Want to versus Have to

Many owners start from “I should sell” or “it is time to sell” or “my spouse wants me to sell.” Yet, they do not really want to sell. This rarely works out well. Listen for the word “should.” It usually indicates a lack of commitment. People do what they want and then rationalize how they got there. When you are talking to an owner, if they do not want to sell deep down inside, they should not go to market at this time. That does not mean they should not be preparing to go to market eventually or if the facts make sense, they should not be working with key managers or family members on a long-term buyout plan. Many owners start those processes way too late.

Other owners genuinely reach the decision that it is time to do the next thing or at least move on from the business. They WANT to sell. Which sounds somewhat like SHOULD but is a completely different place mentally. A shorthand is “Want to vs. Have to.” “Want to” generally should sell. “Have to” should not. At least not yet.

When talking to your client, listen carefully for if they really want to sell or feel they should and therefore have to. Again, have to clients rarely get to closing, wasting tremendous energy.

Time versus Money

Few businesses outside some narrow tech fields are going to sell for a price that is irresistible. Somehow this is the main focus of most accountants: “but you are making so much money compared to what it will sell for.” That is an easy to understand fact even for somewhat befuddled potential sellers.

Your client is probably much more wrapped in the emotion of a possible major life change. Spend time on that.

• What are they going to do next?
• What has changed in the last few years, creating these feelings?
• How do other family members or influencers in their life feel about this?
• Is it really something they want to do or do they feel they have to do this?
• Have they looked at other alternatives like reduced involvement?

Again, most small and very small businesses are going to sell in the broad range of 1.5–3 times the seller's discretionary earnings (SDE) or 3–5 times EBITDA. Basically, what the owner will make in three to four years if the company does not grow. This brings up another broker shorthand: “Owners are sellers when their TIME is worth more than their MONEY.”

Most owners are not sellers because their business is how they want to spend their time. Their business is worth more to them than other potential owners. That is why brokers are so concerned about what owners are going to do next. The void of time becomes bigger as closing gets closer if the seller does not have real plans.

Higher Price, Lower Taxes, AND…

Of course, sellers want a higher price and lower taxes. Often there is something more that they want. Often they do not know what it is or maybe how to express it.

Helping the seller understand these factors, when possible, is important so the broker and other parties in the transaction can try to obtain that. Again, try to understand the underlying motivations. Often your client will not fully understand this either.

Value versus Price

Valuations are important for planning purposes and verification of reasonableness. Only in rare cases do they prove that the best price was obtained. For instance, a synergistic buyer offered 250% of a reasonable fair market value price. Run, do not walk, to complete that transaction. In the same vein, what if the buyer had offered 125%? More than one broker I talked to reports seeing those become 150% of fair market value, in some cases due to implementation of a proper sales process.

What Do Buyers Want?

One of the most important things for sellers to understand is what buyers want. Many small and very small business owners do not really understand what buyers want. They think 20 years in business or a large database of prior customers will provide value. The short answer to that is … Buyers are looking for a proven future cash flow so strong it is worth paying for.

This translates to:

• A “working model” to generate the cash flow. This means systems that work today. People who can operate the systems today who are staying after the sale.
• Simple is better than complex if it meets the test. Annie's Pretzels in high traffic, mall locations (the larger malls that are likely to survive) are wonderful. Simple, organized, profitable.
• A very clear buyer adage is, “If you want to be paid for it, prove it.” In other words, buyers pay for what exists. An apple seed has the potential to be an apple tree. But no one pays for the tree when they are getting a seed.
• Along the lines of the last statement, buyers are buying a business for potential. BUT, they pay for what is proven. Without potential, they will just go get a job.
• Some form of competitive advantage and/or Amazon protection. This can be location, distribution chain, supply chain, devoted or repeat customer base, and so on.

In even simpler terms: people, processes, profits.

Buyers for small and very small businesses want to step into the owner's shoes and successfully run the business the way the owner has for 6–12 months. Then they will venture off and start changing the business to suit them.

They are the most conservative of entrepreneurs. The most risk-tolerant entrepreneurs tend to be those who do start-ups. Then some franchise buyers for new areas. Then existing business buyers.

Issues in Advising Owners on Creating Value

Often the biggest problems confronting advisors trying to assist clients is helping the client grow personally. The adage, “what got you here may not get you there” is true at certain points in growing a business. An owner's willingness to really look at themselves and take the personal risk to change themselves and their related actions often is the biggest impediment to improvement. Tired owners are just one symptom of this. There are many other varieties. It can sound like, “I know my limits.” “We tried that (once).” “My friendly competitor advised me against it.” and so on.

