Often a founder or small business owner’s entire net worth is wrapped up in the business they own. Given how many considerations go into determining the best time for the owner and the business to make this transition, I am always surprised how long they wait to prepare for an exit.
One aspect of the preparation process is thinking through who the potential buyers might be, and which buyer makes the most sense for the owner, the business and the employees. Choosing the best buyer is a multi-layered analysis. Here, we will focus only on a couple issues.
Owners understandably want to be rewarded for their life’s work and seek to maximize its value in a transaction. But attention also needs to be paid to what is actually financeable. Ideally, there are many large, well-capitalized industry participants or large private equity funds with committed capital that can easily afford the value the owner has in mind. But if not, it is likely that the buyer would need to stretch to finance the valuation a seller finds ideal. These buyers will have financial contingency language in their letter of intent stating that they will give best efforts to obtain the needed funding and will seek a longer exclusivity period in which to close an investment. None of that is a red flag, but it identifies areas where the seller should focus to fully understand the risk and reward of choosing this particular buyer.
In such a case, sellers need to understand the buyer’s source of funding. Is it a Small Business Administration loan? Or a commercial bank loan? When the businesses combine, what is a realistic size of borrowing and is it advisable to use that level of debt? Will the business be able to run smoothly under reasonable operating environment? Or will they be hampered by interest and principal payments? Sellers should look at the buyer’s historical and projected financials to understand the viability of the plan, or run it by their own banking contacts to see if they believe the plan is workable.
If working through a fundless sponsor — a professional buyer who negotiates the purchase through a letter of intent and then seeks buyers — sellers should learn how many transactions the fundless sponsor has closed, who is their investor group and the percentage split of their funding between bank and equity funding.
Seller financing is a very common practice meant to bridge the gap between what the buyer needs and what is financeable today. Here, the seller needs to believe that the buyer can realistically make payments on time. And, generally, the less time these arrangements last, the better.
Regardless of the buyer type, their experience closing on time and reaching the expected valuation reflected in the letter of intent is very important. Reputation is critical, and a bad one as a buyer should get them excluded from consideration. Large buyers are more likely able to obtain financing, but sometimes use their large-buyer status to attempt to extract concessions from a seller late in the process. Smaller buyers often lack experience but can compete for a deal if their letter of intent reflects that they have done the work upfront to ensure a smooth and timely closing.
It takes buyer and seller cooperation to close a transaction that achieves the expected benefits. The more detail the buyer includes in their letter of intent is often an indicator of the likelihood of success.
Jeffrey Kadlic is a Founding Partner of Evolution Capital Partners