the purchase agreement will require allocating the price to various components of the business, namely the assets. The asset base consists of fixed assets, a contract prohibiting the seller from going into competition with you over the next several years, and the seller’s agreement to work as a consultant with you during the transition, among others. The balance will go toward an accounting item known as “goodwill.”

As the buyer, you naturally strive to value the assets as high as possible and the goodwill as low as possible since the assets can be depreciated over a significantly shorter timeframe than goodwill. Greater upfront depreciation will lead to lower taxable profits. Lower income taxes
will be due, and, therefore, higher after-tax cash flow is generated. This cash can then be used for other purposes, such as investment in the business or bonuses/dividends to employees and the owner.

Granted, when it comes to taxes, generally what is good for the buyer is bad for the seller, but some creativity potentially can enlarge the after-tax pie for both parties. Given the importance of this and other accounting issues often not properly tended to, I recommend further investigation into the relevant topics for your transaction. Spending some money to on guidance from an accountant may be prudent.

Buying a business requires a mix of patience, persistence, a sense of humor, a little bit of luck, intellectual honesty, an understanding that outside help is available if needed, and upfront commitment to not fall in love with any business until you own it. Pay attention to the details, trust your instincts, and the process will go much more smoothly. Good luck with your future buying.

David Grossman is president of Renue Systems Inc., a global franchisor and operator of specialized deep-cleaning services businesses to the hospitality industry. He can be reached at david.grossman@renuesystems.com with more information available at .

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Thanks to the wealth of information available on the internet, we can (and usually do) research every purchase we make, from vehicles down to can openers. What’s troubling is that some people spend more time and energy researching a car or stereo system purchase than they do researching the purchase of a business. This article is the latest in a series on business acquisitions and will provide tips on conducting a thorough due diligence process. You can find an overview of business-buying best practices in the March/April issue of Cleanfax and advice for drafting a letter of intent in the May/June issue.

The purpose of due diligence is to gather and analyze enough information about the business to make a wise investment. It’s true that you may find a dearth of record keeping from the typical small private company, but much of the information you need is available to the public if you make the effort to track it down. Think of yourself as a detective, gathering evidence and digging deeper into any aspect you find troubling. A thorough due diligence process should allow you to:

• Gain a solid basis of knowledge about the business
• Have the owner help educate you about the industry
• Start preparing for when you are running the business
• Begin to create and/or refine your own internal budget and projections.

Start with the owner

Despite what we may have experienced from our childhood school days, no one has ever committed the crime of doing too much homework. While I advocate digging deeply into all facets of the target business, there are real-world time constraints. Thus, you may want to consider taking a few minutes upfront to develop a plan to maximize your efficiency.

One approach calls for submitting a list of questions and document requests to the owner. This should be the first step immediately after executing the letter of intent since it will frame your future analysis. Also, it will take some time for the owner to address these items. Be professional about it and attempt to develop one list that is comprehensive enough to provide you a solid understanding so that you will not need to make multiple requests for high-level information. Conversely, you may not want to ask for trivial information that will delay her completion of the more critical items.

See the accompanying list of common inquiries from buyer to seller. Two fairly obvious caveats are in order. First, not all of the items on this list apply for every buyer and every business, so customization, additions, and deletions are in order. Second, be prepared for the seller to have incomplete or missing information. After all, this is probably the first time she is going through this process, and she likely manages largely by gut instinct.

To mitigate this risk, you may consider performing an audit where detailed pieces of financial information are examined. This process can include tracking invoices throughout the accounting system and reconciling bank statements with internal records. For the inexperienced, spending money for the assistance of a financial adviser or an accountant may be a solid investment.

To analyze the information from the owner, approach it once again as a detective who initially takes a wide view of the scene, looking at the company’s finances, operations, products/services, suppliers, employees, systems, competitors, and industry. From there, increasingly focus on a smaller number of critical issues that are either most foreign to you or most troubling.

Keep probing deeper on the few key areas until you have learned enough to be comfortable with them or not. If the owner pushes back on your inquiries, then she is either acting unprofessionally (which is likely a sign of how she runs her business) or hiding something (perhaps even more troubling). It is certainly your right to ask for additional information. After all, you are the one in the driver’s seat, and it is your money potentially at stake.

At the end of the process, do not be surprised if you have a better understanding of the company’s true financial picture than the current owner.