A second problem is that you as an outsider may see the problem and solution easily. But, until the owner internalizes it, until they see the problem and, more importantly, until they see the solution as theirs, they are unlikely to act. When doing advisory work, it is really exciting to hear an owner tell you as if it was a brand new idea what you have been suggesting to them for weeks. That is when change begins. When the client has “taken the solution to heart.”

Finally, sometimes growth does require a short-term reduction in profits. Some owners are so short-term profit-driven (which is not all bad) that they will not make the investment in people and plant even when they have a long time-line to reap the rewards.

Increasing Business Value

Most business owners think the quickest path to increasing value is to increase sales, namely, to grow. Valuation professionals realize the quickest path is increasing profitability. Make sure your client really understands the difference.

Steps for Short-Term Value Enhancement

Usually there is not enough time to fully absorb the costs of growth when a sale is planned in the next year or two. Rapid customer growth can be expensive in the short term. Often advertising and sales expenses are high to initially obtain a customer who may be around for many years. Same for capital expenses. High capital expenses often take years to fully absorb. Businesses sell based on profitability. Profits are highest when cost of goods sold are low and sales, administrative and overhead costs are low and are fully absorbed. Buyers pay for proven cash flow. Therefore, the advice is:

• Cut expenses, then cut some more²
• Hold off on major capital expense other than emergencies, safety, and so on
• Hold sales steady or grow while maintaining reasonable gross or contribution margins (If margins fall too much, do not grow.)³
• Document systems and provide limited cross-training
• Recognize the importance of people staying. With a very small business, even a key administrative assistant who is knowledgeable and staying will usually add value. In most instances if everyone leaves, so does the business value
• Maintain energy around staff, namely, lead.

Mid-Term Two- to Four-Year Value Enhancement Steps

Again, improvements allowing a quick return make sense. Major improvements do not. To increase value over two to four years:

• Cut expenses
• Only make “normal” level capital expenses, i.e., replace trucks and equipment but do not fit out a new warehouse or major capital expense requiring three or more years to fully absorb (again, these can be expensive)
• Grow incrementally at a rate that maintains margins
• Look at your products/services, job cost, to understand where you make the largest margins. How can you sell more of those?
• Allocate overhead as best as possible to understand true customer and product costs. Factor this into margin analysis
• Learn the fine art of buying goods and services to increase quality and lower costs. Focus on lowering expenses and costs
• Document and refine systems. “Forever and continuous improvement.” Use technology to make videos of systems with your phone or video work being done on the computer, while talking. This simplifies manual creation. Create a video library or operations manual
• If your business involves professional liability make sure you are properly insured
• Train and retain the best people. Some cross-training is helpful.⁴ If possible obtain “stay” agreements (usually a bonus plan for key employees if they stay after an event like transfer of the company) and non-solicits of clients and other employees.

Longer-Term Value Creation

Now is the time to develop a strategy and revise capital, human, and sales expenditures. There is time to make those expenditures in the early years and hopefully reduce (at least on a percentage basis) some of these expenditures, thus increasing profits and value as the exit nears. In addition, if a sale is planned to family members or employees, this is the best timeframe to begin those conversations. In those cases, additional focus on both financial ability and developing all the skills a new owner will need is essential.

Follow the two- to four-year strategy above

• PLUS
• Develop a plan and review monthly
• Selectively try new products and services. If something looks good and the likely lifetime value is sufficient, market and sell hard to grow early. In general, growth is expensive and most small businesses are sold on profits. Cut back on expenses the last few years prior to the exit
• Make major capital investments if necessary at least five years before exit. It takes a while to fully absorb the costs and maximize profit
• If long term, consider acquisitions. A patient strategy with constant low-level outreach to prospects can pay off handsomely
• Bring in high-level team members that can grow. Obtain non-solicits and possibly stay agreements with bonus provisions for staying through a transition period
• If the company carries debt, see if it can be refinanced to lower rates and improved terms, including loan covenants.

While not sexy, these strategies will produce profitability which is the primary driver of value with small and very small businesses.

Basic SBA Underwriting

SBA loans for business sales are cash flow loans. They can be granted typically when loan coverage is 1.2 times the available cash flow.⁷ 1.2 times means that all costs including principal, interest, and payment of the owner-operators' living expenses are accounted for and covered.

The business must be in an industry that has not had an unusual level of loan losses. For instance, the printing industry which has been under siege due to the internet and the ease of in-house printing (copying to us) is restricted to 50% loan to value loans instead of the normal 90%. Certain industries are restricted for political or economic reasons, such as banking and some areas of finance. Franchises or industries that have had unusual number of losses can be barred or again have a higher equity requirement. Franchises also require a document approval process by the SBA. It is useful to check with a knowledgeable lender to see if the industry or franchise has these types of approval issues. The inability to finance certainly will impact marketability and may impact value.

