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Selling Your Business to an Existing ESOP is a Win-Win

/in , /by Adam Wiskind

While selling your business to a newly formed Employee Stock Ownership Plan (ESOP) is an intriguing and rewarding exit path, forming an ESOP can be complex and expensive, and is not appropriate for all businesses. But, what if you could sell your business to an existing ESOP company, allowing you to secure your financial future, secure the future success and legacy of your company, and benefit your employees? This is a real possibility for many business owners, including one of my recent clients.

Before delving into these two options, I want to point out that an Employee Stock Ownership Plan is a retirement plan that allows employees to become partial owners of the company. Instead of traditional retirement benefits like a 401(k), employees receive the benefit of shares of the company’s stock over time, typically at no cost to them.

Why consider an ESOP for your company?

1. Preserve Your Legacy

For an owner, one of the most significant advantages of selling to an ESOP is the ability to preserve the legacy of the business. Your employees, who are already familiar with your company’s culture and values, can carry on the traditions, values and vision you’ve built over the years. While selling to an existing ESOP company does not guarantee to maintain the cultural continuity of your company, there is evidence that ESOPs maintain more stable employment and survive recessions better than other companies. ESOPs provide the opportunity to create an enduring legacy for you and your employees.

2. Maintain a Motivated and Committed Workforce

Employees who become owners through an ESOP often become more engaged and motivated. They have a personal stake in the company’s success, which can lead to increased productivity and a stronger commitment to the business’s long-term success. Employees gain a valuable retirement benefit, fostering loyalty and attracting top talent to the business.

3. Enjoy Tax Benefits

There can be substantial tax advantages for both the business owner and the company when selling to an ESOP. Depending on the structure of the sale, the owner may be able to defer or even eliminate capital gains taxes on the sale of their company even if it’s to an existing ESOP company.

Form an ESOP or sell to an existing ESOP?

While selling to an ESOP can offer numerous benefits to an owner, forming an ESOP is expensive, time consuming and importantly requires having an experienced management team in the company able to administer it. Sometimes, selling your business to an existing ESOP company is a better strategy. Here are six compelling reasons to consider this option over forming a new own ESOP:

  1. Variety of buyer candidates: According to the National Center for Employee Ownership (NCEO) there are roughly 6500 ESOP companies covering a wide array of industry verticals from technical services to manufacturing, construction, wholesale trade and others. About 2% of these are ESOP holding companies which own a variety of companies. There is likely to be acquisitive ESOPs in your industry.
  2. Immediate Implementation: Creating an ESOP from scratch requires time and resources, including legal, financial, and administrative efforts. Selling to an existing ESOP allows you to skip this lengthy set-up process and immediately transition ownership to a well-established ESOP.
  3. Reduced Administrative Burden: Managing an ESOP involves ongoing administrative responsibilities, such as record-keeping, annual valuations, and compliance with regulatory requirements. Setting up an ESOP requires having management in place that can manage the administration. When you sell to an existing ESOP, these responsibilities are shouldered by the existing ESOP trustees and administrators, saving you time and effort.
  4. Experienced Management: Established ESOPs typically have experienced leadership in place, including trustees and administrators who understand the intricacies of ESOP operations. This can provide peace of mind and ensure a smoother transition for your employees.
  5. Easier Valuation Process: Determining the fair market value of your business can be complex and contentious. Selling to an existing ESOP often involves a more straightforward valuation process because the ESOP trustees are already well-versed in this aspect of managing an ESOP.
  6. Immediate Employee Buy-In: Employees that are working for a company that is being sold to an existing, functioning ESOP are more likely to be receptive to the transition and readily embrace the ESOP model, fostering a positive and motivated workforce from day one.

Selling your business to an existing ESOP can be a win-win scenario for many small business owners and their employees, especially those who lack the resources or infrastructure to form their own ESOP. The benefits include a quicker implementation process, reduced administrative burdens, a simplified valuation process, and immediate employee buy-in. These factors can make the transition smoother and more efficient, benefiting both you as the business owner and your employees.

We can help you to sell your business to an ESOP. If you’d like to have a confidential, no commitment discussion on your exit plans or have related questions, please contact Adam Wiskind, Senior M&A Advisor at (707) 781-8744 or awiskind@exitstrategiesgroup.com.