[infobox title=’Commonly Requested Information and Questions’]

• Complete financial statements (namely, detailed income statement, cash flow statement, balance sheet, and any accountant notes) for the past three fiscal years and for the current year to date; explanation of the accounting methodology used (i.e. cash versus accrual) and any deviations from GAAP
• Corporate federal tax returns for the past three fiscal years
• Projected income statement for the next three years by quarter
• List of assets (inventory, hardware, and equipment) and their book and fair market values; where applicable include the purchase date and the depreciation method used
• Detail of any real estate including property description, size, book value, depreciation method, most recent appraisal date and value, tenant description, lease terms, and any environmental reports
• Accounts receivable aging report, which is a document listing the total receivables as of a certain date, grouped by the number of days outstanding, commonly <30 days, 31-60 days, 61-90 days and 91+ days in age)
• Schedule of largest vendors and suppliers complete with price paid for each product
• Any business plans or overviews
• Any marketing materials, brochures, and catalogs; explanation of current sales and marketing practices in detail; break out percentage of customers by each advertising placement and referral source and acquisition cost per customer of each
• Breakdown of revenue by both customer and product
• Detail of customer demographics and purchasing behavior including frequency and order size; discussion of lifetime value of the customer
• Any material agreements covering customers, suppliers, vendors, employees, affiliates, leases, and others
• List of all employees, contractors, and consultants—with current pay, date of last raise, average hours per week, overtime, start date, job title, job description, direct report, most recent year W2 or 1099 form, and any special relationships—and indicate any who are unlikely to remain with the company
• Description of all employee benefit plans and eligibility requirements
• Product catalog with pricing information
• Description of all material ongoing contingencies, commitments, and liabilities
• Explanation of any customer or revenue sources that may be damaged or lost upon new ownership
• Detail of any past or current litigation, investigations, or inquiries by a third party, employee, affiliate, vendor, customer, or government agency of which the company was a part as either plaintiff or defendant
• List of all software packages used including version numbers
• Overview of the technology architecture
• Description of any intellectual property such as copyrights, patents, and trademarks
• Description of customer-fulfillment system from order to collections
• Educational sources or primers on the industry
• List of memberships in trade organizations and other affiliations; list of any board or active membership roles; list of major trade organizations and publications
• List of competitors including online and offline local, regional, and national players with an estimated size and explanation of how each one differs from your company
• Viewpoint of the current state of the industry, emerging trends, and the company’s position
• Explanation of the most attractive growth opportunities for the business

[/infobox]

Benefits of a consultant

While you want to keep your due diligence expenses low, you may want to turn to a consultant, particularly if the industry is new to you, you have never previously attempted to buy a business, or you feel your finance skills are weak. With some investigation, help can be found to address virtually any need. For instance, an industry veteran may assist by providing background information on the industry and competitors. An experienced business buyer can help you determine the appropriate price for the company, conduct the financial due diligence, or devise the income and cash flow statements.

You will, of course, have to pay for a consultant, but view it as the initial part of your investment. A consultant can not only help inform your decision to buy the business, but also save you time in the due diligence process by handling some of the work and pointing out the most relevant issues to investigate. Some people can comfortably handle the process themselves, but for many, the price paid for outside assistance is a good investment—and it is only a fraction of the cost of the total business acquisition.

Projections and adjustments

If financial projections for the target business were not developed prior to signing the letter of intent, then you will most certainly want to create them at this point. It can be a simple exercise. Using the owner’s historical growth rate as a baseline, future revenue can be projected.

Adjustments should be made based on a number of factors, including your ability to manage the business, investment capital available, trends in the market, competitor movements, and inevitable road bumps and distractions during the transition. This projection will most likely be more conservative than the seller’s projection.

A similar exercise can estimate expenses, starting with the current expenditure level. On a relative basis, expenses should increase less than revenue so profit margins should widen (or if currently unprofitable the business should become relatively less so). If detailed expense records have been maintained, you can perform reality checks and make appropriate adjustments. Key steps include:

• Modifying the owner’s compensation to a level with which you are comfortable: This decision is important since it will need to be high enough to enable you or someone you hire to devote full-time effort to running the business, yet not so high as to limit the cash flow available for growing the business.
• Contacting vendors and suppliers: This is a good way to find out if current product costs are reasonable going forward.
• Changing the rent expense to what your costs will be: This is particularly relevant if you plan to relocate the business or the seller owns the real estate.
• Refining costs: Marketing and acquisition costs should be adjusted based on your plans for the business.
• Examining payroll expenses: It’s important to find out if employees are making market wages, which can lead to an upward or downward adjustment, and if overtime is being paid.

Note that your estimates of future expenses will likely be more accurate than your sales expectations. They are also more controllable should reductions be needed. That said, it is wise to plan a sizable cash reserve for the inevitable unforeseen expense such as replacing an employee with a higher priced one, buying office or other equipment not anticipated, or upgrading antiquated software. (Of course, some of these expenses may be deferred, and countermeasures such as deferring owner salary can be taken.)

More importantly, revenue slippage may occur due to the loss of some accounts upon new ownership, the seller losing momentum while focused on the sale process, or collections of receivables taking longer than planned.  Any of these occurrences can lead to significant shortfalls in cash, which is the measure most important to you. The business does not need to be overfunded when the deal closes, but extra capital should be available.