Another SBA requirement is that the lender must obtain a business valuation for more than the SBA loan amount. If the business has more than $250,000 of goodwill and intangible value or if the parties in the transaction are related (this can be related as in family or in the management structure), then the underwriting requires a third-party business valuation. While the SOP does not specify the standard of value, most appraisers doing work in this area use fair market value. The SOP is clear that the transaction terms need to be specified and the various included and excluded assets and liabilities accounted for.

A factor in the SBA loan process that is hard to fully understand is when an underwriting decision is based on an SBA requirement or a bank underwriter determination. The first tier of consideration with SBA loans is the loan must meet SBA standards or obtain a waiver from the SBA. Then you get to the bank underwriting standards. If the bank has too many defaults, they will run into regulatory issues downstream. So, underwriters often require things above the base SBA standards (i.e., a 20% down payment instead of 10% down payment). Yet they often tell you it is an SBA requirement. Well, what they mean is it is their SBA requirement.

The reason this is being brought up is if you bump into an SBA requirement, then all lenders using the program will have to obey the requirement. But often it is a bank requirement, meaning you might solve the problem by shopping around for banks. Experience dictates if you are assisting a buyer or seller, talk to at least three knowledgeable loan officers and banks. Experience suggests talking with a minimum of five if it is a “difficult” loan. Send them all the necessary documentation. Then see what they come back with. If there is interest, obtain letters of intent or term sheets and make sure you understand all the provided terms in order to fully compare. Loan terms extend far beyond interest rate and the payback timeline. Make sure you understand them all. It is extra work and it is often worth it.

Most small businesses obtaining SBA loans do not have reviewed or audited financial statements. Many do not have compiled statements. This means the Federal Tax Returns are often the primary source of financial information. Year to date financial information is usually internal and of varying quality. For many small businesses, balance sheets are prepared on a cash basis without payables or receivables or a balance sheet is even non-existent. This is particularly the case with Schedule C tax filers.

In many cases, the bank underwriter favorably views the business seller taking back 10–15% of the business sale amount, which can be secured by the business assets in a second trust behind the bank. Sometimes the banker will specify that this loan be a “silent second.” Silent second refers to the fact that the loan security is second or behind the bank and silent in that no payments can be made for a period of years. This will vary with the bank. Payments might start two or three years out or even once the SBA loan is paid off. Once the payments start, the repayment terms can be from a balloon payment to typically five or seven years of even monthly payments. This request will vary based on the transaction and the underwriter but is frequently part of the bank commitment when a borrower would not otherwise qualify. The view held by the SBA and many bankers is that the remaining owner funds will provide an offset for representations and warranties and keep the seller involved during the transition period.

In addition to the business being purchased, the buyer is also evaluated. Reasonable credit scores, relatable experience to what the business will require, cash to close, and, for larger transactions, collateral will be reviewed.

If the buyer has substantial assets, the SBA SOP requires that they be collateralized as part of the loan. What this means is that the SBA program is much more valuable to marginal purchasers who would be rejected without the SBA guarantees than to strong buyers who end up with their assets collateralized. Strong buyers often end up with the complexities of an SBA loan and a 100% collateralized loan. Not an enviable position for an add-on transaction.

Prior to the SBA most small transactions required the seller to finance as there was no one else. Sellers typically required 50% down on smaller transactions and 20–35% down on larger ones. Sellers who were unwilling to do that generally took very large discounts for a cash sale. Because many of these seller-financed loans defaulted, and all cash sale values were small, the market for business sales was much more limited. In addition, a large portion of the “sale price” may never have been paid, as due to renegotiation of the seller loan, it was hard to know what the “real” price was. This is rarely necessary with cash flowing businesses any more. In the last 25 years the SBA has removed these issues and brought stability to the market.

It appears that part of the reason why transaction sale data has become more useful is because there are more consistent transactions. In the end, most sellers take the SBA's loan amount and the sale price is reasonably close to the loan amount. Few sellers want the risk associated with providing financing. The availability and stability of financing have brought predictability to the small and very small business sale market. This in turn has made business valuation using the market method more accurate. This is a major change from 25 years ago that is not fully recognized by many valuators.

Should the SBA program be restricted or if the terms for obtaining an SBA loan become very restrictive (for instance, requiring 35% down instead of the current 10% down), the value of small and very small business will be greatly impacted. This is yet another assumption underlying most small and very small business valuations that no one even thinks about.

