What Ends Up in My ATM After I Sell My Business?
Often sellers get hung up on the valuation numbers that come over in an Indication of Interest or Letter of Intent. While these numbers represent the market value of your business, sellers need to consider adjustments made to that number before the dollars hit their bank accounts.
Here are some things that happen after a purchase price is agreed upon:
1) The Seller Keeps the Cash and Pays Off the Company’s Debts
This can be a difficult concept for sellers to get their heads around but when a buyer offers you a valuation it is most often an enterprise value, which is based on the concept that a buyer doesn’t have to care how you have financed your business in the past, it only cares about what the business earns. If we didn’t adjust for cash and debt in the valuation, a buyer could theoretically pay a multiple of EBITDA (cash flow) and pick up a windfall of cash. Alternatively, a buyer who assumed a lot of the company’s debt would be getting a company worth less than they had paid. I like to think of enterprise value as letting the buyer ignore the balance sheet and pay for the business based on what it generates in cash flow.
So, after you’ve sold your company, you get to keep the cash but you need to pay off any non-trade related debts.
2) Keep The Rest of the Balance Sheet Nice and Steady
Some sellers, when they hear that they get to keep the cash after a sale get to thinking about how to maximize that number. What if the seller accelerates receivables? What if a seller slows down on paying its payables?
Buyers keep account of these manipulations of the balance sheet pre-transaction close by using an average working capital calculation. In that calculation the buyer looks at an average of working capital over some time period that is agreed to by both parties. If you have more current assets than normal, the buyer owes the seller the difference. If you have fewer current assets than average (which would occur if you tried to accelerate receivables for example) the seller would owe the buyer some money back.
Escrow payments exist to make sure that sellers stand by their representations and warranties about their business. They are generally a percentage of the purchase price (right now they are about 10%) and they are held back (in an escrow account) for some period of time. These tend to catch sellers off guard. Remember that unless you have misrepresented the business during diligence, you will get the escrowed funds back. The ultimate success (or failure) of the escrows can be heavily dependent on having a good transaction attorney, a critical member of your advisory team.
Most sellers understand that they will have to pay their advisors fees. However, it can catch some business owners by surprise that this usually happens right away when the purchase price funds get wired. In most cases, your investment banker will add themselves to the wire transfer list and will be paid immediately when the money is sent.
The sale of a business can create a large tax event for the seller. Failing to plan for taxes prior to a business sale can be a huge mistake. After the sale is complete, or even later in the sales process, it can be very difficult to change your tax situation.
You can generally use capital gains tax rates for the sale of a business and do not forget about state sales taxes, which can be substantial depending on where you live.
6) Structures That Pay You Later
A really great purchase price can sometimes involve waiting for your payout. Earn outs, seller financing, or staggered payments can all make a big purchase price seem very small when you check your bank account balance at the end of a transaction.
It is very important to think about structure when you are presented with an offer to buy your business. As you know, cash today is better than cash tomorrow and think hard about any structure that puts purchase price at risk – especially if you can’t control the risk factors anymore. Earn outs and seller financing can be fine for bridging the gap between a seller’s and buyer’s valuation, but be careful not to pre-spend money that is at risk as part of the transaction.
The moral of this story is to not confuse a purchase price on a Letter of Intent with what will end up in your ATM post transaction. Work with your advisors to make sure a transaction is structured in the most beneficial way and be aware of terms that delay your cash payments at close.