Finally, do not forget to account for deal expenses. These expenditures consist of any hired consultants, accountants, and lawyers plus other due diligence costs including travel, credit reports, and third-party background searches performed on the company and the buyer. A hard-and-fast number is difficult to provide, but assume legal fees alone will cost at least $10,000.

Predicting cash flow

Your projections of revenue and expenses, developed for the next 1-3 years, can be used to generate a cash flow model. The cash flow statement is arguably the most important financial forecasting tool for most small businesses. The adage “cash is king” rings true since profit does not pay the bills, but cash does. And after all, what good is growing sales if increased inventory leads you to run out of money to pay your employees, your vendors, or yourself? This is a very common occurrence that can be mitigated through proper cash management planning.

To construct a cash flow model, start with the net income and add back any non-cash expenses such as depreciation and any outside debt or equity investments into the company. Next, subtract capital expenditures and any debt financing (the principal portion only since interest has already been accounted for in net income). Finally, the timing of the lags between sales and collections (a negative hit) as well as invoices and bill payments (a positive one) should both be incorporated. As with the income statement, err on the side of caution when forecasting available cash.

Should the projected cash position become negative, then the business must be run differently. While out of the scope of this primer, suggestions include:

• Scaling back marketing initiatives—even though this will result in slower growth
• Leasing equipment or financing capital purchases as opposed to buying them outright with cash
• Stretching payables with your vendors
• Offering discounts to customers in exchange for quicker payments.

Your internally generated income and cash flow statements should be continually revised as you learn more about the target business. View them as works in process as opposed to one-time static exercises.

Final thoughts

Upon refinements, if you reach a point where the acquisition investment is no longer attractive because the economics are poor, the risks are too great, or any other reason, there are three choices: Make no change, renegotiate with the seller even if you risk losing the deal, or walk away. If you are truly honest with yourself, you probe deeply on the key issues during the due diligence process, and you do your best to remain objective, then you will make a better decision. The worst outcome is making an acquisition while ignoring your strong negative feelings. You may win the battle by closing on the transaction, but you will have increased the odds of losing the war.

Look for the final installment in this series, which will offer an overall quick-tip guide for the business-buying process, in early 2022.

David Grossman is president of Renue Systems Inc., a global franchisor and operator of specialized deep-cleaning services businesses to the hospitality industry. He can be reached at david.grossman@renuesystems.com with more information available at .

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In the March-April issue of Cleanfax, I laid out an overview of best practices for the business-buying process. In this article, find a deep dive into drafting the letter of intent (LOI) with an example letter and a point-by-point examination of its components. In upcoming parts of this series, you’ll find information on the due diligence process as well as general tips for a better overall experience.

Read part one.

A former colleague was fond of saying, “Be careful what you wish for because you just might get it.” An acquisition done under the wrong terms can make for a poor investment, even if the target company is fundamentally solid. Much of a deal’s risk is determined early in the process—when the buyer and seller initially settle on price and terms.

Below is an example LOI, which outlines the key terms for a transaction. It was drafted by the buyer, as is customary procedure.

[infobox title=’LETTER OF INTENT’]

John I. Candothis

President, Newco

1 Park Ave.

New York, NY 10016

June 16, 2021

Jane Beachbound

Owner, Target Company

1 California St.

San Francisco, CA 94111

cc: Bob Middleman

Owner, Middleman Business Broker Services

Dear Jane,

Newco, a corporate entity to be formed by John I. Candothis (the “Buyer”), is interested in acquiring the assets of Target Company (“Target”) from Jane Beachbound (the “Seller”). The following letter of intent (the “LOI”) is a non-binding offer that is to remain confidential between Target and Newco and each of its representatives. This LOI is subject to a number of conditions including, but not limited to, full legal and business due diligence, financing, and no material changes in the business or market conditions.

Terms are as follows:

