VALUING YOUR BUSINESSStrategies to Maximize the Sale Price

John Wiley & Sons, Inc.

Frederick D. Lipman

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VALUING YOUR BUSINESS

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Also by Frederick D. Lipman

The Complete Going Public Handbook

The Complete Guide to Employee Stock Options

Financing Your Business with Venture Capital

Audit Committees

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VALUING YOUR BUSINESSStrategies to Maximize the Sale Price

John Wiley & Sons, Inc.

Frederick D. Lipman

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Copyright © 2005 by Frederick D. Lipman. All rights reserved

Published by John Wiley & Sons, Inc., Hoboken, New JerseyPublished simultaneously in Canada

No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, 222 RosewoodDrive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web atwww.copyright.com. Requests to the Publisher for permission should be addressed to the Per-missions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008.

“Caution Talks: Texaco-Pennzoil Case Makes Firms Careful About Merger Moves,” appearedon April 15, 1986, in the Wall Street Journal. Article reprinted by permission of the WallStreet Journal, © 1986 Dow Jones & Company Inc. All Rights Reserved Worldwide.

“The Gambler Who Refused $2 Billion,” May 11, 1987, by Stratford P. Sherman, reprintedwith permission from Fortune magazine. © 1987 Time Inc. All rights reserved.

Limit of Liability/Disclaimer of Warranty: While the publisher and the author have used theirbest efforts in preparing this book, they make no representations or warranties with respect tothe accuracy or completeness of the contents of this book and specifically disclaim any im-plied warranties of merchantability or fitness for a particular purpose. No warranty may becreated or extended by sales representatives or written sales materials. The advice and strate-gies contained herein may not be suitable for your situation. You should consult with a profes-sional where appropriate. Neither the publisher nor the author shall be liable for any loss ofprofit or any other commercial damages, including but not limited to special, incidental, con-sequential, or other damages.

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Library of Congress Cataloging-in-Publication Data:

Lipman, Frederick D.Valuing your business : strategies to maximize the sale price /

Frederick D. Lipman.p. cm.

Includes index.ISBN-13 978-0-471-71454-5ISBN-10 0-471-71454-2 (cloth)1. Business enterprises—Valuation. 2. Sale of business enterprises

I. Title.HG4028.V3L56 2005658.15—dc22 2005002640

Printed in the United States of America10 9 8 7 6 5 4 3 2 1

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www.wiley.com

To my grandson,Tyler Keith Lipman

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Contents

ACKNOWLEDGMENTS xiINTRODUCTION xiii

PART I Advance Planning

CHAPTER 1 PRELIMINARY CONSIDERATIONS 3

CHAPTER 2 MAXIMIZING THE SALE PRICE 9

CHAPTER 3 ELIMINATING DEAL KILLERS AND IMPEDIMENTS 31

CHAPTER 4 PROTECTING YOUR BUSINESS 38

CHAPTER 5 PERSONAL CONSIDERATIONS 45

CHAPTER 6 MARKETING YOUR BUSINESS 51

PART II Preliminary Negotiations

CHAPTER 7 SURVIVING THE BUYER’S DUE DILIGENCE 61

CHAPTER 8 AVOIDING NEGOTIATIONS TRAPS 68

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CHAPTER 9 LETTERS OF INTENT: A RECIPE FOR LITIGATION 77

PART III The Sale Process

CHAPTER 10 STRUCTURING YOUR TRANSACTION 95

CHAPTER 11 THINK AFTER TAXES: CASH FLOW TO YOU 102

CHAPTER 12 SELLING TO A PUBLIC COMPANY 112

CHAPTER 13 SELLING A PUBLICLY HELD COMPANY OR ACONTROL BLOCK 118

CHAPTER 14 SELLING TO YOUR OWN EMPLOYEES OR TO AN ESOP 121

PART IV Sale Terms

CHAPTER 15 DEFERRED PURCHASE PRICE PAYMENTS: HOW TOBECOME THE BUYER’S BANKER 131

CHAPTER 16 EARNOUTS: ANOTHER LITIGATION RECIPE 138

CHAPTER 17 NEGOTIATING EMPLOYMENT AND CONSULTINGAGREEMENTS 144

CHAPTER 18 AVOIDING TRAPS IN THE AGREEMENT OF SALE 149

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PART VAlternatives to Selling Your Business