Main Street Business Brokerage Process

Main Street business brokers typically charge a 10–12% commission. Many charge an upfront fee of $1,000–$1,500 to offset advertising and other costs of the listing. Most listing agreements also have a minimum fee if the business is sold. This is often in the $10,000–$15,000 range. Due to the complexity of some transactions and the fact that brokers need a “floor” commission to take on selling a business, these are normal. Check the minimum fee stipulation carefully as it is an area where unethical brokers may try to hide a much higher fee than the quoted commission. Typically, listings are for a year and any prospect worked with will be protected under a tail provision for another 12–36 months. This means if a sale happens to one of the protected prospects (buyer prospects contacted or worked with by the broker) after the listing period has ended but during the tail period, the commission will be paid.

The process for smaller Main Street businesses is simple. Get the listing. Don't worry about selling price or terms or anything else other than getting a binding listing signed. Collect the details on the business and put it on the market. Typically putting it on the market means listing the business on internet listings sites. BizBuySell is probably the largest and most active site. But, there are other private listing sites and many brokerage houses, franchisors, associations, and other groups have listing sites.

Typically, Main Street brokers will develop a tear sheet which is a one-page summary of the major attributes of the business and the last year's cash flow. After a simple confidentiality agreement is signed, the tear sheet will be provided. The broker then qualifies the buyer, perhaps has a site and owner visit and, if the prospect is interested, will write up the offer. Standardized sales agreements are often used.

It should be stressed that the owner and buyer prospect meeting is essential. With small and very small businesses the buyer and seller really need to work together during the transition. If they do not like each other, it is hard to come to an agreement for the sale and even harder if transition services are necessary.

If the business does not get activity or the activity is not leading to offers, then the broker generally works to get the price lowered by the owner. While this may seem unscrupulous for most small businesses, the owner's belief in an unrealistic value is often the major impediment to a sale. Finally, for a typical Main Street broker 60–75% of the listings will turn out to be unsaleable. With very small businesses it is very difficult to properly estimate a sales price (many of these businesses have less than $75,000 SDE) or determine buyer interest. Often the purchase is more of an almost synergistic type opportunity cost for the buyer than true business value generated by the seller (i.e., “I was going to start a store just like this but yours is ready to go”). Estimating a price for that type of serendipitous event is hard.

While this process sounds harsh, the economics of very small Main Street business brokerage is that brokers must deal with volume efficiently. Most successful Main Street brokers will have 10–25 listings and will often have four or more in some level of serious negotiation at any time. In fact, it is hard to make enough Main Street sales to stay in business without 10 or more listings. It is a numbers game.

Main Street brokers bring the following advantages to the seller they represent

• Knowledge of the local market and they will help position the business
• Confidentiality as the contacts are not going to the business and some level of confidentiality agreement is obtained
• Standardized agreements keeping costs down
• Advice and guidance on all aspects of business sale process
• Show the business to more buyers than the seller could alone (it is estimated 35% of buyers buy the type of business they thought they would)
• Often will help the buyer find a bank or other lender for an SBA loan
• Allow the seller to stay focused on running the business.

Main Street brokers present the following risks:

• Time split many ways
• Strategy revolves around getting price right, based on interest.

It should be emphasized that there are many experienced Main Street brokers who use the process described below for very small businesses and those with values over $500,000. But, economics and what actually can be known in advance about the value and marketability of very small businesses often demand the above process.

The Lower Middle Market Business Brokerage Process

Most brokers representing larger Main Street businesses and up will use a process similar to the one described below. Different firms may focus more or less on certain areas of the process but most must perform all aspects reasonably well to successfully obtain a favorable price for the business being sold. Steps include:

• Introductory meeting. The owner and broker meet. Key point is to determine trust and ability to work together. Brokers are constantly trying to understand if the seller will pull the trigger and actually sell the business. Many owners get halfway through the process and change their minds. With very small businesses and tired owners, sometimes the business goes out of business before a sale can be completed. These are huge occupational hazards for business brokers
• Valuation. Some firms retain an outside business valuation firm. Most prepare a valuation internally. The valuation can vary from a back of the napkin estimate to an opinion of value. The point is to determine if the owner is a seller at a likely valuation for the business. Some firms tie the valuation price into their contracts for sale. At this point, some lower-level due diligence is likely to be done as part of the valuation
• Engagement. Marketing processes and plans are presented. Details of the listing agreement and goals are agreed to. Most brokers require an exclusive agreement for a year with another 12–36-month tail for genuine prospects they have contacted or worked with.⁹ Fees can vary from $2,500 up front to $6,000 per month for 6 months or thereabout. Brokerage commissions can be a Double Lehman (10% on the first million, 8% on the second million, 6% on the third million, 4% on the remainder) or a negotiated amount usually between 10% and 3.5%, depending on the size of the transaction. Minimum fees in the event of a closing can be from $75,000 to $250,000, again depending on the size of the transaction

  At this point, the broker does his best to obtain the remainder of documents necessary for due diligence. Knowing problems in advance allows dealing with them strategically. Generally, as business size grows, this process to obtain documentation in advance gets easier as sellers tend to be more organized and have true CFOs with organized files who can provide the information. For most businesses under $5 million in value, detailed documents much beyond the financial statements and tax returns are difficult to obtain until a real buyer is asking for them.

