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The Sales Process
Once you’ve established that you’re ready to sell, consider how the process generally goes. Understanding the steps of a typical business sale before the process begins is essential to avoid excessive cost and overly-optimistic expectations.
1. Initial Contact
Whether initiated by the buyer or seller, the first step in the sale process is to establish a mutual interest in the transfer of the company from seller to a buyer. Discussions are exploratory and nonbinding for the sole purpose of determining whether there is a mutual interest in going forward.
2. Preliminary Discussions
Following an exchange of confidentiality and nondisclosure agreements, the parties preliminarily determine the benefits of a transaction for each and define any conditions thought to be nonnegotiable. For example, a seller might require that the current employees are retained for a minimum period following a transaction, or a buyer might require the owner to stay in place for a transition period. Limited financial data, legal documents, and representations might be exchanged for review by each party.
3. Price Negotiations
As a consequence of the data exchanged and each company’s investigations, the parties may agree to a tentative sale transaction called a “term sheet,” which is an abbreviated version of the basic agreement that will be agreed to and executed by the parties. The term sheet is formalized and amended following an extensive verification of the facts and representations of each party.
While a buyer’s decision is often affected by nonfinancial factors, many buyers – especially those represented by business advisors – establish a price based on a multiple of the following:
- Revenues. BizBuySell reported an average revenue-to-sales-price ratio of 0.61 in 2014, so that a company with $500,000 in revenues sold for $305,000.
- Cash Flow. In 2014, the average cash flow multiple for a sold business was 2.24, according to BizBuySell. In other words, a business with $100,000 of annual cash flows sold for $224,000.
- Earnings. A multiple of earnings is usually based on stability and the year-to-year increase of the earnings stream. For example, a company consistently earning a profit of $50,000 might sell for a price to earnings ratio (PE) of four to six, or $200,000 to $300,000. A company with erratic earnings would typically sell at a lower PE. Establishing a sales price on earnings of a small business is considered by some to be less reliable than other indices, especially since revenues and expenses are often manipulated for tax and other reasons.
- Net Assets. Some businesses, particularly those who are involved in natural resources, may sell as a multiple of estimated reserve values. Companies that have been in business for a while are likely to have undervalued assets on the books due to use of depreciation.
4. Due Diligence
Following the preliminary agreement, the purchaser undertakes an extensive due diligence review to verify the facts and representations of the seller. This step may entail a review of customer lists, a review and confirmation of the accounting records – if the seller’s financials are not prepared or audited by an independent certified public accountant (CPA) – and a physical confirmation of tangible assets.
Due diligence expenses of the buyer can be high, especially if outside consultants and experts are utilized. At the same time, the seller’s resources can be strained as company personnel are frequently involved in the process, rather than in the day-to-day operations of the company.
6. Price Adjustment
Depending on the due diligence findings, the final sales price and terms of payment may be tweaked to reflect new disclosures. This negotiation is the last bite of the apple, so to speak, for both parties to amend the purchase agreement. Sellers should be aware that negotiations often continue until the final agreement is reached and signed by both parties.
The closing is the culmination of the entire process in which final documents are signed, and money is exchanged. Both parties may also be subject to future obligations if detailed in the closing documents.
For example, the purchaser may be required to pay an extra amount if revenues exceed a predetermined target in the year (or years) following the transaction. At the same time, the seller may be liable for any undisclosed and documented liabilities.