ACCOUNTING: Don’t be fooled by incomplete offers for your business

“Based on the numbers you have shared with me, I think the business should fetch about $5 million.”

This statement was made to one of my clients by a business broker after an hour-long meeting and a brief review of a couple of years of my client’s financial information.

I sat quietly in disbelief observing my client’s body language change from anticipation to relief and joy. I could see him doing the math in his head-$5 million was the number he needed.

After the meeting, I sat down with my client and reviewed what had just happened. Although we had discussed the basic “seller’s formula” before, it was time to walk through it one more time.

The seller’s formula is an algebraic equation in which you must have two of the variables to solve for the third. In his case, the basic formula of “term + structure = price” was incomplete; the broker had given us the price, but we were missing the two other variables.

To make my point, I told my client that I would be happy to pay him twice that price-$10 million-as long as I could pay him $1 per year for 10 million years. He quickly got the point and recalled our earlier discussions about the need to know all three variables before a decision could be made as to how good the deal really was.

The term of a deal is the period over which the payments are to be made. Generally, the longer the term, the more risk the seller assumes because of future events and conditions that are typically outside his control. Since businesses are rarely sold without some future payments, the term can be a critical element of any transaction.

Generally, the longer the term, the more the price must increase. Conversely, the more cash to be paid at closing, the lower the total price. The younger the seller is, the more he or she may be willing to live with a longer term. Older sellers will generally bargain for a shorter term, even if it means less money.

The most important part of the seller’s formula may well be the structure, and the most important element of structure is the determination of what is being sold. If the ownership interests of the business are being sold, it is commonly referred to as a “stock sale.” Likewise, if the assets of the business are changing hands, it is commonly referred to as an “asset sale.”

In the example of my client’s business, if the broker was talking about an asset sale, the selling price would not include paying off all of the liabilities of the business-likely a substantial amount. On the other hand, if the broker was talking about a stock sale, it would include the purchase of all assets and assumption of all liabilities.

The lack of clarity as to what exactly is being sold often causes sellers a great deal of confusion. Brokers and potential buyers often use the terminology “purchase of the business” without being specific as to what is being purchased.

Not only is the sales price significantly different in an asset sale vs. a stock sale, but the seller’s profit is usually different because of how the proceeds are treated for income-tax purposes. And even if the purchase price in an asset sale is many times greater than the price to be paid in a stock sale, the amount that ends up in the seller’s pocket might be the same.

Other elements of structure that will be discussed in future articles include interest rates, discount rates, consulting fees, employment agreements, tax allocations and many others.

For the time being, however, it is important to remember that, until the seller has all of the variables of the seller’s formula analyzed, the sales price itself means little or nothing.