Getting your clients organized in advance for the “paper chase” requirements of selling a business will increase their value as organization does count. The next steps are:

• Marketing the Business. Brokers generally prepare a “teaser,” being a one-page blind summary and a comprehensive confidential package. Information on the teaser is used publicly to market the business. Typical marketing methods are listing on public listing sites like BizBuySell for smaller businesses. For larger businesses it may make sense to put them on private sites like Axial. Direct mail and email to likely synergetic or industry buyers and cold calling to high-level likely buyers. Ads may be placed in industry magazines
• Key in the process is verification of the ability of the prospect to perform financially. The prospect must have a genuine interest, and a logical connection with the business. Also important is the ability of the buyer and seller to get along, and of course completion of a comprehensive nondisclosure agreement. Confidential sales packages for Lower Middle Market are often thorough enough that the buyer can understand cash flows, business structure, significant contracts, systems, and people. Some brokers provide extremely detailed packages but most do not get too detailed as the broker and seller really cannot be completely sure who they are sending the package to. Common prospects are upper middle-class and moderately wealthy individuals who “just want a good business.” As the company being sold gets larger, a more comprehensive deal room will have all documents available for all qualified buyers upon qualification, as there will be smaller pools of buyers who can be researched and verified more thoroughly
• Part of the qualification process is the buyer and seller meeting. The focus of the first meeting really is, can these people all work together? Certainly, many details of the business will be covered but the ability of a buyer and seller to work together is essential in small business sales
• Negotiation. The point of the brokerage process is to make a market across the likely buyer pool for the business. For most small businesses under $1 million in value, the business will be purchased by an individual. For a typical $2 million value business, this includes potentially being an add-on investment for a private equity group (PEG) or competitor, or selling to an individual who sometimes wants to be more of an investor and sometimes is looking to be an owner-operator. The different groups often view the business differently and experienced brokers will talk and qualify them differently.

  The goal is to get three or more LOIs at about the same time to allow negotiating power on behalf of the seller and to verify the market. (Valuations are useful for planning but they are NOT proof of a market.) Quality brokers will evaluate the offers, including underwriting payment likelihood of offered terms. Quality brokers are good negotiators. Fear of loss brought on by multiple bidders is what creates negotiation power. Quality brokers know this and will work to obtain the best price––terms––conditions available based on the sellers' wishes and market realities.

  While many negotiations devolve down to multipliers and cash flows, the strongest position a seller can negotiate from is that another buyer may win the sales contest. That is why a business valuation can only be used to determine relative worth, not as proof that it was the best deal possible. Having said this, certainly on some synergistic acquisitions, there are offer prices where it is clear statistically that the best thing the seller can do is close the deal as opposed to making a market

• Due Diligence. After the LOI or equivalent level offers are made and negotiations have occurred, a purchaser must be selected. Typically, the non-binding LOI is signed. The non-binding LOI will often have binding provisions around the deposit (deposits are common on Main Street deals and less common on Lower Middle Market) and perhaps a no-shop provision barring the seller from continuing to bring in new buyer prospects. From there, detailed due diligence will begin.

  As negotiations begin on the binding sales agreement, the bank financing or other financing process will begin in earnest. Due diligence tends to take 30 days for all cash small businesses and up to 150 days for larger deals requiring SBA financing. The goal of the seller and business broker is to minimize the time period to closing.

  There are always problems in due diligence. Unfortunately, it is hard to know what exactly they will be before they arise. A frequent problem is the buyer wanting to adjust the price. Sometimes this is based on real newly discovered issues or changes in results during the due diligence period but often it is purely based on the difference in buyer/seller power. The seller has the power during the bidding process. The buyer has more power (restarting the process can be expensive and painful) once selected as the winner. Business brokers assist the seller by adding credibility during these negotiations that if the seller must start again, the seller is ready

• Closing. As financing approvals are obtained and the remaining due diligence items are resolved, closing approaches. It is important to make sure all approvals, such as landlord approvals, permits if possible before closing, utility switchovers, franchise approvals, tax releases, and the like are obtained. Inventories and work in process, and any working capital adjustments need to be estimated and agreed to by the parties. Working capital is often more difficult to agree to than price. A closing sheet showing the money flow must be prepared and agreed to. Finally, all schedules and agreements including a seller non-compete must be completed and agreed to. As transactions get larger, this list can be quite daunting but must be completed in order to close
• Post-Closing. Generally, the broker does not participate in post-closing. But the buyer and seller need to complete the work under any transition employment or consulting agreements. The seller must abide by the non-compete. Often, in many states, permits and vehicles need to be transferred after closing. Post-closing receivables and payables need to be transferred between parties as agreed and received or paid. Finally, often the seller will have a seller note or escrow tied to successful completion of the representations and warranties and perhaps the result based on an earn-out.

