River’s Edge Alliance Group BLOG

As small business owners we spend most of our time competing to build the better mousetrap or provide the better service. We become so focused on our customers and our competition that we lose sight of the most important thing to us as the owner, creating value so that we can one day sell the business. We know that the more value we create the more money a buyer will pay. But, do we really know how to create that value?

Value is determined by available cash flow and the risk associated with obtaining it. Simply meaning, buyers buy cash flow. The more you have, the more a buyer will pay.

Don’t get me wrong, buyers care about your product, service, market, reputation, etc. But how are they going to judge your product or service? How will they know that you have a great reputation? By how much cash flow you generate!

Everything that you do in your business should be with the expectation of generating cash flow and adding value to your business. I will challenge you that if an activity does not create cash flow (and value) then why are you doing it?

Not only is cash flow the best indication as to the quality of your product, service, reputation, etc., it is the single greatest reason that people go into business for themselves. It’s great to love what you do but, if you can’t make money doing it you won’t last very long. Business owners enjoy freedom but you can’t afford freedom if you don’t make enough money to feed your family, pay your bills and live the lifestyle that you want to live.

As a result, when a buyer evaluates your business for potential purchase they will evaluate it based on the cash flow it generates. An individual will want to understand if that cash flow is enough to support their lifestyle. An existing company will want to understand if the cash flow supports their investment and provides a viable platform for growth.

What does all this mean for you? When you sell your business you are not competing for buyers’ attention simply with businesses producing similar mousetraps or providing similar services. You are competing with every business seller in your local marketplace. You will win favor and attract buyers by having the most cash flow available for purchase.

The best buyer for your business may not be the buyer that offers the highest price.

Business sellers can become so focused on the offering price for their business that, at times, they will overlook a number of other factors that may prove more significant in the deal than the actual price. For example:

1.  Financial Capabilities of the Buyer – This is not the amount the buyer is willing to pay for the business but rather the overall financial strength of the party making the offer. In today’s tumultuous lending  environment not all buyers can actually produce the funds needed to purchase your business. A properly capitalized buyer with a slightly lower offering price may be worth more consideration than chasing a higher offer from a cash strapped buyer.

2.  Industry Experience – Oftentimes, as small business owners, post-sale customer service and employee retention is just as important as your actual exit from the business.  Especially when your compensation is tied to the future performance of the business.  The practice of tying the seller’s compensation to the future performance of the business is common in the sale of service oriented businesses and is referred to as an earn-out.

3.  Liabilities – Depending upon whether the transaction is structured as an asset deal or a stock deal, certain liabilities may remain with the seller post-sale. The ability to transfer liabilities to a buyer may make a lower offer more attractive than a higher offer where liabilities remain the seller’s responsibility.

4.  Taxes – NEVER FORGET ABOUT TAXES!! In any transfer of ownership there is always an adverse tax effect. The question becomes with whom does the tax obligation lie? Depending on the structure of the transaction and the potential allocation of purchase price, there can be a significant difference in how the IRS views the transaction. A buyer will (in all likelihood) be looking for an asset deal with the majority of the value allocated to operating assets to achieve a step-up in basis and a quick depreciation write-off. On the other hand, you as the seller will be looking for a stock deal or an asset deal with the majority of the value attributable to capital assets to achieve capital gains tax treatment on the proceeds in excess of basis.

Rarely when buying or selling a business is the structure that’s best for the seller also the best for the buyer. There is always give and take. Experienced buyers and their experienced advisors know that the offering price is only one small part of the deal. There are a number of other things that qualify an offer as “good” or “bad”. Be sure to consider the entire offer, including: price, the ability of the buyer to pay, the buyer’s experience within your industry, what liabilities (if any) will transfer and who is responsible for the impending tax obligation.

On February 17, 2009 President Barack Obama signed the “American Recovery and Reinvestment Act of 2009” (“ARRA of 2009) into law. Section 1251 of the bill temporarily reduces the recognition period for “built-in” gains tax (BIG tax) on S Corporations from 10 years to 7 years for the 2009 and 2010 tax years.

Why is this important?

Historically, if you were a shareholder in an S Corporation that converted from a C Corporation and sold the company within 10 years of the date of conversion, you would be subject to BIG tax. For 2009 and 2010, that 10 year “recognition period” has been reduced to 7 years. So, if you sell your S Corporation in 2009 or 2010 and it has been converted from a C Corporation at least 7 years prior, you will avoid the 35% BIG tax. Companies originally organized as S Corporations have never, and remain, not subject to BIG tax.

A Closer Look

When you sell a C Corporation the proceeds from the sale of the assets are owned by the corporation. They get taxed once at the corporate level (35%) and then again upon distribution to the shareholders where they are taxed at your personal rate. This effective “double tax” makes it advantageous for the shareholders of a C Corporation to convert to an S Corporation prior to sale. In an S Corporation the proceeds from sale are “passed through” directly to the shareholders and taxed ONLY at their individual tax rates.

Since the result of converting a C Corporation to an S Corporation is a reduction in revenue for the IRS, the IRS states that the conversion must occur prior to the recognition period or the proceeds from sale will be taxed on a prorated basis.