Top 8 Reasons why Buyers Walk Away from an Acquisition

/in , /by Exit Strategies

Deciding to pursue a merger or acquisition can be a complicated process fraught with risk. Even when the financials look good and the potential rewards seem great, there are several reasons why a buyer might decide to walk away from a deal. Understanding these reasons can help sellers prepare for negotiations and improve the likelihood of a successful outcome.

Here are eight common reasons why M&A buyers might decide not to proceed with a deal:

  1. Big Surprises in Due Diligence:  During due diligence, the buyer may discover that the target company is not what they expected. This could be due to operational issues, poor recordkeeping, inadequate systems, or other concerns. If the buyer believes that these problems make the investment too risky, they may walk away. That’s why it’s important to “go ugly early.” In other words, put all the negatives on the table right away, to reduce the chance of surprises ruining a deal later on.
  2. Financial Concerns:  When evaluating an opportunity, buyers are looking at a company’s financial health and future earnings potential. If, during due diligence, they find significant financial issues, such as declining revenue, over-aggressive addbacks to prop up EBITDA, or inaccurate financial statements, the buyer may abort the deal process.
  3. Cultural Red Flags:  An acquisition involves the integration of people and organizational cultures. Buyers and sellers should have had culture discussions before the letter of intent stage. But sometimes new information reveals itself as the parties work together. If the buyer perceives significant cultural misalignment, they may walk away to avoid potential integration challenges or disruption to their own corporate culture.
  4. Liability Concerns:  As part of due diligence, buyers look at a range of risk factors. They don’t want to face an unexpected lawsuit or deal with the aftermath of someone else’s improper corporate conduct. Concerns here include ethical and legal issues, including non-discrimination and employment practices, regulatory requirements, and contracts, as well as tax liabilities.
  5. Environmental Issues:  Many transactions will include an environmental site analysis. Even if you aren’t selling the real estate with the business, the buyers may want assurances that the business hasn’t been the source of any unknown leaks or contamination. Unfortunately, environmental events do occur, and some sellers find themselves tied up in years of environmental remediation issues before they are able to alleviate buyer worries and put their business back on the market.
  6. Strategic Shifts:  Changes in a buyer’s strategic priorities can prompt them to walk away from an acquisition. Sometimes a buyer’s board of directors or investors don’t approve the deal. Something as simple as the buyer losing a key executive who championed the deal can sideline an otherwise healthy transaction. We’ve seen it happen!
  7. Unresolved Negotiation Issues:  Negotiating an M&A deal requires reaching consensus on a wide range of deal terms, including price, payment terms, contractual obligations, warranties, working capital, and other deal-specific issues. If the buyer and seller cannot resolve key negotiation points, it can lead to deal termination. Resolving these issues can be a critical point of failure for many deals. That’s why it’s a good idea to work with an experienced M&A advisor and attorney who knows what’s normal and customary for your industry and won’t obstruct your deal with overzealous demands or omit critical deal terms. You want an attorney who will protect your interests, but you also want a proven deal maker, not a deal breaker. This is also why you want the buyer to outline as many deal terms as possible in the letter of intent (LOI). At the LOI stage, you still have other buyers at the table, giving you more leverage and options.
  8. External factors:  Finally, some deals get foiled by external factors outside everyone’s control. For example, COVID-19 killed or delayed many deals. The dot.com and housing busts, 9-11, political shifts, supply chain disruptions, strikes, rising interest rates—these are just some of the many external events that have delayed deals or stopped them in their tracks.

It is important to note that walking away from an M&A deal can be costly for both the buyer and the seller. The buyer loses the money they have spent on due diligence, and the seller may lose the opportunity to sell their company. However, in some cases, walking away is the best option for both parties.

Before entering into an LOI with a buyer, your advisors can help you check their refences and deal history. You want a buyer with a track record of completing deals and staying true to commitments.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

Exit Strategies Group Advises California Caster in Strategic Sale

/in , /by Exit Strategies

California Caster, a respected and long-established industrial hardware design and distribution company located in Oakland, CA, was recently acquired by OneMonroe, an international industrial hardware manufacturing and distribution company.  Exit Strategies Group, Inc. advised the seller in the transaction. Terms of the transaction are confidential.

 

California Caster was founded in San Francisco more than 70 years ago.  Company services include the design and distribution of casters, hand trucks and other industrial hardware solutions.  Customers are located all over the world and include many of the world’s largest enterprises. Greg Williams, the owner of the Company since 2010, was looking to spend more time with his family and to reduce his workload as he owns several businesses.

