By: Patrick Ungashick
This is Part 2 of a three-part article series. In Part 1 of this series, we examined how to handle the stream of inquires that you may receive about potentially selling your business. We also discussed how to conduct an introductory call with a inquirer if you decide to investigate that opportunity, including important mistakes to avoid and information you should gather. Finally, we left off with asking the potential buyer to send a non-disclosure agreement (NDA) if you wish to continue the discussion with that party. From this point, let’s look at the next steps.
Step 1: Engage a mergers and acquisitions (M&A) lawyer to review the NDA on your behalf. Too many business owners skip this step because NDAs appear short and harmless. Do not make that mistake. A small legal bill can protect you and your company against big potential problems later. Use a lawyer who is an M&A specialist. M&A is a highly specialized legal field. Just as you would not ask a general practitioner medical doctor to do heart surgery, do not ask a general-purpose attorney to do M&A work. Your M&A lawyer will review the NDA and, if necessary, recommend edits. NDAs are usually not contentious, so if this potential buyer becomes difficult to work with on the terms of the NDA, then you might have just learned that it’s time to conclude discussions with this party.
Step 2: Getting your M&A lawyer to approve the NDA is usually simple compared to this step. Before you submit the signed NDA, you must be ready to provide the potential buyer with the information they are going to ask for. In most cases, your potential buyer will immediately ask for financial reports starting with your company’s previous three to five years’ income statements and balance sheets, and additionally the company’s current financial results year-to-date. Do not sign and submit the NDA until you have these reports available and up-to-date, and specifically formatted to share with a potential third-party buyer. Many owners will not have these reports already formatted in the necessary manner, so let’s examine that issue.
Step 2a: Review the financial reports to remove any overly sensitive information that may be visible, such as the names of specific customers, distributors, vendors, lenders, or employees. Rename or redact any protected information.
Step 2b: Make sure that the income statement shows the company’s adjusted EBITDA. If you are 100% certain that the company financial report accurately shows the adjusted EBITDA, then you can proceed to Step 3 below. If your company has not historically tracked adjusted EBITDA (and many companies don’t), or if you are not fully certain about what constitutes adjusted EBITDA and how to calculate it, keep reading.
In many situations, potential buyers will typically first look to a company’s adjusted EBITDA to determine their interest in acquiring that company and at what price. EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. Contrary to popular perception, EBITDA does not calculate a company’s profitability. However, buyers put such importance on EBITDA because it shows the company’s current earnings power. Many owners do not regularly calculate EBITDA while operating their company, instead focusing on revenue and profits. Yet for most buyers, EBITDA is the first and most important step in determining what they will pay for a company.
If that’s EBITDA, then what is adjusted (also described as “normalized”) EBITDA? Like many business owners, you might not always make decisions that maximize your company’s EBITDA. Often you have other priorities, most commonly minimizing taxes. Many tactics that reduce taxable income also artificially reduce EBITDA. Common examples include:
- Above-market compensation: If your salary exceeds the amount that you could reasonably pay somebody else to perform your job, your extra above-market compensation reduces the company’s earnings, hence lowering EBITDA.
- Company-paid expenses: EBITDA is also lowered by ownership-related perks such as vehicles, expense accounts, travel reimbursement, and large retirement plans contributions.
- Inflated lease: If you own an office building and lease it to your company at a higher rental rate than might be available from another landlord, the extra rent lowers the company’s taxable earnings and also reduces EBITDA.
- Additional payroll costs: Putting family members on payroll with generous salaries is a common tactic for many privately held companies, but also lowers the company’s EBITDA.
A company’s EBITDA is not always understated. Other business decisions can cause EBITDA to be overstated. For example, if you are paying yourself a below-market salary, perhaps to free up cash to reinvest into the company or because you take the lion’s share of your income in the form of profit distributions, then the company’s initial EBITDA may be higher than it otherwise would be if you were paying yourself market-rate wages. Many issues can impact EBITDA positively or negatively, including accounting methods, employee benefits programs, and product development costs. The bottom line is that many privately held companies either do not track their EBITDA, or their initially reported EBITDA has not been adjusted to reflect business decisions that may understate or overstate the figure from the perspective of an outside third-party buyer.
