CHAPTER 12

Filtering for the Owner’s Commitment to Sell

The remaining deeper filter is the owner’s commitment to sell. You might reasonably wonder why we include this as a filter: Isn’t the fact that the owner has retained a broker or, in the case of a directly sourced prospect, engaged in several conversations with you and sent you confidential information a sufficient indication that the owner is a committed seller?

Our experience is that because most owners of the kinds of small businesses we have described are first-time sellers, they aren’t yet aware of the consequences of selling their companies. As they learn more during the sales process, they often are disappointed with how hard it is, how long they will have to stay involved in their businesses after the sale, and how little money they get for their companies. Add the owners’ commitment to their employees and that their work has defined their lives for decades, and it isn’t surprising that many owners who initially are interested in selling decide against it once they are faced with the realities of the process.

But it often takes owners months of learning before they decide to abandon a sale. In the meantime, you are busy working to bring the acquisition to a close, and as we explain in part IV, “Making an Offer,” this effort will absorb an enormous amount of your time and substantial cash outlays to lawyers and accountants. When the owner decides not to sell late in the process, it is a miserable experience that could have a devastating impact on your search, especially if you have stopped sourcing new prospects or reached the end of your resources—even if you provided for broken-deal costs in your budgeting, as we recommended earlier.

We suggest applying a filter to gauge the owner’s commitment to sell before proceeding to the next stage of your investigation of the company, even if the prospect has passed all your other filters. Like the other deeper filter—enduring profitability—assessing the commitment to sell is an iterative process. As you learn more about the company, you will have a better understanding of why the owner is selling and will therefore (hopefully) be more confident in the owner’s commitment to sell.

External Factors

Our experience is that most owners of high-quality smaller firms sell because they have to, not because they want to. Correspondingly, the clearest and most reliable indicator that an owner is committed to selling is an external factor that is compelling the sale. Indeed, that is often the only information you will have about their commitment to sell if your filtering is based on the limited information in a CIM or shared by the owner in a call or two—and it may be very vague. Still, we believe you can glean some real sense of that commitment if one of these situations—or something like them—is forcing the sale:

• Retirement
• Poor health
• Divorce
• Inability of business partners to get along
• Death of the owner, and sale of the business through the estate

Focusing on owners who are experiencing one of these unhappy events doesn’t mean you are taking advantage of someone’s misfortune. It just means you are looking for sellers who are seriously intending to sell, just as you are seriously intending to buy. Without you—a willing and able buyer—the sellers’ choices are much worse.

Most of the entrepreneurs through acquisition that you have met in this book purchased from sellers who faced some sort of compulsion to sell. Greg Ambrosia—the army veteran who purchased the high-rise window-washing business in Dallas—bought the company from two sisters who both wanted to retire and who felt increasing pressure to care for their elderly parents. Family health issues also drove the sale of the fire-hose testing business that Tony Bautista purchased. More recently, one of our students, Eric Calderon, purchased a business that manufactured specialized oil-testing centrifuges. The owner had managed the business until he was 89 years old and in failing health; he died a few months after the transaction was completed.

As Randy Shayler investigated Zeswitz Music, he found no specific compulsion for the owner to sell, but there were, nevertheless, strong indications that the owner was committed to selling the business. The owner also owned a larger company located in New York and New England. The larger company was similar to Zeswitz; the initial intent when Zeswitz was acquired in 2006 had been to combine the operations of the two entities. However, that never happened, and Zeswitz had remained largely a stand-alone business with its own operations and general manager.

Because the CIM didn’t specifically address the owner’s reason for selling, Randy asked the broker and learned that the owner had abandoned the idea of combining Zeswitz with her larger rental business. She wanted to focus her efforts on the larger business, together with a few other smaller music-related endeavors. This reasoning made sense to Randy, and he moved forward to the preliminary due-diligence stage. Still, he recognized that the owner did not have a compulsion to sell and that she could abandon the sales process later on. In fact, during some tense negotiations, the owner raised the possibility that she would postpone the sale for a few years. This option was never pursued, but, without a compulsion, the risk that a seller might abandon the sale is always present.