Most brokers are active participants throughout this process. They educate the parties and bridge the rough spots. Keeping clear lines of communication and reducing the effect of personalities and emotions throughout the process form an important part of what brokers provide.

Because of the role brokers play, along with the availability of SBA financing, they have created more uniform markets for the sale of small businesses. Most brokers use Deal Stats, Bizcomp's, and West's Guide by Tom West for market information. Many know the valuation ranges for many businesses in their local market. If valuing a business for sale, it just makes sense to ask a local broker what it might be worth.

Selecting a Business Broker

This is a difficult task. While the company affiliation may have some limited value, in general, the knowledge, experience, and efforts of the individual broker are going to have the biggest impact on results.

Most business owners believe sales experience in their industry is important. For most small businesses outside of restaurants, there may not be enough transactions for real specialists. But, in many cases, if a true industry specialist can be found, they may know the real values, likely buyers, and be able to shorten and simplify the sales process.

If a true specialty broker is not available or if you are uncomfortable with that broker, the above-described brokerage system properly implemented by experts with good professional judgment will result in a high value (at least for that market at that time) for most cash-flow businesses.

Brokers understand how to emphasize and demonstrate those features that support stable upward cash flows whenever they exist. This is what creates business value in the business sale market. It can be viewed as “A belief in future cash flow so strong it is worth paying for”––that is what business buyers pay for.

To select a business broker, you should look at the following:

• How long has the person been a business broker?
• What types of businesses have they sold?
• Are their sold businesses about the same size with similar complexity and issues? (This is far more meaningful than industry in most cases.)
• What difficulties did they overcome selling each business?
• How long have the last three business sales taken?
• Do they have references that can be called?
• What do the references say? (Most people never call the references – you might want to.)
• Ask competitors about them. While most competitors will say nothing or be lightly complimentary, there are always a few brokers (there are two small and one large in my market area) that competitors will give warning about. Run from those warnings
• Will I listen to this person when push comes to shove? Do I trust them? (Many deals fail when sellers stop listening. The sellers have final say but the brokers have experience.)
• How many businesses are they selling now?
• What size are those businesses?
• What type of support staff exists?
• Will I have his or her personal attention or will the transaction be handed off?
• If handed off, who to?
• What percentage of the businesses listed do they generally sell? (Main Street is 30% or so. Lower Middle Market is probably 50% or 80% where the sellers do not change their minds. Again, this may not be much above 35%. This will also vary with the local economy.)

If you are working with potential sellers, introductions to quality business brokers can be very beneficial to your client. For cash-flow businesses, brokers will make a market and create negotiating power. Usually that adds far more to the sale than the broker's fee. (Of course, the fact that the fee is less than the price increase is impossible to prove, like many issues in business valuation.)

Businesses are selling current cash flow. Many a seller becomes so focused on the sales process that their profits fall, reducing value. A good business broker minimizes this distraction. After all, sellers need to run their businesses like they will never sell.

General Negotiation Tips

There are many steps to a well-run or well-won negotiation. Several key points are:

• Research and background. Do your research on the parties, including the actual participants. What are their socioeconomic profiles? What do they personally like and dislike? Interests, hobbies, family, philanthropies, and the like can have an influence. What would be success to them and what will they never agree to? Remember emotion and desire drive large parts of negotiations. Use this information in selecting negotiators, room settings, snacks and food, etc. Emotion and the subconscious are underappreciated by all but the most experienced negotiators
• Determine your lines in the sand. Think through what is a clear win, what is acceptable, and at what point you walk away. What are the comparative timelines? Do the timelines help or hurt you? Do a SWOT (Strengths, Weakness, Opportunities, and Threats) analysis for each party and/or the matter at hand. Consider alternatives and ways to reduce risk and increase reward. Understand your alternatives if you must walk away and always be ready to do so. Think through requests for chipping, as described below
• Negotiate the negotiation. Who sets the agenda? Where do you meet? What are the likely steps? These all set the tone and often allow for agreement to be reached on easy matters. These matters do make a difference, by all means set the agenda and think through one that assists you
• Build a relationship, ask questions, and listen. See the section, “How to Ask Questions Effectively” in this chapter
• When stuck on a point, move on and then circle back. Bring in different options, tradeoffs, and opportunities. You can even expand this to multiple offers (i.e., package a, or package b). Be open to reasonable mixing and matching from the packages
• Remember win-win negotiating. Win-win is when you can find something of low value to you that is high value to the other side and vice versa. Carefully trade those wins away to move negotiations forward
• When you give something, make sure you get something in return. Do not concede points without something, even something small in return
• Chip away. Ask for one more favor, or I will give you that for X which you have already requested and Y, a new request by me. Depending on the number of points being negotiated, small gains can add up
• Earn-outs and contingencies––share the risk. As the price or other valued term increases risk to the other party, be willing to make some of the increase subject to performance guarantees and price adjustments
• Workability. Remember reaching agreement is only a starting point. Make sure the agreement can be administered. What are the schedule provisions, responsibilities, meeting and reporting requirements, proof of financing, and other terms and conditions? Make sure these terms are workable.