1. Accompanying this LOI, the Buyer shall submit ten thousand dollars ($10,000) of good-faith money to be deposited in a dedicated escrow account (the “Buyer Escrow”) held by Middleman Business Broker Services (the “Business Broker”). The Buyer Escrow shall be immediately refundable at the Buyer’s discretion and upon termination of this LOI.
2. The Buyer shall make a cash payment to the Seller of an additional one hundred ninety thousand dollars ($190,000) (the “Cash Down Payment”) upon closing.
3. The Buyer shall issue to the Seller a note of one hundred thousand dollars ($100,000) (the “Seller’s Note”) to be due three (3) years after closing. The Seller’s Note shall bear an annual interest rate of five percent (5%) with interest paid quarterly. Principal shall be repaid quarterly in equal installments, although no principal installment shall be paid until the end of the sixth (6th) month after closing, at which point, payment for two (2) quarters shall be made. There shall be no penalty for prepayment, and the Seller’s Note shall be senior in preference to all other capital in Newco except a debt facility of up to one hundred thousand dollars ($100,000).
4. At the discretion of the Buyer, existing management shall have the ability to exchange a portion of the Seller’s Note for equity in Newco prior to closing on terms to be determined.
5. Newco shall acquire all assets of Target except any cash balances and accounts receivables existing upon closing.
6. An amount of twenty thousand dollars ($20,000) of the Cash Down Payment will be held in escrow (the “Seller Escrow”) for ninety (90) days after closing in order to cover any adjustments, representations, or warranties. Any decreases in Target’s inventory or fixed assets shall reduce the Seller’s portion of the Seller Escrow on a dollar-for-dollar basis.
7. The Buyer expects the Seller to remain and cooperate for a period of up to twelve (12) weeks to transition Target to the Buyer. A forty (40) hour per week commitment is expected. Beyond this period, the Buyer shall consider an employment agreement with the Seller to remain with Newco after closing under terms of any such arrangement to be determined.
8. The Seller shall enter into a standard multi-year, non-compete confidentiality agreement.

The Buyer is requesting an exclusivity period of forty-five (45) days commencing upon execution of this LOI, during which time Target shall not solicit, encourage nor engage in any discussions for financing other than that which is in the ordinary course of business. This offer is valid for a two (2) week period from the date above, at which point it shall expire.

Within ninety (90) days of the execution of this LOI and subject to the Buyer’s satisfactory completion of due diligence, the Buyer and the Seller shall enter into a definitive purchase and sale agreement.

I am extremely bullish about the prospects of the business and look forward to working together to continue to build significant value in Target. I await your response.

Sincerely,

John I. Candothis

Newco

[/infobox]

Exploring the letter of intent

Let’s now walk through this LOI to see the best practices for building such a letter. The opening paragraph spells out the parties involved (Jane [seller], John [buyer], and Bob [broker]) and that this will be an asset purchase. The decision between a stock acquisition and an asset sale is beyond this article’s scope, and a lawyer should help with this decision. Clearly stated are the conditions that this LOI is not to be shown to others and that the buyer can back out of this transaction for many reasons with no repercussions.

Terms 1-3

These points state that Newco, the company to be formed to make the acquisition, is proposing to acquire Target for a total of $300,000, of which, $200,000 will be paid in cash upon closing. The balance will be paid over a three-year period.

It is common for the seller (and business broker if there is one) to request a small amount of money upon execution of the LOI to show the buyer’s seriousness. Make sure this money is fully refundable and deposited into a dedicated escrow account not accessible by the holder for other purposes.

Note that Term 1 is only included because the buyer was told before submitting this LOI that it was a requirement.

Determining the value of a business is clearly one of the most important exercises a buyer performs. As a general rule, companies under $10 million in value are sold for three to five times the previous year’s cash flow. However, there is a broad range, and the exact price should be adjusted by a number of factors including change in revenue over the past several years: A business growing greater than 20% per year would warrant a higher multiple than one that is experiencing declining sales, high customer concentration, and significant ongoing capital expenditures.

Term 3

The Seller’s Note warrants further discussion. Here are some important points to keep in mind:

• John set the payback schedule of the Note only after carefully projecting the anticipated future financial performance of Target. The cash flow after all expenses, taxes, interest payments, and capital expenditures are expected to be sufficient to meet the requirements of this Seller Note.
• A grace period is helpful because once John takes over the business, there inevitably will be unforeseen road bumps during the transition. Examples range from the loss of a major customer to the need to buy new software, which both lower the amount of available cash. In reality, if an occasional payment is late or the initial payments must be deferred for a short period, most sellers are accommodating. Remember that Jane wants the business to succeed so that her Seller’s Note will ultimately be repaid.
• Prepayment without penalty keeps open the buyer’s options in the event that, at some point during the repayment period, the seller finds an alternative, better financing source that can replace the Seller’s Note. This can take the form of an increased or less expensive facility obtained elsewhere, among other things.
• The “senior in preference” clause is intended to create a balance. On one hand, the seller has the concern that she may not be repaid if the business does not perform well. On the other, the buyer has the hesitation of incurring additional debt, either to help finance the purchase of Target or to grow the business after closing. For businesses without tangible assets, obtaining bank financing may not be realistic, but for some companies it is an option. Here John is proposing to allow $100,000 of additional debt to be incurred without Jane’s permission, but no more.
• Not covered in the LOI is “repayment security.” It is very common for the seller to request a personal guarantee for the money owed her. This pledge from the buyer to make good on the note, regardless of the performance of the business, is customary, in addition to the seller having claim to the value of all the assets of the business, thereby affording her added protection.
• Naturally, a personal guarantee is cause for serious introspection, and the buyer will want to push back on this provision, as it can result in a large personal liability should the business not succeed. That said, more often than not, if the buyer is not able to make good on the Seller’s Note, a manageable financial resolution between the two parties is typically reached as opposed to the seller personally going after the buyer for the full amount outstanding.
• For negotiating, two provisions are included: a 5% interest rate and a quarterly payment timeframe. The interest rate can be raised and the payments made monthly with relatively minimal impact to Newco. If needed, John can make these accommodations during the negotiation process in exchange for obtaining more important concessions from Jane.