Example:

Assume a C Corporation converted to an S Corporation less than 7 years prior to sale. A valuation of the company is needed at the date of conversion. All sale proceeds up to the dollar amount of the valuation are taxed at the BIG tax rate of 35% and distributed to the shareholders where they are again taxed at the shareholders’ personal rates. This effectively recognizes the value created within the company while it was organized as a C Corporation and taxes it accordingly (known as BIG Tax).

The valuation at the date of conversion is then subtracted from the sale price to determine the value created while the company was an S Corporation. That value is “passed through” directly to the shareholder in accordance with S Corporation treatment.

Before February 17, 2009, BIG tax treatment could only be avoided if a C Corporation converted to an S Corporation at least 10 years prior to the date of sale. Now, with the signing of the ARRA of 2009, a C Corporation that converted to an S Corporation in 2002 or prior can avoid the BIG tax by selling their business in 2009 or 2010.  A C Corporation that converted to an S Corporation in 2003 or prior can avoid paying BIG tax by selling their company in 2010.

Popular sentiment among business owners considering the sale of their businesses is that it is not a good time to sell. These fears stem from the recessionary strains being experienced by the business and their potentially diminishing effects on the company’s valuation.

Although your business may be experiencing a down year, that does not mean it is not a prudent time to sell. Consider the concept of marketability. Marketability is the measure of an assets ability to be bought or sold.

The marketability of your business is dependent upon:

1. the supply of comparably sized businesses within your industry
2. the location of similar businesses currently offered for sale; AND
3. the corresponding buyer demand for these businesses.

At present, there are significantly more business buyers in the business transaction marketplace than there are businesses available for sale. The primary reason for the lack of supply is the incorrect perception above; that it cannot be a good time to sell because of the condition of our economy.

Reasons for the high buy-side demand are as follows:

Individual Buyers – A number of workers have recently lost their jobs, are disenchanted with corporate America, and are reconsidering their futures as employees. A number of these individuals are considering the purchase of a small business as a way to earn their future living.

Strategic Buyers – Existing small and medium sized businesses are finding it difficult to grow their businesses due to a decline in consumer spending. Smart management teams realize that the fastest way to grow an existing business is through acquisition. As a result, management teams are scouring the marketplace looking for acquisition opportunities that will allow them to geographically expand, diversify their product and service lines, vertically integrate and continue to grow.

Financial Buyers – While these professional buyers have always had minimum size requirements for potential acquisitions, these minimums have loosened as deal flow has slowed. The decrease in available acquisition targets has forced many private equity firms to shift their focus to smaller add-on acquisitions that compliment their core portfolios. Small businesses that would not meet the minimum size requirements for private equity during its heyday are now finding themselves to be attractive acquisition targets.

As a seller considering an exit from your business, more needs to be considered than strictly your valuation when determining timing. A slight decline in your financial metrics over prior years may not warrant a delay in sale. Many times an increase in the marketability for your business will sufficiently offset the decline in your financial performance.

While you may not currently know the answer to this question, understanding the different types of buyers (and their motivations) allows you the ability to position your business in a way that makes it most attractive to the broadest audience.

Individual Buyers – Individual business buyers are individual people just like you and me. This person will typically only ever purchase one business in his/her lifetime. They are looking for independence and freedom. They want to create personal wealth and/or develop a legacy for their family. An individual buyer understands that with business ownership there are sacrifices, both personal and financial. But, these sacrifices are worth it to them (within reason) in order to obtain freedom of thought, schedule and decision. The most important characteristics of business targets for individual buyers are location (proximity to their home and their families), stability and track record. Most individual buyers have significant experience in the workforce and have developed some level of success there. While they are looking for freedom and independence, they are also looking to maintain their current standard of living. Earnings history, a proven track record and stability are extremely important.

Strategic Buyers – Strategic buyers include public and private companies both foreign and domestic. These buyers already own and operate existing businesses and are looking to grow or vertically integrate their operations. Attractive acquisitions will allow these companies to diversify their product base, expand their market reach, acquire intellectual property, shorten their research and development cycle or achieve cost savings. The most important characteristics to this group are size, market share, reputation, developed technology, trademarks, patents, trade names, a skilled workforce and recognizable quality products and/or service. These buyers are looking to grow their companies and expand their corporate footprints by means of acquisition.

Financial Buyers – Financial buyers include angel investors, private equity firms and investment funds. These buyers are looking to acquire existing companies with the potential for substantial growth. While the acquisition target may lack a sophisticated management team and capital for growth, these buyers typically bring such resources to the table. They are professional business buyers with serious capital and sophistication. They are looking to infuse their talents and money into an existing organization, grow it exponentially and sell it in a relatively short timetable for a significant return. As you may reasonably estimate, these buyers are inundated with acquisition opportunities and afforded the luxury of sifting through candidates before settling on their selection. In order to make the grade with this group you must offer stable yet substantial returns with the opportunity for quick growth and a planned exit.

All three buyer types vary in their desires and their approach. Knowing their motivation allows you to position your business so that it is appealing to the broadest audience.