Filtering for Commitment to Sell in the Absence of External Factors

Not all owners of high-quality small businesses sell them because of an external compulsion, however. During your search, you will come across owners with all sorts of reasons for selling. Some owners are healthy and energetic but just want to take a break from the constant demands of running a company. Maybe the value of the business has hit their magic number and they want to cash in on their success. Others want to focus their time on a different business, their families, a charitable cause, or a hobby. Business owners certainly sell companies for these reasons, but you need to recognize that owners selling for these reasons can change their minds at any time in the sales process. The filtering challenge is to decide which of the owners who do not have a compulsion to sell are likely to remain committed to the sale through closing.

At the same time, keep an eye out for eager sellers who seem very committed to the sale and who may be hiding a bad deal. We especially distrust owners who tell buyers they are selling because they’ve taken the business as far as they can and that they believe a new owner can take the business “to the next level.” Their statement may be true, but few people, especially those who have managed a business for a decade a more, have such a humble and detached perspective. Still, even if the seller imagines some bad news on the horizon, it could well be a mirage. It is up to you, the buyer, to decide for yourself.

Assessing the owner’s commitment to sell when there is no external compulsion to do so is a qualitative process. You are trying to understand whether, later in the process, the owner will learn something that will lead them to abandon the transaction. These triggers often involve disappointment about the owner’s cash proceeds from a sale and can stem from various circumstances:

• Differences between presale and postsale after-tax cash flow
• Overestimates of the sales price
• Misunderstanding of the transaction
• Continuing involvement in the business after the sale

We describe each of these traps below, along with ways to filter out or overcome them.

Cash flow consequences for sellers

In chapter 2, “Is Entrepreneurship Through Acquisition for You?,” we explained the financial attractiveness of becoming an entrepreneur through acquisition. Of course, if it is financially attractive for the buyer, it is financially unattractive for a seller without external motivation. We emphasized that the acquisition price of a small company is much lower than that of larger, public companies in similar businesses; small firms of the size we discuss in this book regularly sell for three to five times the company’s annual profits. That means if an owner is taking home $1.0 million a year in pretax annual profits (which comes out to $600,000 after taxes if the tax rate is 40%), the company is worth somewhere between $3.0 million and $5.0 million. Let’s assume a midpoint of $4.0 million. If the owner has to pay capital gains tax of roughly 20% on the sale, the net after-tax proceeds are $3.2 million. If that money is invested in mutual funds, a 10% expected return is probably generous, so the pretax earnings of the seller’s portfolio is $320,000. And, of course, income tax is due on those earnings. If the tax rate is 40% on the investment income, the seller’s after-tax income is $192,000. That’s less than a third of the $600,000 in after-tax income the owner got while running the business. And it might be much less if the owner used the business to shelter some of the income. So, selling is financially very unattractive compared with the annual cash flows from running the business.

Many owners come to understand this arithmetic only late in the selling process. Typically, they will seek some tax advice about how to structure the details of the transaction when there are just a few weeks until the scheduled closing. Some owners still pursue a sale, but others decide to continue to manage the business for a few more years instead of selling immediately. The arithmetic will still be the same when the sale occurs, of course, but the owners can use those years to accumulate more savings, which will allow them to fund their retirement more fully. Others might decide not to sell and instead hire a general manager to run the day-to-day operations of the business for, say, an annual salary of $150,000. If that works—and it often doesn’t—the profitability is reduced from $1.0 million to $850,000, but the owner can retire with much more money than if the business was sold outright and the proceeds invested in mutual funds. Keeping the tax rates in the earlier example, with the manager running the business, the after-tax income of the owner is $510,000 (60% of $850,000), which is much better than $192,000.

As you try to filter on the commitment to sell, seek to gauge whether there is an employee who could be successful as the general manager for an absentee owner; if so, you should be more concerned about the commitment to sell. In contrast, if the owner seems particularly eager to leave the business, perhaps fatigued by the constant demands of the day-to-day management of the business, and there is no competent general manager, you can be more sanguine that the owner will remain committed to selling.