Term 4

The seller sometimes requests this addition, but, in this case, the buyer wanted to include it for two reasons:

1. While he would give up some of the ownership, replacing debt with equity capital would lower the cash requirements of servicing the Seller’s Note.
2. The provision is intended to test the seller’s faith in the buyer and the business. If she is interested in investing in the buyer, then it is a signal of her confidence, and the buyer should interpret that as a positive sign; conversely, the buyer should not be discouraged if this option is not exercised.

Term 5

This term specifies what John is purchasing and what he is not. For an asset sale, it is typical for the seller to keep the cash and receivables outstanding at the time of closing. Typically, the buyer would then collect any receivables on behalf of the seller in exchange for a 4% administration fee. In a stock sale, this provision is not necessary—as all assets and liabilities are typically transferred to the buyer.

Term 6

Term 6 addresses any shortfalls in the actual condition of Target at closing relative to what was expected from previous financial statements. A small reserve is held to cover such items as: less equipment present at closing; settling vendor disputes that were incurred by the seller (Note that, while in an asset purchase John would not be liable for such items as vendor, supplier, or trade payables, he may want to settle any discrepancies regardless to maintain positive relations with an important partner); and any decrease in value of the inventory.

Terms 7-8

These speak to Jane’s requirements, both during and after the transition. Should she not live up to these responsibilities, remedies stipulated in the longer, more detailed closing documents can be enforced. Measures can include not paying her the full Seller Escrow, deducting money from the Seller’s Note, and taking legal action.

Closing

The final paragraphs set realistic timeframes both parties should strive to achieve. While a thorough due diligence effort is warranted, transactions must maintain momentum, lest they decrease the sale’s likelihood. John is also requesting an exclusive look at the business so Jane cannot shop the deal during his due diligence.

The document ends on a positive note because the LOI should also serve as a sales piece for John. After all, at this point Jane still has the leverage, a situation that will change once the agreement is executed.

Bob is copied to include him in the process. Often the LOI will go first to the business broker who will present it to the seller. Regardless, the buyer will want to establish the strongest relationship possible with the broker since he has influence over the seller.

A few final points

This article does not cover negotiating strategy. A buyer should form in his own mind, before submitting any LOI, acceptable terms given what he knows of the target company at that point. This set of conditions should be considered the bottom line. An opening position should leave sufficient negotiating room to come off your initial proposal while satisfying your “must haves.”

Even after signing this document, these terms should be frequently revisited since more will be learned about the business and its industry, competitors, employees, etc. All terms in the LOI will be explored in more detail in the closing documents.

By the end of the due diligence process, if you are not comfortable with the established terms—and you must be honest with yourself—you have two choices: renegotiate or walk.

David Grossman is president of Renue Systems Inc., a global franchisor and operator of specialized deep-cleaning services businesses to the hospitality industry. He can be reached at david.grossman@renuesystems.com with more information available at .

The post Be Careful What You Wish for: Drafting a Letter of Intent appeared first on Cleanfax.

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I had made a number of investments with other peoples’ money where I effectively limited my upside—and, importantly, my risk—before I first began seriously considering acquiring a small, private business. During my path to ownership, I started taking notes on what I was experiencing and what I was learning. They helped me improve the acquisition process, both in terms of streamlining the hunt and minimizing mistakes.

This multi-article series aims to serve a wide variety of situations. It is both for someone first considering buying a business and someone who has built a track record of acquiring companies. This first article provides an overview of the acquisition process, with the articles that follow diving into drafting a letter of intent, conducting due diligence, and general tips for a smoother overall buying process.

Buying a business is certainly more art than science. By this I mean, no matter what others may say, there is no generic, cookie-cutter recipe of steps to take in buying a small business. That said, I am attempting to provide some guidance as to what might help those in the process based on my experiences. This is by no means an attempt to be a definitive resource guide, but rather a handful of hopefully beneficial advice.

I will start from the assumption that an interesting business has been identified. Finding a target is a significant part of the challenge and requires a separate, lengthy discussion. (See sidebar for a quick guide to choosing a business to buy.) Also, for the purposes of example, throughout this series, I will refer to the seller as Jane and the buyer as John.