Strengthening the Negotiation Position of Sellers

Key in any negotiation is the strength of the offering. The stronger the offering, the more aggressive the negotiations can be. Therefore, step one is to have a highly valuable company whenever possible.

Attracting motivated buyers is key. Understanding the level and reason for motivation requires qualification. Even if there is only one prospect, the more that is understood about the other party, the more effective the negotiation. This requires questions. Ask many questions. Ask important questions two or three times. When done properly, you will receive more detailed answers. People deflect questions but if nicely asked in slightly different ways, you can get deeper. The question, “Why?” may be the most powerful word on earth. Ask that often. You will be surprised at what you learn.

Read the “How to Ask Questions Effectively” section of this chapter. Figure 13.1 shows the qualification process which is further explained below.

Qualification is part of the questioning process. The prospect must be properly qualified. This means you must verify that they are ready, willing, and able.

Ask about:

• Their general background
• How does that relate to looking for a business?
• Do they have direct experience in this type of business?
• Other businesses they have looked at?
• Why did they not buy them?
• Have they made any offers?
• What happened?
• Why are they interested in this business?
• Who is on their team?
• How would they finance?
• What would a win look like?
• What would they change first?

The last question is for a little further in the sale process. Often when people start “seeing” themselves in a situation and thinking through changes, etc., they are becoming involved and motivated. Again, that is emotion showing through. The point is to understand their overall situation, ability, and most importantly, deep motivations.

Two of the biggest questions that need to be answered in any negotiation are:

1. What deep down inside is motivating this person to want to do this? (This is rarely the public answer you are told.)
2. What will this person never do?¹⁰ (If it is a deal breaker for your party, all the rest is a waste of time.)

Once the driving emotion is determined, when things stall, ask a question that ties back into the emotion. For instance, “I know this counter is 5% too high and you are thinking of walking away. But, in the long run, if you did pay that amount, would you still meet your goal of building a business like your dad's?” In all likelihood, you will not get much of a response that day. But, the prospect will think about it and likely come back in a day or two with at least a counter.

Where are the drive and desire coming from? Emotion drives transactions. Desire and need. Driving emotion gets the parties through the tough spots. Any business broker will tell you the problem with the fair market buyer definition is there is no “reasonable buyer.” You have to want it bad. You cannot effectively negotiate with someone who does not care.

Finally, multiple prospects and multiple offers create a fear of loss. Buyers cannot help but start counting their money when they put in an offer. Many buyers will tell you they are not willing to engage in a bidding situation. But almost all of them will if really motivated (including the ones who said they would not). Multiple offers allow the opportunity to counter, creating the concern of loss of the deal. This is how to increase value 20% or more. Many negotiations eventually end up in a conversation about multiples and cap. rates but that is a losing battle for the seller. A new offer that might take the deal away from a buyer prospect is much more persuasive.

If representing a buyer in a good market, it is hard to negotiate aggressively for your client and still end up as the winner of the bidding war. Some buyers will do almost anything to win the bidding war and then try to renegotiate in due diligence. At that point, the buyer is the only one left. Restarting the process can be expensive and time-consuming. This strategy can be effective and it can be a huge waste of time depending on the business, the market, and the seller.

Due Diligence in Transactions

A business valuation is the starting and perhaps end point of proper due diligence. The valuation is a starting point using seller-provided data early on. The valuation should be adjusted as due diligence indicates variations from the original facts and assumptions. Due diligence should be performed by sellers BEFORE starting the sale process. The fewer surprises and better preparation, the better the final result. But, most owners of small and very small businesses will not provide the level of detailed documentation necessary early in the process. Helping owners prepare and solve “easy” problems prior to starting the sale process will increase value and reduce timeframes on the market.

