You’ve probably heard the conventional wisdom: you need an exit strategy as soon as you start your business. This rings true across industries. When embarking on the long and complex process of selling your business, there are several considerations, not the least of which is value. Sellers want the highest possible price for their business. How do they accomplish this?

The first in a four-part series on mergers and acquisitions, this article will discuss a few considerations for a successful exit strategy.

Valuation: Getting the Best Price

Starting with the End in Mind

Unfavorable investor terms have a way of coming back to haunt founders when they decide to sell a company. So, before taking the first, highest, or seemingly best offer, scrutinize the terms of the agreement to ensure it is favorable to you not just now, but down the road. What will it require of you? Does it leave you in a sub-optimal position as compared to your investors? If so, can you stomach the terms? Are they fair?

Cleaning up the Mess

Buyers will look for as many items as possible to allocate risk and/or reduce the price they are willing to pay. Even before starting due diligence, take time to iron out any system issues in your business. All founders, even those who take the time to build a business upon a strong foundation, will face some level of mess to clean up before selling. One simple way to do this is to keep your corporate and financial documents in good order as you grow your company. A particular item that trips up many business owners is cash vs. accrual-based accounting. Most small businesses use a cash basis, but many buyers (particularly PE firms) will require an accrual-based view. This is, frankly, a huge pain in the neck and every business owner with an eye to selling should be ready for it.

Cultivating Competition

The first potential buyer may not offer the highest value. Rather than lunging at your first choice, consider engaging an experienced investment banker to help you gather and evaluate options. Investment bankers can be valuable partners in the exit process, as they bring knowledge of potential buyers as well as experience in structuring and negotiating deals. They can often leverage this experience to get you more money and/or a deal with more favorable terms by running a process to increase the number of potential buyers and create a bid situation.

Looking Beyond Valuation

Ask yourself whether your sole goal is to get the highest price. Each deal carries different circumstances. Especially in deals where the seller will continue to operate the business, the terms of the deal matter. We will discuss rollover equity and earn-outs in a subsequent article, but for now, be aware of the possibilities that can stem from taking a deal that looks shiny but causes headaches later.

Considering the Best Deal Structure

There are different ways to structure a deal, but the two primary options are stock purchases and asset purchases. A stock purchase involves buying all of the company’s stock, which means the buyer purchases the stock from the owners of the target company, with all of the company’s assets and liabilities. Conversely, in an asset purchase, the buyer purchases the assets from the business (not from the owners). In an asset deal, the buyer purchases most or all of the assets of a business, tangible or intangible, and leaves most or all of the liabilities with the business.

Sellers generally prefer stock purchase agreements because the tax effects are usually gentler. The seller may be eligible for QSBS (Qualified Small Business Stock) treatment, and the liabilities of the company go to the buyer. However, the buyer generally doesn’t want to deal with the unknown liabilities they would inherit in a stock deal. Conversely, asset purchase agreements are generally preferable to buyers because they typically want all assets and no liabilities, and an asset structure often results in better tax results for the buyer.

In some cases, buyers can get a stock acquisition treated as an asset acquisition for federal income tax purposes. This is called a 338 election, a tool that can be useful when a buyer has a business reason to acquire stock rather than assets, for instance, if they have an issue reassigning licenses or permits but still want to reap the tax benefits of an asset acquisition.

Other Considerations

Entity Type

More specifically, what do sellers and buyers need to take into account when the target company is an S corporation versus an LLC or a C corporation? The most important consideration is the tax effect on the parties when the company being acquired is a passthrough entity (like an LLC or S corporation) or a C corporation, where the owners are subject to double taxation. These tax effects will change when the deal is a stock purchase versus an asset purchase. These are complex issues that require personalized, tailored advice, so it’s vital to consult a tax advisor before proceeding.

Necessary Board and Stockholder Approval

What is the general rule for who needs to approve the acquisition or sale? How does the general rule change if you’ve previously taken outside investment? In most cases, investors have veto rights over the sale of the company or its assets. You can spare yourself significant headaches by ironing out these issues before proceeding with the sale.

Entrepreneurship through Acquisition (ETA)

This applies largely to the buyer side: Entrepreneurship through Acquisition (“ETA”) is a buzzword now, but really all it does is describe something that happens frequently in business acquisitions. Many business people embark on their entrepreneurial journeys not by building something from the ground-up, but by buying and growing an existing business. It is a great option for business people who want to keep their risk low by buying into a product or service that the market has already tested. The concept is further explained in a book called Buy Then Build by Walker Deibel, for those who want to learn more.

Tools for Founders

To learn more about business acquisition and all issues related to it, you can visit our blog, check out our video series, or download the New Business Blueprint.

Headquartered in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in the Triangle, throughout the Southeast and in Silicon Valley / San Francisco. We also represent venture capital funds and other investors who invest in companies throughout the U.S. The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.