Calculating your company’s adjusted EBITDA involves carefully reviewing these issues and preparing a true picture of company earnings. Items that artificially understate EBITDA are “added-back” into the figure, and items that overstate EBITDA (“negative add-backs”) are subtracted. The math is not difficult, but it is essential that you or somebody working with you has deal experience and knows the normal and customary adjustments to take. Buyers typically want to see the prior three to five years’ financial statements, so it is imperative to have adjusted the EBITDA where necessary over that entire period. Otherwise any of the following problems can occur:
- If your EBITDA is artificially understated, as is common, offers from buyers may be lower than otherwise possible. For example, if a buyer offers to pay seven times the earnings for your company, then every $1.00 that your EBITDA is understated will cost you as much as $7.00 off your sale price.
- If your EBITDA is overstated, this will likely come out during negotiation or the due diligence process, throwing a rather large wrench into your plans to sell the company for a certain price. For example, a buyer paying seven times the earnings may reduce its offer price by $7.00 for every $1.00 that EBITDA is discovered to be overstated.
- Whether under or overstated, if you and the potential buyer cannot agree on what the accurate adjusted EBITDA is, it will be hard to reach agreement on the company value and other important figures, undermining your chance to sell the business.
If your company does not have financial statements ready for a buyer to review—and this is common—then you must temporarily pause the discussion with this inquirer until the company reports have been properly reviewed and recast. Explain to the potential buyer “You contacted me, and my company financial records are not yet ready for a buyer. We both know that this common when a company is not being marketed for sale, which mine is not. My team and I will get our reports ready and then I will get back to you.” Be prepared for your potential buyer to press you to keep talking and even meet with them, because they want to keep you close and extract more information from you. In most cases it will be best to resist having any more conversations until your documents are ready. If the potential buyer is legitimate and their interest in your company is genuine, usually they will wait a few weeks while you get the company’s financial records in order.
To calculate and track the company’s adjusted EBITDA, you need people on your team who are familiar with the exercise and understand how potential buyers view these issues. If your company has a chief financial officer (internally or outsourced) that has guided companies of your size through acquisitions, then he or she can likely do this work. If nobody on your current team has this experience, then in Part 3 of this article series we will discuss advisors who can help with these calculations before you sell.
Step 3: Start doing your homework. If you chose to go forward with this potential buyer, the next step will be a bigger one than many business owners fully appreciate. Up to this point likely you have had a brief conversation or two with the potential buyer, and you have not shared a lot of details about your company and your personal situation and goals. (Hopefully you have not.) However, once you sign the NDA and submit the company’s financial data, your conversations with this potential buyer will rapidly expand and dig into greater detail about your company and you. What started as a harmless little inquiry can quickly become a time burden and confidentiality risk. The potential buyer often will bring more people from its team into the conversations and will pivot into asking for more information and documents. They will also want to meet and may ask to visit your facilities—a scary proposition if employees or customers learn what you are considering. The entire time, you will be sharing detailed information with a company that either is a competitor or might be one in the future if they don’t acquire your company but later buy another.
Your potential buyer likely has acquired many companies and possesses a team of experienced staff and expert advisors. In contrast, if you are like most owners then your company may be one of the few and perhaps the only company that you ever sell. You cannot take the risk of going forward without doing your homework to be prepared. You must learn what it takes to sell a company, evaluate if you are truly ready, and assemble your own team to guide you through the process.
NAVIX has three free resources designed to help business owners in your situation prepare for your next steps:
- Download our free white paper “Top 10 Signs You are Not Ready to Sell Your Company”. Just like any important decision, the question of selling your company should not be made hastily. Every business owner and every company are unique, yet there are some universal signs that business owners can use to help determine if they are ready to begin the sale process. Overlooking any one of these signs can lead to a significant amount of lost value or derail the sale altogether. Because most business owners exit only once, it is important to learn what is involved in getting ready to sell—otherwise you risk discovering half-way through that you missed something critical. This white paper explores each of the ten signs and offers resources to help owners address each issue. At the conclusion, the white paper identifies further steps to help you prepare for the sale of your company.
- Watch our free on-demand webinar “Knock Knock!...How to Know if the Potential Buyer at Your Door is a Waste of Time or the Opportunity of a Lifetime.” This educational webinar explores how to recognize if a potential buyer is serious, how to evaluate the situation quickly, effectively and in the safest way (especially if the inquiry comes from a competitor), and how to sell your company without the cost and risks of a full sale process.
- Contact us to schedule a complimentary and confidential phone or video call to discuss your situation. Since 2009 we have helped about 500 business owners prepare for exit, and we are glad to learn about your situation and offer any assistance that we can.