Proper due diligence is beyond the remit of this book. It is also rarely performed for small and very small businesses. That said, a starting point for minimum due diligence that should be performed is:

• Employment. Are the employees all legal and reported? Are their taxes being collected and paid to the correct jurisdictions?
• What are the benefits and what will need to be done to transfer them? Health insurance can take a long time to set up. 401Ks, etc. may need to be dealt with
• Are key managers and key employees expected to stay?
• Are there employee contracts, stay agreements, bonus or stock agreements, non-solicits and/or non-competes?
• If a union workforce, are there unfunded pension liabilities?
• Are systems documented?
• Are people cross-trained or is another back-up in place?
• Who is opening up new checking accounts, payroll accounts, forming the new company, etc.?
• What insurance is required? If professional liability is involved, is the seller buying tail insurance? Usually it works best to obtain insurance from the seller's current broker and carrier with small and very small businesses (generally the buyer can get going concern vs. new business rates) but do look around
• Independent contractors. Are they really independent contractors under state and Federal law? (State law rules can be much more aggressive toward employees than Federal law.)
• Is the company properly registered in each state or jurisdiction where it does business per requirements?
• Is the company reporting and paying taxes in those jurisdictions?
• Are there any concentrations of suppliers, referrers, customers? If yes, have they been contacted and does it appear that the relationship will transfer?
• Will the real estate lease be transferred? Can it be modified? Will the seller's personal guarantees be released if on a lease?
• Do any customer agreements, franchise agreements, supply agreements, licensing agreements, co-op agreements or the like require approval to transfer?
• If the buyer is to assume debt, can this really be done?
• How will equipment leases be handled?
• Are there bonds or sureties in place? How will they be handled?
• Are there licenses and permits that need to transfer? Are they pre-closing or post-closing?
• Will software licenses transfer or will new up-front fees be required? (This is becoming less of a problem with software as a service.)
• Is there any other intangible property and is it properly protected?
• Does the company own software outright and are the underlying code and related licenses in order?
• Are suppliers expected to continue to supply the new owner and extend credit?
• How are cut-offs for inventory, work in process, accounts receivable, accounts payable, etc. going to be determined and final amounts and payments agreed to?
• Are normal internal controls in place?
• Are cash controls in place, including proper segregation of duties?
• Review the nature of revenues to ensure they are truly forward-looking revenues as opposed to one-time or ending revenue streams
• What are the credit extension policies to customers?
• Are accounts receivables and accounts payables in good order and current?
• Is working capital agreed between the parties and is it supported by bank statements?
• Tie bank statements and, if applicable, point of sales data into the books into the tax returns. Perform limited sampling of source document
• Are there lawsuits or a history of lawsuits or disputes?
• Any known open reasons a lawsuit might be coming?
• Any other possible contingent liability, over- or under-valued asset?
• What is being missed? Spend some time on this one. Something important is being missed.
• Investigate all expected problems.

It must be noted that most small businesses will have problems when screened carefully. In most cases the buyer is going to have to accept some risk on these matters. Exactly where to draw the line and how to negotiate or accept each separate risk takes experience and a qualified deal team (e.g., lawyer, broker, CPA, tax professional).

One more point, it is reported that most mergers and acquisitions do not result in increases of value to the acquirer. There is a key word that explains why, culture. The list above is a page and a half of due diligence items that are comparatively easy to count, estimate, and calculate. So everyone focuses on them. But in most cases what is really being purchased is the combined knowledge and skills of the employees.

Companies and owners can have very different attitudes and values. This can strongly impact the outlook of the employees in both firms. Loss of motivation or of trained efficient people can have strong negative impacts on any acquisition. This is also very hard to access. To evaluate culture look at:

• How have other acquisitions gone?
• What is the reputation of the firm in the industry?
• What financial backing and depth do the buyers have if things go sideways?
• Are office and people policies similar both in what is written and as applied?
• Are office, equipment, and plant fit-out similar or very different?
• Would third parties categorize the companies similarly, for instance, hard charging, relaxed, genteel, and so on?

Culture and the ability of two cultures to merge well are very difficult to evaluate. But, if trained and experienced people are one of the motivations in the merger, it is very important to assess.

As a seller, you would like to reduce due diligence (do not hide things, that rarely ends well). Buyers should perform extensive due diligence. Particularly if the representations and warranties in the agreement of sale are extensive. The seller interviews and questionnaires with clear answers and back-up are very important for proving that a representation was researched diligently vs. being missed. A wrong answer on a questionnaire or interview follow-up letter when a problem later arises strengthens the due diligence case and possible downstream price adjustment.

Included is a sample due diligence checklist (Figure 13.2). Every situation is different. These serve as starting points. But recognize, just sending a 10-page due diligence list in a small transaction is rarely productive. It will likely not be reviewed, much less completed. With small and very small businesses, it is often best to orally review the long list in a meeting, taking clear notes that are provided back to the seller. Then send the written questions of the truly important items. Otherwise sellers, due to the form's length and fear of being wrong, tend not to complete anything.