Journal

Dec 09

Preparing to Sell Your Business – Step Five: Answering the Hard Questions

Journal entry by steve, Dec, 09 2014

This series of articles examines the steps that a business owner should walk through in preparing for a business sale transaction. To request a copy of the full series to date, please contact michelle@piedmontbusiness.com.

 

Step Five:  Answering the Hard Questions

We people do not like to answer hard questions, particularly if the truthful answer will make us look bad.  A dishonest person may just lie, while even an honest person will do what they can to avoid answering the question, or at least to answer in a way that minimizes the damage to them personally, professionally, financially or otherwise.  Every new parent quickly learns this basic principle of human psychology and social interaction, if they did not already know it.  Children naturally lie, and must be taught to tell the truth.  Ask a child whether he tied up the family dog, and he will quickly look away.  Or he will start out telling you why the dog deserved it.  Or he may just change the subject, telling you what his sister has been up to.  He will do whatever he can to avoid answering your simple question with a simple, truthful “yes, I did tie up the dog”.

In business sales, the hard questions should be asked and answered before the buyer raises the question.  A significant negative aspect of a business brought up very late in the process, during the buyer’s inspection of the business or later, will be very difficult for the seller to explain satisfactorily.  For example, if a buyer first discovers a competitor lawsuit against the business while conducting his own due diligence, it may be extremely difficult at that point to explain the litigation to the buyer’s satisfaction.  The buyer will be concerned that the lawsuit was not disclosed, even if the buyer never asked the question.  More significantly, a buyer who herself discovers a material negative factor about a business will naturally assume there are other negatives that have not been disclosed or discovered, multiplying the impact of that one issue and often killing a transaction.  On the other hand, if the litigation were clearly disclosed in an offering memorandum, the seller would have the opportunity to explain why the lawsuit is not a significant threat to the business, or at least how it will be managed.  A prospective buyer may or may not accept that explanation as satisfactory, but regardless he will likely give the seller credit for having made the disclosure.  Just as importantly, the buyer will have no reason to assume that there are several other negative factors that were not disclosed.

There are two important reasons – namely, time and money – why it is in the seller’s best interest to answer the hard questions early.  In many transactions the seller and buyer agree to basic terms in a letter of intent, term sheet, indication of interest or other preliminary agreement.  The price is agreed upon at that stage, based on the information available to both parties at that time.  Negative factors disclosed from the outset will be factored into the agreed price, and will not be a basis for later adjustment unless circumstances change.  The buyer will have no grounds to request an adjustment to the price on the basis of something the seller disclosed from the outset.  However, the seller can be assured that the buyer will want to re-negotiate the price when some concerning news about the business comes up later in the process – during inspections or, even worse, shortly before closing – and the requested adjustment will not be small.  Remember, the buyer will assume that this is not the only negative issue she did not know about when the price was negotiated.  She will assume there are others, and will factor the perceived risk into the requested price adjustment, if she is even willing to move forward with the transaction.  This leads to the second reason why a seller should want to make full and open disclosures, which is time.  A failed transaction can add many months or even years to the business sale timeline, which itself might have a drastic impact on value, not to mention the distractions of having a business on the market for a long period of time.

So what are some of the hard questions that should be answered early?  As a general rule, anything that is “material” to the business should be disclosed and addressed.  Material issues might be defined as those that would be considered important by a typical buyer in making a purchase and value determination.  Remember that the buyer will often be unfamiliar with the particular operations of the business, and some things that a seller considers routine might raise flags for a buyer.   A business owner should attempt to view his business from a potential buyer’s perspective, and give discussion to those points that a buyer might consider important.

There are a few questions that every buyer will ask, and these should always be answered preemptively.  Depending upon the business and the seller’s situation, these may or may not be difficult questions.  “Why does the owner want to sell this business”?  If the owner is retirement age, the answer will be simple.  On the other hand, if the business owner is working too many hours, or burned out, or tired of dealing with difficult customers, he should be prepared with an honest yet tactful explanation of his circumstances.  Perhaps the business just needs someone with more energy, patience or motivation, or better organizational skills, and these are all fair answers to the question.  “How much money can I make in this business”?  If the business is profitable, a well-done cash flow analysis from a buyer viewpoint will go a long way toward answering the question before it is asked, and selling the business.  If the business is losing money or just getting by, and the owner has not drawn a salary for five years, the owner must be prepared to explain how the business can be turned around and why the owner has not been able to do it.

Another difficult question frequently faced by sellers is whether the customers or employees will remain, after the sale.  This one issue makes the sale of professional service businesses, such as medical practices, accounting firms, and law offices, particularly challenging.  If a large number of professional staff will remain, aside from the departing owner, the owner may be able to provide a satisfactory answer to this question.  In any business in which the owner is directly involved with and serving customers, the question should be asked and answered in the business sale offering materials.  Does the business have a significant customer concentration issue – for example, half its sales derived from one customer?  Every buyer will see this as a concern, unless the buyer happens to be that one large customer.  It is best to raise the issue in advance and provide an explanation of how it will be addressed.

Negative sales or profitability trends often require explanation.  What can the buyer do to reverse the trend?  Are there opportunities that the current owner has not been able to exploit, for one reason or another?  Perhaps investment of capital, exploitation of industry contacts, or simply new energy is all that is needed to improve sales and profitability.  Frequently, the current owner has simply lost interest in running the business and is not investing the time or energy necessary to grow the business.  Perhaps the owner should have retired years ago, or the business has simply passed its “sell by” date.   A buyer is not likely to give the seller the benefit financially of the things the seller could have done, but providing a reasonable explanation for negative financial trends may encourage the right buyer to invest and make the effort to turn things around.

The hard questions will vary about as much as the types of businesses that exist, but the general principle is the same.  It is natural in marketing a business, or really anything, to highlight the positives and avoid the negatives.  However, it is important that the business owner address the challenges, providing a positive and reasonable, truthful explanation for why the business is, nonetheless, a good business.  Businesses are complicated, and nearly every business will have challenges to be addressed in one area or another.  Prospective buyers understand this, and will appreciate the owner’s honesty.  They will be more likely to give credence to the positive factors, as well as the negatives, if the owner is forthright in disclosing the challenges.   Given the substantial investment and financial risk required to acquire a business, the buyer deserves (and expects) to have all important facts disclosed.  In the end, the business is likely to sell for a higher price, and more quickly, both to the seller’s benefit.

 

Coming Next – Step Six:  Dealing with Real Estate

 

Stephen C. Minnich, J.D.
Certified Business Intermediary
Piedmont Business, LLC
(336) 202-7905
www.piedmontbusiness.com

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