Getting answers

A good first step in the acquisition process is to review financial statements and any business plan or description. After that, it is appropriate to have a meeting—whether in person, via video chat, or by telephone. Even if schedules and geography permit an early face-to-face meeting, I typically like to first schedule at least a phone conference. I do this in the spirit of expedience and not wasting time since the business is still fairly unqualified at this point.[/one_half]

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One of the first questions I like to ask Jane is “Why are you selling the business?” Her response to this question can give early insight into the success you might have with the business and the selling process:

• If she is young and has had the company for less than five years—yet claims she is burned out or wants to pursue other interests—skepticism is warranted.
• If she offers no compelling reason, and you sense she is merely entertaining offers but has no real desire to sell (unless she receives a “can’t refuse” price), you may well never reach an agreeable price.
• On the other hand, if she is 70 years old, has run the company since she founded it at the beginning of her career, and has no children who can take the reins, then a rationale of retirement sounds legitimate.

It is important to understand and believe the seller’s position because:

• You do not want to go after a business that the seller wants out of because it is a perceived train wreck.
• You will have a better sense of deal terms she will find acceptable.
• An unmotivated seller frequently backs out of the deal even late in the game.

A few other questions to the seller might be helpful. Knowing the length of time the company has been on the market will provide a hint as to the difficulty in closing the transaction. If Jane has been trying to sell her business for over a year, it might mean her price is too high or the business has some problems. Since it is possible she simply has poorly advertised the availability of the business, you would benefit from asking her if she has received any previous offers.

In addition, you might want to investigate whether she has tried to sell the business to a competitor and ask: If not, why not? And if so, why did a sale not happen? It is possible that a strategic buyer does not view the company as valuable.

You should also determine Jane’s specific responsibilities and the extent of her involvement. Note that in virtually every small business, the owner—assuming she is active—is the chief or only salesperson. She also may be involved in most areas of the business including bookkeeping.

Whatever the situation may be, a replacement for her and her responsibilities should be found. In this piece we will assume that new owner John will be full-time active and handle the responsibilities Jane currently does (and then some). The same logic applies to the individual brought in to manage the company on John’s behalf, should he choose to play a less active role and hire someone to run the firm.

When a meeting between the buyer and seller does occur during the acquisition process, it can be very beneficial to meet with the employees in as informal a setting as possible. In doing so, you can learn a significant amount about the company, the employees’ collective morale, and their individual capabilities.

However, since most small business owners are very nervous about causing apprehension in their team, they often do not even inform staff that the company is for sale until very late in the process. In many cases, buying a business where you have had few, if any, interactions with the employees is a risk you may simply have to take. You may not know if you want them to stay, and, conversely, they may not know if they want to stay with you. One potential mitigating factor is to have a price adjustment included in the agreement with the seller in the event a key employee leaves during the first three months.

Making an offer

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Once some preliminary financial information has been reviewed and a company has been visited, it may be time to make an offer. This involves drafting a “letter of intent,” which is also known as a “term sheet.”

While this step may sound intimidating, it is recommended that a lawyer be engaged to create this document—particularly if this is your first time through the process. If done properly, the offer is wholly reversible as the offer should be completely contingent on satisfactory due diligence, a discussion of which is found later in this article.

It is important to note that any required down payment should only be made if it is deposited into a dedicated escrow account and considered fully refundable immediately should the transaction not occur for whatever reason. There are few worse situations than a deal that falls apart and then requires the buyer to take legal action to obtain his deposit.

Trying to reach an agreement early in the acquisition process can save you a lot of time, energy, and money because often the seller’s expectations for her business are way out of line with the buyer’s valuation. Specifically, making an offer is done through submitting a letter of intent with fairly detailed information that outlines the following:

• The total purchase price
• The portion of the purchase price that is in the form of a cash down payment
• The terms of the purchase price’s balance (referred to as a “seller’s note,” which is money paid over the next several years) such as the interest rate and the payback schedule
• The work and specific action requirements of the seller during the transition
• Some key accounting issues, such as specification of a stock sale versus an asset sale—and in this case, if there are any assets such as cash or accounts receivable not included (See sidebar for a note on sale types.)
• Any other important

As a general rule, the letter of intent should be comprehensive enough so that all major terms envisioned at the time are addressed but not so detailed that it takes a team of lawyers and weeks to execute it. Two or three pages is sufficient. Bear in mind that likely little is known about the target company (and possibly the industry) at this time, so expect changes and additions to be made to the deal terms when the transaction is consummated.

You may benefit from requiring a reasonably short timeframe, say one week, for the seller to execute the term sheet in order to decrease the risk that she uses your offer to shop the deal with other potential buyers. Furthermore, I recommend obtaining an exclusive look at the business (a “no-shop provision”) once the letter of intent is accepted. That way, the seller cannot entertain other offers while you are conducting your investigation. In exchange, a timeframe for due diligence can be added so as to not bind the seller for an unreasonably long period of time to do a deal only with you (should you choose).