“Exit Strategies Group guided us through a process that was new to us and positioned us to achieve a very successful transaction,” stated Greg Williams, owner of California Caster. “We absolutely could not have achieved the same results without their steady support and expert counsel.”

California Caster was advised by an Exit Strategies Group team led by Al Statz and Mark Harter. Michael Dalton of Donahue Fitzgerald LLP provided legal counsel and Paul Batrude of Batrude and Jones CPAs tax advice.

This transaction illustrates Exit Strategies Group’s expertise in lower middle market transactions and continued commitment to providing strategic valuation and M&A advisory services to North American industrial design, technology, distribution and service companies.

If you have questions or want information about Exit Strategies Group’s M&A advisory or business valuation services, please contact Al Statz at 707-781-8580 or alstatz@exitstrategiesgroup.com. Deal terms will not be disclosed.

Strong Business Acquisition Prices so far in 2023

/in /by Exit Strategies

Valuations on deals completed in the first quarter of 2023 averaged 8.0x Trailing Twelve Months (TTM) adjusted EBITDA, rebounding from the 6.9x average recorded in 4Q 2022 and in line with the 8.2x average set in the third quarter.

In Q1 2023, M&A transaction multiples experienced a rebound, indicating increased valuation levels compared to the previous quarter. This rebound despite increasing price of debt demonstrates a positive sign for sellers. 

For transactions between $10M-$50M, multiples have already been trending above their 20-year average. The aggressive start to valuations in 2023, significantly above the averages for 2022, suggests increased pricing and potential confidence in the lower middle market.

The rebound in valuation is not seen across all sectors; as those industries which are less impacted by inflationary pressures are the ones seeing increases in multiples.

We will see what the rest of year brings!

GF Data collects and publishes proprietary business valuation, volume, leverage and key deal term data on private equity sponsored merger and acquisition transactions with enterprise values of $10 to 500 million. GF Data gives M&A deal participants and advisors more reliable external information to use in valuing companies and negotiating transactions.

For help planning and executing a successful business sale, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com.

20 Exit Planning Questions that Every Business Owner Should Ask Themselves

/in , /by Al Statz

Eventually every business owner will retire and hand over the keys, and in my experience, the farther ahead owners plan for their exit the happier they’ll be with their exit.

While there are many things to consider when planning an exit, particularly for owner-operators of businesses, here is a list of twenty questions that business owners should be able to answer with clarity and confidence.

Twenty Questions that Every Business Owner Should Ask

  1. When do I want to retire? And what will I do when I retire?
  2. What must my company be worth when I sell, to fund my desired retirement lifestyle or next business venture?
  3. What is my company worth today?
  4. Is there a gap between what my business is worth and what I need? If so, what can I do to close that gap?
  5. How marketable is my business?
  6. Do I want a role in the company post sale? What role and for how long?
  7. What should I be doing to demonstrate to buyers that my company will continue to prosper when I leave?
  8. What are the potential benefits and risks of retaining a minority equity stake in the company?
  9. What will my taxes be on a sale? And do I have the best entity structure to maximize my after-tax proceeds?  If I don’t, what can be changed and when?
  10. Do I understand the pros and cons of selling to family, managers, a private equity group, a consolidator, a competitor?
  11. What should I do if I want to sell to my key managers? And is my company an ESOP candidate?
  12. What should I do if I want to sell to my children?
  13. Which of our key employees should we have non-compete agreements or retention bonus agreements with?
  14. What language should we have in our contracts with customers and suppliers to facilitate a change of ownership?
  15. What is considered high customer concentration in my industry and should I be taking steps now to diversify?
  16. What is considered good financial performance in my industry and how does my company compare?
  17. Should our financials be Audited or Reviewed? For how many years before the sale?
  18. Should we have a Quality of Earnings analysis done before going to market?
  19. In a sale, how does it matter if our liability insurance policy is claims made vs occurrence? What is tail insurance?
  20. Beyond money, what are my priorities and preferences in a sale?

For those seeking professional assistance, engaging an M&A advisory firm is a great way to set your business up for post-sale success. At Exit Strategies Group, we can estimate the probable selling price or fair market value of your business. We can evaluate your business for factors that are boosting or detracting from its value and marketability, and we can work with you to improve these factors over time. And when you are ready to sell, we can maximize your value and ensure a smooth and successful transition through our structured M&A sale process.