Unrealistic price expectations

Owners who retain brokers or respond favorably to a direct outreach from a searcher may enter the search process even though they are unwilling sell at the prevailing market price for smaller firms. Instead, some might be willing to sell “at the right price.” This right price is, of course, a very high price, one you ought to be unwilling to overpay no matter how much you like the business. Other owners are just wondering what their business is worth. That is a natural curiosity because their business is probably their most valuable asset. We think most of these owners, however, are simply unaware of prevailing market conditions and thus substantially overestimate the likely acquisition price for their company.

Because most small business owners are first-time sellers, they often know little about purchase prices of smaller firms. Sale valuations aren’t tracked and widely published, so it is very difficult for owners to discover the prices at which similar companies have sold. Imagine trying to keep track of your weight if you never have access to a scale. As the years go by, your own fond self-evaluation gradually drifts away from reality. And in business valuations, both casual acquaintances and market professionals often distort the little market information that is available. Boasting often leads other sellers to express high multiples by underestimating EBITDA and overestimating sale price. Brokers, in an attempt to portray their abilities to potential clients, also do much the same.

Furthermore, owners preparing for a sale often reconstruct their business’s financials incorrectly. For example, they may add back to their company’s profit the salary they receive and not recognize that after they sell, the business will still have to pay a CEO’s salary, though it will be paid to someone else. Sometimes, owners set their business’s valuation multiple by comparing it to a large publicly traded company in a similar industry, not understanding that the multiples for smaller companies are much smaller. Sometimes, owners decide on their selling price by imagining the amount of money they want to have in retirement, rather than reflecting the economics of the business. Owners might seek advice, but it often comes from a family attorney or a tax accountant who has little exposure to the market prices for smaller firms. Most owners learn about the true value of their business during the sales process, and first-time sellers are almost always disappointed.

As a result, an owner’s initial interest in selling isn’t a reliable indication that he or she has a sense of the prevailing market prices for smaller companies. To filter out this unreliability, talk to the broker, if there is one. Ask about the price expectations of the seller as one of your follow-up questions on a CIM. The seller’s opening number will obviously be on the higher end of the negotiating range, but if it is 5x the EBITDA, you’ll know that the owner is more committed than if the broker tells you the number is 10x this figure.

For directly sourced prospects, it is trickier because you won’t know much about the business during your first few conversations with the owner. But you can still suggest a general valuation range: “I’m looking to buy a business at 3x–5x pretax EBITDA.” The response should help you gauge whether the owner’s idea of the purchase price is within the prevailing market range and thus whether the owner will remain committed to selling at that range. It is essential that, early on, you filter out the owners who have unreasonable price expectations; you cannot waste time pursuing a deal that will never occur.

Misunderstanding the sales process

There are two common deal terms that often confuse owners and cause them to abandon the acquisition late in the process. The first is that small businesses are purchased on a debt-free and cash-free basis, and the second is that these deals typically include a so-called normal amount of working capital. Both of these terms are explained in detail in the asset purchase agreement, which is negotiated by lawyers late in the sales process, so disagreements over these two terms arise late. Moreover, because the amounts of money involved can be substantial, these disagreements often mean the abandonment of the deal. We’ll explain each of the terms in more detail in part V, “Completing the Acquisition,” but we’ll sketch out the issues here to give you a sense of how to filter for the owner’s commitment to sell.

A debt-free, cash-free acquisition means that the seller gets to keep the cash in the business but also must pay any outstanding debt of the business. So, if there is a $500,000 cash balance in the business’s bank account, the seller gets to keep that money at the closing. The seller will think that fair because the business earned that money while he or she managed it. But if there is a $1.0 million loan, perhaps related to the purchase of a building or a piece of machinery, the seller needs to pay off that loan; the buyer doesn’t have this liability, even though the buyer gets the building or the machine the borrowed money was used to purchase. Some sellers misunderstand this term, and one very disappointed searcher reported that a seller abandoned an acquisition within a few weeks of the scheduled close even after multiple discussions about pricing. As the seller told the searcher, “I thought those pricing discussions were about my equity and that you were going to assume all the debt. After all, you are getting the assets; it makes sense you should get the debt too.”