CHAPTER 19 LEVERAGED RECAPITALIZATION 173

CHAPTER 20 GOING PUBLIC 178

CHAPTER 21 VALUING INTERNET BUSINESS 189

PART VIAppendixes

1. SELECTED SALES OF BUSINESSES WITH SALE PRICESFROM $10 MILLION TO $1 BILLION 207

2. SELECTED SALES OF BUSINESSES WITH SALE PRICESFROM $1 MILLION TO $10 MILLION 219

3. SELECTED RECENT SALES OF BUSINESSES WITH SALEPRICES FROM $500,000 TO $1 MILLION 241

4. SAMPLE CONFIDENTIALITY AGREEMENT 264

5. SAMPLE STANDSTILL AGREEMENTS 268

6. SAMPLE LETTER OF INTENT 269

7. SAMPLE AGREEMENT TO SELL ASSETS FOR CASH 271

8. SAMPLE AGREEMENT AND PLAN OF MERGER 302

INDEX 321

C O N T E N T S i x

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Acknowledgments

I want to acknowledge the helpful comments and editorial efforts ofmy partners at the Philadelphia office of the law firm of Blank RomeLLP: Chapters 1 and 2: Fred Blume, Esq.; Chapters 3, 4, and Appen-dix 4: Alan L. Zeiger, Esq.; Chapter 5: Lawrence S. Chane, Esq. andHenry M. Kuller, Esq.; Chapter 10: Robert M. Broder, Esq.; Chapters11 and 14: Joseph T. Gulant, Esq.; Chapter 14: Arthur Bachman, Esq.;Chapters 15 and 16: Steven Dubow, Esq.; Chapter 18: Francis E.Dehel, Esq., Edward J. Hoffman, Esq., and Jennifer Hale Eagland,Esq.; Chapter 19: Harvey I. Forman, Esq. and Lawrence F. Flick, II,Esq.

I absolve the editors from any responsibility for any errors in thisbook.

Helpful suggestions for this book were made by Seth Lehr of LLREquity Partners L.P. and my partner Fred Blume.

Jim Twerdahl, chairman and chief executive officer of Mayco Col-ors, Inc. was kind enough to permit me to use portions of his com-prehensive buyer’s due diligence checklist in Chapter 7.

Ken Patton and Matt Crow of Mercer Capital Management Inc.(Memphis, Tennessee, Web site www.mercercapital.com) share theirwisdom on valuing Internet businesses in Chapter 21.

Last but not least, I owe a special debt to my secretary, BarbaraHelverson, who typed the updated manuscript.

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Introduction

This book is intended for entrepreneurs who want to fully under-stand how to maximize the valuation and ultimate sale price of theirbusiness. This process requires careful advanced planning, whichshould begin as early as five years before your target sale date. Evenif your exit date is less than five years from now, this book will enableyou in the time remaining to accelerate the maximization of your val-uation and help you avoid traps that can reduce the sale proceedsyou receive.

Inexperienced business owners may think that it is simple to selltheir businesses. They think they can just let it be known that thebusiness is for sale, receive offers, sign legal documents, cash thebuyer’s check, and then golf for the rest of their lives.

Only one in ten business sales occurs this smoothly. The remain-ing nine out of ten may be plagued with at least one of the followingproblems, which can reduce, if not destroy, the value of your busi-ness:

• Key employees leave when you announce your decision to sell,taking important customers with them.

• Overvaluing your business can mean that it takes so long tofind a buyer that new, well-financed competitors have time toestablish themselves before your sale, thereby lowering thevalue of your business.

• Customers find out about your pending sale and seek out yourcompetitors.

• Competitors find out about your pending sale and use this in-formation to win away existing and potential customers.

• Suppliers who are important to your business start selling toyour competitors when they realize that your business will besold.

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• In the course of their due diligence investigation, potentialbuyers discover your proprietary information and use it to starta competitive business.

• You and your top executives spend so much time involved withthe sale process that the business itself begins to go downhill.

• Income taxes can consume more than 50 percent of the pro-ceeds from the sale of your business.

• You are the trustee of family trusts that own shares in your com-pany, and your children, who are the beneficiaries, hire theirown lawyers in an effort to maximize their share of the saleprice.