Al Statz is the founder and President of Exit Strategies Group, Inc. For further information on this subject or to discuss an M&A, exit planning or business valuation question or need, Email Al or call him at 707-781-8580. 

Questions to ask when hiring an M&A advisor

/in , /by Exit Strategies

When it comes time to sell your company, the right M&A firm or investment bank can make all the difference. From preparing a stellar offering memorandum, to running a well-organized process, to generating multiple offers, to negotiating the best possible deal for you, your advisor needs to bring the right mix of transactional skill, processes, resources, and chemistry to the table. This article presents several questions that you should be asking as you search for the right M&A advisor.  

Why do you want to represent my business?

  • In today’s market, a successful investment banker will turn away more opportunities than they accept. They need to know they’re a good fit for you and your business. And they need to be confident that they can successfully sell your business and meet your goals.  

What’s your fee structure?

  • M&A advisor fees usually vary with the size and complexity of the transaction. The 2022-2023 M&A Fee Guide from FIRMEX helps pull the curtain back on M&A fees, revealing what’s normal and customary for the industry.  
  • The bulk of the advisor’s fee should be earned as a success fee, when a deal closes. The most common success fee structure, used by 40% of survey respondents, was the Lehman formula in which the fee percentage decreases as the deal gets bigger. Roughly a third charge a fixed percentage, and 18% used an accelerator formula which gives the advisor a higher percentage on deals that exceed a benchmark price. According to the FIRMEX report, the most common fee for a $5 million deal is between 6.1 to 8%. For deals over $150 million, the most common fee is between 1.1% and 2%. 
  • Most investment bankers (81%) also charge an upfront retainer. According to the FIRMEX report, lump-sum retainer fees generally fall in the $26,000 to $50,000 range, while monthly fees fall between $5,000 to $10,000 a month.  
  • When evaluating advisors, consider whether their fees are similar to the above. If fees are significantly higher or lower, proceed with caution. The right fee arrangement aligns the advisor’s incentives with your own.  

What is your experience in selling businesses like mine?

  • Consider deal size and industry experience. Do they work on deals of similar size to yours?  Also, no advisor can be well-versed in every industry, but they may have partners with strong experience in your space. 

Who have you worked with in the past?

  • Ask to speak with a few past clients directly. Do they feel they got good value in exchange for the advisor’s fee? Was the advisor transparent and forthcoming with status updates? Did they do what they said they’d do? 

How many people will work on my deal?

  • An investment bank will typically have a team of people assisting with marketing, research, and managing the details of due diligence. Expect a mix of senior advisors with experience and contacts as well as more junior analysts to help manage the workload.  

How many other deals will you be representing?

  • Arguably, a lead advisor with a full team behind them could successfully represent four or five engagements at a time. Advisors with less junior staff generally handle two or three. Much beyond that, and they could lose focus or be unavailable to you at critical times.  

What is your success rate and why have deals failed in the past?

  • No investment bank closes every one of their transactions. There are many reasons deals fall apart, including unforeseen market changes, inaccurate business records, and shareholder conflicts, just to name a few. A successful advisor will be able to identify a lot of pitfalls ahead of time and may not take on higher risk deals. Asking this question can help you get a sense of how confident they are in their ability to sell your business, as well as how they handle bumps in the road.   

On average, how many offers do you get per deal?

  • You’re looking for an investment bank who can bring multiple buyers to the table at the same time. This creates an auction-like environment and gives you options to choose a buyer that’s the best fit for your goals. 

What’s your average over benchmark?

  • In the lower middle market, deals are marketed without a published asking price so as not to create an artificial ceiling on deal value. A benchmark is a private target price set between the seller and the advisor based on an objective assessment of the business and the market. An advisor who outperforms benchmark is doing the necessary work to obtain the maximum value the market will bear.  

How will you ensure the confidentiality of my business information?

  • Ask if you’ll be able to review marketing materials and buyer lists before information is released. Talk about other steps, including non-disclosure agreements, secure online deal rooms, buyer financial disclosures, and other tools that will be used to protect confidentiality and vet buyer inquiries throughout the sale process.  

Asking the above questions will help you gain a better understanding of an advisor’s qualifications, experience, and approach, and determine if they are the right fit for you. 