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Doing due diligence

While it is difficult to estimate the length of the due diligence period, 3-6 weeks for a small business is the norm. This assumes Jane is available to respond to John’s information requests in a timely manner. If the industry is foreign to the buyer, the business is complex, or outside financing from investors or a bank is needed, then a longer period of time may be warranted. From a practical standpoint, a buyer should not be concerned about having inadequate time for due diligence because, if the process is moving along, he will most likely be able to obtain a short extension from the seller.

Now it is time for our buyer John to roll up his sleeves and begin the real due diligence process. Here we assume that what John learns about the business and the industry—as he continues to peel the onion—confirms what the owner (and/or the broker) has previously disclosed. That does not mean he should not probe and probe deeply. The buyer should remain very skeptical when digging into the company’s operations, finances, employees, partners, customers, competitors, and industry.

John must be prepared to pay the price offered under the terms specified if the business truly is in the condition advertised, but it is important to note that the offer is contingent on the buyer’s satisfaction of due diligence efforts. I have never seen a transaction go through that is exactly the same in the end as specified in the initial letter of intent because results of the due diligence process necessitate making some adjustments. Common changes include:

• Lowering the price because the actual or projected profitability is not what was divulged
• Lengthening the timeframe of the seller’s note payback because the capital expenditure needs are greater than anticipated, resulting in less cash generated from the business to pay the seller
• Increasing the owner’s transition period because getting up to speed will take longer than

I am not advocating a bait and switch strategy; rather, if the buyer is professional about documenting findings and conveying concerns, he is justified in requesting needed changes. At the end of the day, once the letter of intent has been accepted, the leverage switches from the seller to the buyer. If changes are warranted, to show goodwill (or out of necessity), the buyer might consider sweetening for the seller some of the terms that are less important to him, such as the interest rate on the seller’s note.

Drafting the purchase agreement

After completing the due diligence period, if John is still comfortable moving forward, it is time to draft the purchase agreement and any other closing documents. At this point, if a lawyer has not been involved in the acquisition process, the buyer most certainly will want one. Unlike the letter of intent, in which the buyer typically writes the document, it is less clear as to which party writes the first draft of the closing documents. Factors into that decision include:

• Speed: Which side’s lawyer is more available?
• Cost: The buyer might end up with a higher bill if he drafts the documents and the deal falls apart.
• Leverage: The party who drafts the agreement generally has the leverage.
• Thoroughness of the letter of intent: If there are a number of previously unaddressed terms, controlling the process will benefit the buyer, as he can initially propose those

Finally, John will need to decide which corporate structure is most appropriate for the situation. This is a lengthy topic best handled via the input of legal counsel. Either an LLC or an S corporation, where there are no corporate taxes but the owner is shielded from personal liability, is generally recommended.

Expect the documentation process to take several weeks and possibly longer. If time is critical, legal papers can be drafted concurrently with the due diligence process. However, they likely will need to be amended if the deal terms change, thereby increasing legal fees. More importantly, the buyer could be stuck with a large bill if the transaction does not close.

Facing potential problems

As you find yourself moving along through this acquisition process, you should listen to your instincts and stay on guard against issues that could arise. While nervousness and anxiety are normal emotions experienced as the process unfolds, if at any time you gain the sense that you should not move forward with the purchase, seriously consider calling off the process—or at the very least altering the terms.

One area I pay a considerable amount of attention to is the financial performance of the business from when I first started looking at the company. If the business’ sales or profitability is deteriorating or is not performing relative to the seller’s plans, you should be concerned. It is common for the owner to claim that she has not been able to adequately focus on running the business during the due diligence and documentation processes, but you should be very careful here.

Some of the best deals are the ones not done, so there is no shame in calling off a deal at any point even if considerable time and money have been put into it. That will be a small amount lost relative to buying a bad business or buying a business on unfavorable terms.

Look for three follow-up articles in this series in future issues of Cleanfax. Find a more detailed explanation of the letter of intent’s key elements in part two, and for more on the due diligence process, see the third installment. Lastly, the fourth article will offer a list of buying tips to help save time, energy, and money during the acquisition process.

David Grossman is President of Renue Systems Inc., a global franchisor and operator of specialized deep-cleaning services businesses to the hospitality industry. He can be reached at david.grossman@renuesystems.com with more information available at .

The post The Art of Business Buying appeared first on Cleanfax.

Perhaps you have owned your cleaning company for a number of years, but growing it is becoming increasingly challenging. Or maybe you are considering leaving your employer and starting a cleaning business. Starting and operating a business all on your own has its benefits, but it can also be a daunting and lonely task. Whether you have been in business for a while or are just starting out, you may be better off finding a partner—in the form of a franchisor. Like so many things in life, joining a franchise system is a trade off. On the one hand, there is an initial cost and an ongoing fee. On the other hand, a franchisor with a solid track record can more than pay for itself.

