Entrepreneurship is frequently defined as “starting” or “developing” a business venture or idea. While many entrepreneurs do start a business from “scratch,” others purchase a going concern or selectively buy assets that can enhance their own opportunities to grow. Growing through acquisition—which frequently makes financial headlines—is not just for publicly traded, high profile companies. Medium and small firms can use acquisitions to implement strategic objectives and build their business. Acquisitions may make strategic sense
- To jump start entry into a new product line
- To access or expand a customer base or distribution channels
- To acquire technology or expertise
- To facilitate entry into a new geography
- To increase sales or reduce costs
The recent economic downturn has had the effect of making many respected and well-run firms take a look at core competencies and shed assets or divisions that no longer “make sense” for their business model. Such divestitures create opportunities for entrepreneurs willing to devote the time and attention necessary to maximize value. Even in the best of times, business founders frequently look for opportunities to “cash out.” Acquiring businesses from the folks who built them—frequently with the opportunity to tap the experience and talent of the founders as part of a well-planned transition—gives entrepreneurs a competitive and strategic advantage in the market. Moreover, increased access to both private and government funding allows even small and mid-size firms to take advantage of growing through acquisition.
Acquiring a business is an important decision. Not only does the purchaser risk losing his investment, undisclosed and unanticipated liabilities might affect the bottom line for years to come. However, with planning and counsel, purchasers can avoid many of the pitfalls associated with an acquisition. Some important steps to consider:
Assemble A Team
Business acquisition is not a “do-it-yourself” venture. Even an experienced manager may need qualified experts to help make a strategic decision about the value of the business and whether it meets his needs.
A fundamental understanding of the financial infrastructure of the business being purchased is critical. An accountant can be instrumental in helping to understand the financial health of the business and in navigating the tax implications of the transaction.
Transactional attorneys skilled in the purchase and sale of businesses of comparable size can assist in identifying and reducing risks. Attorneys can assist in negotiating the purchase; identifying and evaluating critical issues; and drafting the operative documents. In transactions with post-closing obligations—such as subsequent payments to the seller or non-competition agreements—knowledgeable counsel can assist in assuring that the buyer realizes the value in his purchase.
When financing an acquisition through debt, early contact with the lender is important to understand the availability of funds and the terms and conditions that will apply. Careful review of loan and financing agreements will eliminate the risks of hidden fees and provide a clear understanding of any other financial obligations.
Retaining a business broker or consultant may also be of great assistance when valuing a possible acquisition target. Valuing a business can depend on a number of factors including sale prices of comparable businesses; the industry in which the business operates; and estimated growth. Access to a broker or consultant—particularly during the process of valuing the business—can avoid “buyer’s remorse” if you believe you have overpaid.
Depending on the type of business, other expertise may be beneficial. For example, if the business has trademarks, service marks or patents, intellectual property counsel is advisable. If real estate is part of the transaction, the team may include inspectors and environmental engineers.
Decide On Assets or Stock
One of the early decisions in the acquisition process is the decision whether to purchase the equity of the business or the assets. The decision on how to structure the transaction has a significant impact on how the transaction is taxed; what liabilities are assumed; and whether the contracts of the business continue in effect after the transaction. While purchasers frequently prefer an asset sale where they can select the specific assets they wish to acquire, the decision on the form of the transaction should be made with an understanding of the business as a whole, including the potential reaction on suppliers and customers.
Decide On Your Purchase Price
The final price that is paid for a business is usually result of a negotiation process. Nonetheless, buyers should have a good sense of how to value the business and how much they are willing to spend to acquire it.
The price of a business usually consists of a base price and a number of “adjustments” that are made to reflect the changes to the base price.
There are a number of ways of determining the base price. One of the most common is a price equal to a multiple of sales or income. For example, a business whose annual in income is $3 million dollars might carry a multiple of 5 in one industry for a total sale price of $15 million, but carry a multiple 8 in another industry, with a resulting sale price of $24 million. In some industries, sale price is a function not of income but of other parameters—such as customer acquisition or profit. Multiples are also dependent on economic conditions—both in general and in specific industry. Whatever the process, a consideration of recent multiples used in valuing comparable businesses provides an external validation that the business being acquired has as much value to the market as to the individual purchaser.
Engage in “Due Diligence”
Due diligence is the investigation undertaken by the buyer prior to purchasing a business. Frequently buyers will not be allowed to engage in due diligence until they have executed a Non-Disclosure Agreement. The Non-Disclosure Agreement (NDA) obligates the buyer to maintain the confidentiality of any information that he receives from the seller as part of the due diligence process. Due diligence provides the buyer with an opportunity to better understand—and appraise—the business that is being purchased. The scope of due diligence varies widely and is sometimes the subject of negotiation between the buyer and seller. Some important areas of inquiry include:
- Identification of key assets and assessment of their condition
- Review of financial statements for current and preceding years, with particular emphasis on bad debt and other expenses
- Identification of key employees and employment agreements
- Review of any past or pending litigation and any notice of claims that might lead to litigation
- Assessment of environmental liabilities associated with products or real estate
- Review of employee benefits and outstanding liabilities
- Review of customer contracts, licensing agreements and supplier agreement
- Identification of key suppliers
- Identification of future capital needs
- Interviews with customers, suppliers and key employees
- Evaluation of insurance coverage
While a comprehensive due diligence process will not eliminate all risks for the buyer, it does offer an opportunity for the buyer to assess such risks, and if warranted, seek an adjustment in purchase price.
Document The Transaction
“Papering over” a transaction
Drafting the legal documents that describe the transaction and transfer the business—may occur at different stages of the transaction. Parties sometimes execute a “Letter of Intent” indicating their intent to proceed to a final Purchase and Sale Agreement, subject only to certain identified conditions. Letters of Intent can present legal challenges. Parties sometimes sign such agreements, believing that they are not undertaking any legal obligations. Despite language that sometimes implies that such agreements are without legal effect, letters of intent have been the basis of damage awards.
Once the contours of a transaction have been agreed on, counsel prepares a Purchase and Sale Agreement that identifies all of the details of the transaction, including but not limited to the sale price and the basis for any adjustments; a description of the assets and/or stock being purchased; disclosures of liabilities and potential liabilities by the seller; and any post-closing obligations of either party. The provisions of the Purchase and Sale Agreement must take into account the risks and conditions specific to the business that is being sold. A well-drafted document ensures that neither buyer nor seller will be “surprised” during the transaction and provides a framework for cooperation in the period after the sale takes place.
Buying a business can be stressful and risky. One size does not fit all. The most successful transactions are those that recognize the unique risks and rewards in a particular acquisition and uses the law to accommodate the needs of the parties. With proper counsel, even small to mid-size firms can reap the benefits of growing through acquisition.