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

Market Pulse – Seller Market Sentiment

/in , /by Exit Strategies

Lower middle market M&A is experiencing a dip in seller market sentiment, marking the lowest levels seen since early in the pandemic and resembling figures observed during the recovery from the Great Recession.

In a seller’s market, buyers typically compete for deals, leading to increased values and more favorable deal terms for sellers. However, this recent slide in sentiment signifies a change in market dynamics, where sellers may still receive strong valuations, but buyers may look to shift more risk to the seller through earnouts, seller’s notes, and rollover equity.

About the Market Pulse Survey: Each quarter, the M&A Source and IBBA, in partnership with Pepperdine University’s Private Capital Markets Project, publish the results of a survey of North American lower middle market M&A advisors and business brokers, called the Market Pulse Survey.  For further information on market conditions or to discuss an M&A, exit planning or valuation question or need, Email Al Statz or call him at 707-781-8580. 

How ASC 842 (the lease reporting standard) Can Impact the Sale of Your Business

/in /by Adam Wiskind

What is ASC 842?

The Accounting Standards Update (ASU) 2016-02, commonly known as ASC 842, requires that all companies large and small that issue GAAP-based financials account for leases on their financial statements.  It was issued by the Financial Accounting Standards Board (FASB) in February 2016 and was effective January 1, 2022. ASC 842 significantly changes how companies account for leases on their financial statements and may impact the sale of your small business.

ASC 842 applies to both private and public companies that enter into lease agreements. The standard applies to all leases, including operating leases and finance leases, with certain exceptions such as short-term leases (leases with a term of 12 months or less) and leases of low-value assets (such as office furniture and equipment).

For companies with complex lease agreements, including operating leases for real estate, equipment, and other assets. The implementation of ASC 842 affects how these leases are reported on financial statements and can have a significant impact on a company’s financial metrics.

 

Impact on Due Diligence

One of the primary impacts of ASC 842 within a sale transaction is the increased complexity of due diligence. Under ASC 842, companies must report all leases on their balance sheet, including lease liabilities and right-of-use assets. This requires a detailed analysis of all lease agreements, including identification of lease terms and conditions, calculation of lease liabilities and right-of-use assets, and determination of lease classification. This diligence will likely be a focus of a buyer prospect and their advisors.

The lease assets and lease liabilities will not always be equal. Under ASC 842, the initial recognition of the lease liability is equal to the present value of the lease payments over the lease term, discounted using the interest rate implicit in the lease or the lessee’s incremental borrowing rate.  The lease asset under ASC 842, is the conveyed right to control the use of the identified property.  It is initially measured as the sum of the lease liability, any lease payments made at or before the commencement date, and any initial direct costs incurred by the lessee, such as leasehold improvements. Therefore, if the lessee makes any lease payments before the commencement date or incurs any initial direct costs, the lease asset will be greater than the lease liability.

Additionally, the lease liability may change over time due to various factors, such as changes in lease payments, modifications to the lease agreement, or reassessments of the lease term or discount rate. This could cause the lease asset and lease liability to differ at any given point in time.

This increased complexity can make due diligence more time-consuming and costly, especially for companies with a large number of lease agreements. As a result, buyers and sellers may need to engage additional accounting resources or expertise to ensure compliance with ASC 842 and accurately report lease obligations.

 

Impact on Valuation

Another impact of ASC 842 on a business sale transaction is the potential effect on valuation. ASC 842 brings previously off-balance sheet operating leases onto a company’s balance sheet.  By reporting all leases on the balance sheet, ASC 842 can impact a company’s financial metrics, such as debt-to-equity ratio and in some cases adjusted earnings metrics, like EBITDA.

Adjusted earnings could change based on the classification of a lease as an operating or finance lease.  Under an operating lease the company typically reports the entire expense as lease expense under SG&A.  Expense under a finance or capital lease consists of amortization and interest.  While reported income is relatively unaffected by this difference in treatment, the expense classification impacts adjusted earnings for valuation purposes because amortization and interest expense are typically “add-backs” and lease expense is not.  An example of how the classification of a lease can affect EBITDA can be found in this article: https://blog.netgain.tech/exploring-operating-vs.-finance-lease-journal-entries-and-amortization-calculations.

A lease classified as a financing rather than an operating lease will likely affect a company’s EBITDA, resulting in a change of value.  However, the difference in value would be offset to some extent in a business sale transaction where the liability incurred under the financing lease is considered a “debt-like item” and is paid off by the seller.