• Your spouse, anticipating the sale proceeds, decides to divorceyou and hires the most aggressive lawyer in town to maximizehis or her share.

Selling your business is an exit strategy and a method of diversify-ing your assets. Because most businesspeople have the overwhelmingpercentage of their net worth tied up in their businesses, a sale per-mits them to diversify their asset portfolios and avoid the risk of busi-ness failure.

Most business owners have little experience in the actual sale of abusiness, however. The skills that permit entrepreneurs to grow abusiness are not necessarily the skills that would permit them to sellthe business successfully. There are also many costly traps for thenovice seller.

The six stages of selling your business are described in Table I.1.The key to maximizing the sale price of your business is careful

advance planning, which starts many years before your target saledate. The advance planning steps taken over a five-year period arediscussed in detail in Chapters 1 through 6. These steps start withstage 1 and end with stage 3. The purpose of these steps is to enhancethe value of your business and its appeal to potential buyers.

Chapter 1 focuses on your motives for selling, which must guidethe entire sale process, including your negotiation strategy. Unlessyou are experienced in selling businesses, you must also assemble aprofessional team of advisers in advance of the sale. Chapter 1 tellsyou how.

You must understand how your business will be valued so that you

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can maximize your sale price through steps taken prior to the sale.Those subjects are covered in Chapter 2.

During the presale years, you must identify and eliminate dealkillers and other impediments to the sale. The elimination of dealkillers may take many years to accomplish, and consequently, youcannot begin too soon. Chapter 3 discusses these issues.

You also must give careful advance thought to how you will pro-tect your business during the sale. This includes maintaining confi-dentiality of both your decision to sell and your proprietaryinformation. It is important that your key employees, customers, andsuppliers do not become privy to this information earlier than neces-sary and that you do not inadvertently give potential buyers valuableproprietary information about your business. Chapter 4 tells youwhat you must do years before your target sale date to protect yourbusiness and proprietary information during the sale process.

Finally, you must take steps prior to the sale to minimize the taxeson the sale proceeds, including estate and death taxes, as well as fed-eral and state income taxes. This is discussed in Chapter 5.

Businesses do not sell themselves. You must market your businessand understand the motivations of buyers. You would not launch anew product line without careful study of the marketplace and a de-tailed knowledge of your customers’ needs. This study might take sev-eral years. The same careful study must be done prior to themarketing of your business. Chapter 6 tells you how to plan for themarketing of your business and discusses the pros and cons of usingan investment banker or business broker. Chapters 5 and 6 describestage 3 and prepare you for stage 4, the actual marketing of the busi-ness and the negotiations with the buyer, which are covered in Chap-ters 7 through 9.

Chapter 7 explains how to survive the buyer’s due diligenceprocess.

Chapter 8 provides a negotiation strategy for sellers, includingthe use of auctions to maximize the sale price.

Chapter 9 covers letters of intent, which may be more bindingthan you think.

Chapters 10 and 11 cover the structuring and tax issues to whichyou must be sensitive and teach you to think in “after-tax” terms.

If you are selling to a public-company buyer, Chapter 12 is essen-tial.

Chapter 13 explains the special problems of selling a public com-

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pany. The sale of a control block of stock in either a public or a pri-vate company is also discussed.

Some entrepreneurs would prefer to sell their business to theirkey employees. Chapter 14 tells you how and explains the surprisingtax benefits of selling to an ESOP (employee stock ownership plan).

Chapters 15 and 16 deal with notes and earnouts and the trapsinherent to accepting these deferred payouts of the sale price.

Chapter 17 advises you on how to negotiate your employment orconsulting agreement with the buyer.

The traps in the agreement of sale and closing (stage 6) are cov-ered in Chapter 18.

Chapters 19 and 20 discuss two possible alternatives to sellingyour business: leveraged recapitalization and going public. Althoughneither alternative is possible for all businesses, it is important to un-derstand these alternative exit strategies and their pros and cons.

Chapter 21 discusses the specific valuation problems in valuingInternet businesses after the meltdown of this industry in the year2000. This chapter was written by Ken Patton and Matt Crow of Mer-cer Capital Management Inc., located in Memphis, Tennessee,(www.mercercapital.com).