Working capital is the amount of money needed to run the business. Most simply, it is accounts receivable plus inventory minus accounts payable. Sometimes there are other items too. When you agree on a price—a topic covered in part IV, “Making an Offer”—you specify an amount of working capital that will stay with the business. In many small businesses, this amount is substantial, sometimes in the millions of dollars, but more often in the hundreds of thousands. The buyer includes the working capital because it is, effectively, an operating asset of the business. The seller, however, has a different view, and deals often break down over this issue. As sellers explain it, “Those sales were made when I owned the business, so I should get that revenue when it is eventually paid. The accounts receivable should be mine.”

To filter out these misunderstandings, we recommend that you talk with the owner about these terms repeatedly throughout the sales process, certainly beginning no later than when you submit your first offer. You can also, earlier on, get a sense of what the owner understands would “go with” the business. It can be an informal conversation, but it should give you a good idea of whether the owner understands these deal terms and considered them in the transaction price.

Continuing involvement after the sale

Owners generally believe that when they sell their businesses, they get the purchase price in cash, are completely finished with the business, and then move on to whatever they plan to do next. In fact, it rarely works that way. Typically, the seller needs to continue working with the buyer for three to six months after the purchase to help with the management transition. These owners keep a lot of the information about the business—customer preferences and promises, for example—in their heads, and the buyer’s only mechanism to reliably learn that information is for the seller to help “train” the buyer.

Plus, as we will explain later, sellers typically lend the buyer part of the purchase price. Part of the purchase price is also usually tied up in escrow accounts, and some of it might be in the form of an earn-out, in which the seller gets some portion of future profits. So, the seller needs to stay involved and the searcher needs to filter the search for the owner’s willingness to work with the buyer for some period after the transaction is completed and to help finance the purchase. Again, this filtering is largely qualitative; if the owner cannot seem to interact professionally with you at this early stage, the likelihood of a smooth transition after an eventual sale is far less. Similarly, if the owner has plans—“I’ve been getting my boat ready to sail around the world”—be dubious about the transition and the willingness to help finance the transaction.

Are All Owners Committed to Selling?

As you investigate an owner’s willingness to sell, don’t forget that, sometimes, ownership is held by more than one partner and only one partner is committed to selling. For example, a business we observed had been started by three partners. Now, one partner was in ill health and ready to sell, while the other two were in fine health, happy to keep working, but willing to sell at “the right price.” Of course, all of the discussions around the sale occurred with the partner who had a compelling reason to sell, and the deal seemed to be moving along at reasonable market terms—until the other two partners rejected the deal late in the process. In another instance, a potential seller gave away small ownership percentages to key employees as he slowly disengaged from the day-to-day operations. The seller thought he could convince the minority holders to sell, but he could not and the deal collapsed.

As you search, filter on ownership structure. The more complex the structure, the less likely it is that all the owners will be committed sellers.

Next Steps

The trick to efficiently managing your search is to be ruthless and quick in rejecting prospects by applying the initial and deeper filters we’ve discussed in this part of the book. If a prospect has passed these filters, you’ll move on to preliminary due diligence.

But remember, it is an iterative process in two ways. First, you’ll always be going back over your filters, especially the deeper filters on enduring profitability and the owner’s commitment to sell, throughout the sales process as you learn more information.

Second, what you learn in the filtering stage will have an impact on your upcoming due diligence. We think you should be especially cautious of young, healthy sellers who face no external compulsion to sell. No matter how much investigation you do, the sellers will always know the business better than you will. You will need to work especially hard during the due-diligence stage to make sure they aren’t unloading the business before some bad news becomes apparent, and hopefully your diligent investigation will uncover any problems.