Ultimately, analysis will need to be completed on a case-by-case basis to understand the magnitude and direction of impact from ASC 842 on a company’s business value.

 

Impact on Deal Structure

ASC 842 may also impact the structure of your deal. For example, buyers may choose to structure the transaction as an asset purchase rather than a stock purchase to avoid assuming the seller’s lease liabilities. Alternatively, buyers may negotiate adjustments to the purchase price based on the impact of ASC 842 on the target company’s financial statements.

 

Conclusion

In conclusion, ASC 842 may have significant implications for the sale of your small business. The increased complexity of due diligence, potential effect on valuation, and impact on deal structure require careful consideration by both buyers and sellers. Companies with complex finance and capital leases should work with experienced accounting professionals to ensure compliance with ASC 842 and accurately report lease obligations. By doing so, they can help facilitate successful sale transactions and minimize the risk of unexpected financial impacts.

 

Adam Wiskind is not an accountant, but he can certainly refer you to a good one.  If you’d like to have a confidential, no commitment discussion on your exit plans or the sale of your business, please contact Adam Wiskind, Senior M&A Advisor at (707) 781-8744 or awiskind@exitstrategiesgroup.com.

Representation and Warranty Insurance in M&A

/in , , /by Exit Strategies

When selling your business, you make a set of promises to the buyer. You “represent and warrant” certain facts about the business. Essentially, you’re certifying that you provided accurate information and there are no known issues pending (e.g., financial, legal, tax, compliance, etc.).

 

If it turns out those promises are false, the buyer has the right to recoup a percentage of the purchase price. Non-fundamental reps and warranties (typically all items aside from key ownership, legal, and tax items) typically allows the buyer to recoup up to 10-50% (a “cap”) of the transaction if there is a material breach.

 

At current trends, businesses over $20-$25 million often require an escrow to help fund any breaches in reps & warranties. Smaller transactions, however, will often offset against a seller note or earnout.

 

On a $20-25 million deal, escrow amounts can commonly be 10-20% of the purchase price, held for a period of 18 – 24 months. On a $30 million deal, for example, the seller might have to delay receiving $3-$6 million of the purchase price until the reps and warranty period has expired.

 

Representation and warranty insurance offers an alternative to seller escrow. This insurance product is designed to isolate risk and the resulting claims between buyer and seller in the event of a non-fundamental breach in reps and warranties. (Note: Reps and warranty insurance will not cover fraud and intentional misrepresentation.)

 

Pros and cons of reps and warranty insurance 

For the seller, the advantage of reps and warranty insurance is that they can realize the full value of their purchase price, without holding money in escrow. For many sellers, the holding cost of that money is enough to justify the cost. It also reduces seller risk, for inadvertent, unknown mistakes.

 

For the buyer, reps and warranty insurance offers a way to collect a claim without jeopardizing their relationship with the seller. Consider a buyer who wants to do multiple deals in the industry. They want the seller to provide a positive referral in the future, encouraging other sellers to work with them.

 

Similarly, consider a buyer who has retained the seller in a leadership position. They don’t really want to make an expensive claim against their new CEO or sales director. Having reps and warranty insurance protects any ongoing buyer/seller relationship.

 

Reps and warranty insurance can also expedite the sale process and drive down your legal fees. When sellers know they’re indemnified against certain risks, they don’t have to lobby as hard to protect themselves. To put it simply, negotiations are easier with insurance in place. Conversely, this insurance product requires third party due diligence which can slow the overall process.

 

What does it cost and who pays?  

Reps and warranty insurance can be purchased by the buyer or seller. Minimum fees are typically $250,000, which makes this product cost prohibitive on smaller transactions. In a competitive market, some buyers will offer to pay or split the cost of reps and warranty insurance with the seller as a way to sweeten their offer.

 

Sellers need to have adequate representation looking out for their interests. Watch out for exclusions that are overly broad (e.g., an ‘impact of covid’ exclusion) or non-standard for the market.

 

Be aware that the policy will have a retention figure (like a deductible) – often around 1% of enterprise value. Who covers that retention is another point that needs to be negotiated in your deal terms. Again, we might see a 50/50 split here. So on a $30 million deal, the seller may have to escrow 0.5% or $150,000 (far less than the $3-$6 million escrow estimated above.)