The keys to a successful sale of your business are careful advanceplanning and a clear understanding of your motivations for the sale.Your motivations will dictate the manner in which you conduct thesale, your strategies for negotiation, and which alternatives you willconsider. For example, if you believe that your business is goingdownhill, you may wish to promote a fast sale and price your businessaccordingly. You also might instruct your attorney to take somewhathigher legal risks in order to avoid delaying or interfering with aprompt sale.

A clear understanding of your motivations also will prevent youfrom suffering from seller’s remorse or will at least alleviate the symp-toms—and a substantial bank account always helps.

This book is intended to guide you through the sale process andaround the traps inherent in that process. Every effort has been madeto ensure that all information contained in this book is current as ofJanuary 2005. However, there is no substitute for an experienced pro-fessional team of advisers, including a tax attorney, who should alwaysbe consulted to ensure that current statutes of the law and account-ing principles are met in each specific circumstance. This book willhelp you pick such advisers.

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VALUING YOUR BUSINESS

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ADVANCEPLANNING

P A R T I

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PRELIMINARYCONSIDERATIONS

Selling a business is a complicated, time-consuming, and at times,emotional experience. You should give consideration to all ofthe following factors before seriously embarking upon the saleprocess.

UNDERSTANDING YOUR MOTIVES

It is important that you understand your motivation for selling yourbusiness. Your motivation will dictate the nature of your buyer andthe structure of your transaction.

For example, if you are no longer interested in operating yourbusiness, you do not want to sell to a financial buyer or to have anearnout. An earnout is a provision in the agreement of sale thatwould measure the purchase price in whole or in part by the futureprofits of the business.

A financial buyer will typically not have the management in placeto run your business and will expect you to remain to operate thebusiness under a long-term employment or consulting agreement.You would not want to agree to an earnout unless you are in controlof the business because otherwise, your final purchase price could besignificantly reduced by poor performance of the managers installedby the buyer.

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Understanding your motives to sell your business also helps youavoid what is called “seller’s remorse.” In general, seller’s remorse re-sults from the significant change in lifestyle that the sale of your busi-ness can bring, together with the emotional attachments that youhave toward the business. Truly understanding your motivation willhelp you get through a very natural period of doubt and uncertaintyconcerning the wisdom of selling your business.

The following are some typical reasons for selling, which are usu-ally a mix of personal and business:

• You are tired of working so hard and are ready to retire.• You have no children who are interested in taking over the

business.• You have children who want to take over the business, but they

are not competent to operate it.• New competitors are moving into your business area, and you

do not have the capital with which to fight them.• You would like to have enough money in the bank so that you

can support your lifestyle for the rest of your life.• You need more capital resources than you can acquire to grow

the business.• Your business is going downhill, and you would prefer to sell it

before it reaches the bottom.• You were just divorced, and you retained the second-best

lawyer in town. Unfortunately, your ex-spouse retained the bestlawyer in town, and you owe your ex-spouse a huge amount ofmoney.

• Your partner just died, and you do not have enough life insur-ance to buy out your partner’s family as required by your share-holder agreement.

• You just died, and you did not maintain enough life insuranceto pay death and inheritance taxes.

The preceding are only the major motivations; many other rea-sons may exist. At the beginning of the decision to sell your business,you may have one set of motivations and by the time the process isthrough, you may have dropped those motivations or added newones.

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What is important, however, is that you fully understand your mo-tivations to sell your business and that you allow those motivations tocontinually guide the logic of your sale.

ASSEMBLING YOUR PROFESSIONAL TEAM

Your first step should be to assemble an outstanding professionalteam to advise you.

Most businesspersons select their professional team on the eve oftheir sale. This is far too late in the sale process. By selecting your pro-fessional team several years before the target date for your sale, youcan obtain their guidance in the presale years as to methods of mini-mizing the obstacles. Your professional team will help implement theadvance planning recommendations contained in Chapters 2through 6.

M&A Attorney

The first person on your team should be an attorney specializing inmergers and acquisitions, an M&A attorney. This person might notbe your regular attorney, who may be inexperienced in this area. Youmust carefully interview your attorney to learn about his or her ex-pertise. Ask your attorney how many mergers and acquisitions he orshe has handled in the last three years and what size businesses theywere.

If a public company is a potential buyer, does your attorney havesecurities law experience? Has your attorney ever handled the sale toa public company where stock was part of the purchase price consid-eration?