So, when considering a franchise versus an independent business, how do you decide which is best for you? Let’s take a look at some of the key pros and cons of joining a franchise, as well as some considerations when selecting a franchise if you do choose that path.

Franchise cons

Here are some of the key considerations of joining a franchise, starting with the downside:

• Fees: A franchisor typically charges $25,000-$100,000 to start and then 4-8% of revenue for use of their trademark, systems, and support.
• Autonomy: Being part of a franchise system grants you business ownership and the freedom that comes with it, but you are also agreeing to operate within certain parameters.
• Territory: Although it may be sizable, the geographic footprint in which you operate is often limited.
• Requirements: To keep uniformity across the entire brand, a franchisor usually has specific requirements regarding equipment and chemicals, services provided, hours of operation, cleaning protocols, and other aspects of the business.

Franchise pros

On the other hand, there are many benefits of joining a franchise, namely:

• Start-up: Buying a franchise can be done quickly, and then starting your business or converting your existing business is also a short process. The entire process can be done in only a few months, a major benefit if you believe in the expression “time is money.”
• Odds of success: Think of a franchisor as an NFL team: They have a detailed playbook. A key benefit of this tool is that you will make many fewer mistakes than if operating as an independent business. Plus, you will spend significantly less time and money teaching yourself how to, say, restore marble or eradicate odors. It is not a surprise that, based on SBA loan default rates, franchise businesses as a group outperform independent ones, although there is a wide variety of performance across different franchisors.
• Support: Your franchisor wants you to succeed (because they capture a percentage of your sales, and unhappy franchisees will make it difficult to attract future franchisees). To that end, they typically offer assistance for many facets of their franchisees’ businesses, including operations, sales (which may be particularly needed for an existing independent cleaning business), administration, finances, and human resources.
• Camaraderie: One benefit not often considered is the network of fellow franchisees which can be a strong source of advice and ideas.
• Savings: Most equipment, supplies, and chemicals must be purchased through the franchisor or one of their affiliates. This requirement is to ensure uniformity and quality, but it also can result in a cost savings since many franchisors have buying power generated by the volume of purchases across the network.
• Exit: Though you may not be thinking about it when starting your business, selling a franchise is usually much easier than selling an independent business. You are likely to sell the franchise more quickly and at a higher profit multiple (even after accounting for the franchisor’s sale fee).

How to select a franchise

Once you do decide to explore a franchise, the big decision is which franchisor to choose. Key factors in this decision include:

• �ұ�Dz���������:��The franchisor must have territories available in your location. Some franchisors carve up every city into small areas and others grant large regions.
• Track record: Each year franchisors are required to file a Franchise Disclosure Document, a long legalese document. However, there is much useful information inside about their track record, requirements, and current performance of their franchisees.
• Fit (size and culture): An often-overlooked consideration is fit. Do I like the culture? Do I want a small entrepreneurial environment, or do I want a large formal situation? Questions like these are important to assess whether you will work well with the franchisor.
• Financial situation: It goes without saying that you want to join a franchisor with adequate financial resources to thrive and support you for many years. You may also want to inquire about their ownership (private equity owned companies, as an example, tend to sell every five years) and primary revenue streams (are they making most of their money off your royalty, marking up chemical sales to franchisees, or selling new franchises).
• Validation of current franchisees: The sentiment of existing franchisees and their level of satisfaction, as well as their prior backgrounds will shed some light on how well you can expect to perform.
• Franchisee role: Some systems are geared for smaller franchisees—the proverbial “man in a van” where the franchisee spends the bulwark of time performing the cleaning. Others are geared for more leader-focused franchisees who rarely work in the field but instead manage a team of workers while marketing for new business.
• Buy-in cost: While many financial institutions provide financing, the start-up cost may disqualify some franchise systems from your consideration. Note that, while a franchisor has limited ability to change the terms of the franchise agreement, for an owner of an established business the franchisor may allow for a reduction on the initial fee or phase-in the ongoing royalty.
• Support: Most franchisors do a good job at teaching their system of cleaning, but it is a mixed bag as to their effectiveness in helping their franchisees win customers.
• Management: Arguably the most important factor to consider when choosing a franchise system is the quality of the management team. Are they committed to helping you succeed? Will your relationship remain strong when you invariably encounter a challenging situation? Your franchisor is your partner, and your relationship with them—which could well last twenty years—is of paramount importance.

To guide you through the process to find an appropriate franchise is a cottage industry of franchise brokers. There is no cost to you, as these individuals are compensated by the franchisor, so pursuing a franchise may be something worth considering. In joining a franchise, you can operate a business for yourself but not completely by����dzܰ��������.

David Grossman is President of Renue Systems Inc., a global franchisor and operator of specialized deep-cleaning services businesses to the hospitality industry. He can be reached at david.grossman@renuesystems.com with more information available at .

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