 

Considerations and alternatives  

Reps and warranty insurance is a newer product on lower middle market deals in the US. Since it’s a relatively young offering, it’s harder for buyers to vet insurance brokers as the track record for payout is not well established. (In other words, the buyer may have a policy, but can they actually collect on it? And what legal fees will they incur in order to collect?)

 

In cases where buyers are looking for a mechanism to collect without the overhead cost, other options may be more appropriate. For example, if the deal terms include a sellers note, the buyer may prefer to offset a sellers note proportionally to any breach.

 

Again, sellers should consider that reps and warranty insurance reduces their risk. They may wish to consider that when evaluating buyers and may give some preference to buyers who accept a lower cap (the max amount they can come back for in the event of a breach) or who are willing to cover all or a portion of reps and warranty costs.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

Selling your business should not be a 50/50 coin flip

/in , /by Exit Strategies

So, you’re ready to sell your business. You have an M&A advisor helping you, your numbers are in order, and you’re feeling confident. But did you know that only half of businesses will successfully sell—and that’s with a qualified advisor?

For years, member advisors of the International Business Brokers Association and the M&A Source have been reporting their quarterly closing rates in the Market Pulse Report. Every quarter, roughly 50% of deals terminate without a successful sale. And these are professionals who invest in their craft and their career.

In fact, analysts estimate the actual closing rate for small and medium businesses is closer to 25-30%. That number includes business owners who try to sell on their own as well as those who list with real estate agents, lawyers, and other “hobbyist” M&A advisors.

What makes the failure rate so high? Advisors in the Q4 2022 Market Pulse Report were asked to share why their deals failed. Here’s a breakdown by sector:

 

Main Street failures due to financials and financing  

In the Main Street market, that is businesses valued at less than $2 million, poor financials and financing problems were the leading reasons companies didn’t sell.

There are any number of reasons a business isn’t performing well, and many factors (like economic swings, bubbles, and pandemics) are outside an owner’s control. But some sellers hold on too long, waiting until they’re burned out or the business has evolved past their skill set.

Generally, you’ll get the best value for your business when you go out on a growth trend. Once a business is on a downward slide, it gets harder (and sometimes impossible) to sell.

As for financing the Main Street market, banks generally prefer to lend off hard assets, not cash flow, and individual buyers can struggle to raise the capital they need. That can leave a bit of a no man’s land at the upper end of the market, unless the deal qualifies for an SBA loan.

A small business is a lifestyle operation for many owners, generating a sufficient income. Meanwhile, many buyers in this market are looking to “buy a job.” But at a certain scale, the business doesn’t generate enough profit for the buyer to both earn a living and pay debt service. These deals are tough to get done.

 

Unrealistic expectations plague lower middle market  

In the lower middle market, where businesses are valued between $2 million and $50 million, seller expectations become the bigger concern. In these situations, the seller believes their business is worth more than the market will bear. When the advisor can’t deliver on those lofty goals, the engagement terminates.

In an ideal world, advisors wouldn’t even take these deals. You can do a lot of harm by testing the market with unrealistic expectations. You can burn through buyers, risk confidentiality, and weaken your own drive to keep the business performing.

The market ultimately determines the value, not what you want or need out of the business. It’s important to trust your advisor and the process they’re running. If they’re reaching a large pool of capable buyers, then you probably have a true reflection of the demand for, and value of, your business.

 

Economic uncertainty played a role 

For Main Street and the lower middle market together, advisors reported that economic uncertainty was the second leading cause of deal failure. Just five or six months ago inflation was rising, and economists were warning of a recession in 2023. (Now they’re predicting a “shallow” downturn in 2024.)

When there’s uncertainty in the market, deals get shaky. If it’s a perfect business, the transaction still gets done. But if there’s any hair on it, lending can be a problem. Equity shortfalls can trigger a price adjustment and bad feelings follow. Other times, buyers simply hit the pause button while they wait to see what the economy will do.

 

Plan ahead to avoid pitfalls 

It’s important to understand why businesses fail to sell. Poor financials, financing, risk conditions, delays, and unrealistic expectations all play a role.

Business owners should get a regular estimate of value so they know what their business is worth and how to increase that value in a future sale. Advance planning can help you make informed decisions and put your business in the best position for success.

Remember, deals can fall apart for any number of reasons, and market conditions can change rapidly. But with the right mindset, preparation, and advisor, you can find yourself on the right side of that 50/50 statistic.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.