If you do not get favorable answers from your personal attorney,look elsewhere. Most large corporate law firms maintain groups of at-torneys who specialize in M&A. Select someone who not only is wellexperienced in M&A but also has good business sense and is some-one with whom you have a good rapport.

The requirement that your attorney have good business sensecannot be overemphasized. You will need to make delicate trade-offsduring negotiations, which require business and legal judgment fromyour lawyer. You need a lawyer who thinks like a businessperson butalso has the necessary legal skills to protect you. It is a mistake to hire

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a lawyer who is a good scrivener but cannot properly translate legalrisks into business risks and assist you in evaluating their importance.

During the sale negotiation, it is not unusual to instruct your at-torney to play “bad cop” while you play “good cop.” The good cop–bad cop negotiation strategy helps insulate you from the angry emo-tions of the buyer. This is particularly helpful if you expect to workfor the buyer, but is also useful if you want to maintain a distancefrom the give-and-take of the bargaining. Be certain that your M&Aattorney can play the bad cop role but also knows when to stop play-ing it.

Be wary of attorneys recommended to you by an investmentbanker or business broker involved in your sale. These attorneys maybe experienced in M&A, but they also may feel beholden to the per-son who recommended them. Carefully interview such attorneys todetermine if they are sufficiently independent that they could rec-ommend that you (1) terminate the investment banker or businessbroker or (2) not proceed with an agreement of sale that is againstyour interests but would result in a fee to the recommending invest-ment banker or business broker.

Tax Attorney

In addition to an M&A attorney, you will need a tax attorney. This istrue even if you have a good tax accountant. Unless the tax conse-quences of your sale are simple (which you cannot know in advanceof its structuring), you will want to double-check any tax advice youreceive with a second tax professional. Tax attorneys and tax ac-countants sometimes approach tax issues differently, and you shouldsolicit the views of both.

If your business is a C corporation for federal income tax pur-poses, one of the first questions to ask your tax consultant is what thetax consequences would be of changing to an S corporation. Thereare serious tax disadvantages to selling a C corporation, which are dis-cussed in Chapter 11.

It is worthwhile to weigh the costs of changing to an S corpora-tion five years prior to your sale target date versus staying a C corpo-ration for the same five years and suffering the adverse taxconsequences when you sell. This, of course, does not necessarilyapply if you have a C corporation that is qualified under Section 1202of the Internal Revenue Code, which is discussed more fully in Chap-ter 11 under the heading Fifty Percent Exclusion.

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Accountant

It is generally not necessary to select a new accountant in order to sellyour business. Most accountants can perform this task.

Some business owners use their accountant to negotiate the busi-ness terms of the sale. Caution should be exercised in doing this. In-quire how many sales transactions your accountant has previouslynegotiated, as well as their size and complexity. Discreetly inquirefrom other clients of your accountant as to whether they were satis-fied. You must be discreet, because you do not want to announce tothe world your decision to sell your business.

Your accountant and your personal attorney may be losing a sig-nificant portion of their revenues if your business is sold. Be sensitiveas to how important your fees are to them.

WARNING Be careful in using any accountants or lawyerswith an economic interest in killing your sale. Have a heart-to-heart talk with them before engaging them, and, in case ofdoubt, look elsewhere.

Investment Banker or Business Broker

As early as five years before your sale target date, you should considerobtaining advice from an investment banker or business broker. Theadvice should primarily cover the following areas:

• an estimated value of your business as it currently exists andthe factors that affect that value (see Chapter 2)

• the likely buyers for a business such as yours

You should seek this advice even if you intend to sell the businessyourself and do not expect to retain an investment banker or busi-ness broker.

The purpose of this advice is to help guide you in the growth anddevelopment of the business during the years prior to the sale targetdate. If negative factors about your business are identified by the in-vestment banker or business broker, you should take steps to elimi-nate them to the extent possible.

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For example, if you are advised that you have a weak manage-ment team, you should consider strengthening your managementstructure during the years prior to sale. Likewise, if you are advisedthat your overdependence on a single customer will materially re-duce your ultimate sale price, you can make efforts to diversify yourcustomer base in the years prior to sale.

The investment banker or business broker you select as an advi-sor need not necessarily be the same one you choose to sell your busi-ness (see Chapter 6). You should select your investment banker orbusiness broker based upon their familiarity with your industry andthe quality of their advice.

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