The usual process for selling any companyis to first provide the buyer
prospect with very general information; sufficient for the prospect todetermine further interest, but not to reveal competitive secrets.
The seller andbuyer prospect will then discuss various aspects of the business, followed by aletter of intent that sets forth, usually in broad terms, the basis on whichthe buyer proposes to purchase the company. The letter of intent, which is prepared by the buyer, requires theseller to take the company off the market as to other purchaser prospects. It also starts the process of the detaileddue diligence at which time the buyer will see the competitive information,such as customer names, billing rates, operating procedure manuals; and maytalk with key personnel.
Having reached this point in the process,the seller has lost its chance to negotiate a better deal from other purchaserprospects, and has shown the buyer prospect its competitive secrets. It’s now critical that there are nomisunderstandings or surprises that keep the transaction from closing. This is even more important for securityguard company sellers when negotiating with a competitor – usually the mostlogical buyer.
The likelihoodthat the transaction will be successful is very high if the process is properlymanaged. A transaction manager, whoshould be experienced in handling the sale of security guard companies, willhave qualified the buyer prospect’s financial resources to consummate thetransaction, and track record from previous deals, before the negotiationprocess begins. Before the letter ofintent is signed the manager will guide the owner in understanding the detailsof the proposed transaction that determine the price, terms, and otherconditions that are important to the seller.
An experiencedtransaction manager will know that there are many pricing computation methodsand conditions to the sale that are unique to security guard companytransactions. The manager will knowthat every active buyer in the marketplace today has its own criteria whenlooking at seller candidates. The different assumptions underlying each ofthese various models make it highly likely that a seller not being representedby a manager will not understand the letter of intent, or worse yet, willmisinterpret it.
For thesereasons the seller should not make any assumptions on the important details ofthe transaction not spelled out in the letter of intent. The seller’s manager should ask the probingimportant questions – how the selling price will be computed; the conditionsthat affect the seller’s ability to receive the agreed upon price; and, if it’simportant to the seller, how the employees will be treated after the sale. Here are a few of the details a sellershould know before signing the letter of intent:
Theseller should understand how the price will be computed.
Experiencedbuyers go through return on investment (ROI) computations in arriving at theprice they are offering for the company. This price is based on general financial and account informationprovided to the buyer prospect. Itoften takes several weeks after the initial offer for the transaction to close,and this preliminary information on which the buyer made its offer usuallychanges. For example, the seller mayadd or lose accounts, or have price increases. This necessitates setting up a price adjustment mechanism in thepurchase agreement, which increases or decreases the initial offering pricebased on those changes.
There’s not astandard formula in the industry for making this adjustment. Just as it uses its own pricing andvaluation models, each buyer also has its own unique method for the adjustment,which usually uses gross units as its base. As an example, the adjustment may be based on a percentage of annualgross revenue or multiples of gross monthly billings. The adjustment may also be made as a multiple of changes in netprofits of the company.
This reconciliationof the initial offering price to a company’s actual level of business atclosing becomes even more complicated. Not only do buyers differ in the mechanism they use in making theadjustment, they also differ in choosing the time period on which theadjustment will be based. Some use thebook of business at the day of closing; others use a two-week period beforeclosing; while others use various other methods such as three-month averagebefore closing or trailing twelve-month (TTM) revenue.
The sellerneeds to know which of the above methods the buyer will use. The method and the time period determinewhat the seller will get out of the transaction. The resulting difference between the methods may be significant.
The sellerneeds to know what assets or liability assumptions are included in the offeringprice.
This is onearea where there’s likely to be amisunderstanding between the parties regarding the offer; and themisunderstanding could represent very large discrepancies in price and/or terms. This happens when the buyer simply statesthat it is buying the business for a certain sum. Whether the transaction is being structured as a stock or assetpurchase, the seller should make sure there’s an understanding of what isincluded in this offering price: Doesit include equipment? Does it includeworking capital? If it includes workingcapital, does it also include cash in the bank?
As a result ofseveral financial buyers recently entering the security guard business, many ofthe offers – even in asset transactions – now are assumed by the BUYER, butoften not the seller, to include “normalized” levels of working capital (cashand accounts receivable less payables and accrued payroll).
The preciseamount of working capital usually cannot be agreed upon without some financialdue diligence by the buyer. This iswhy the amount of “normalized” workingcapital in the letter of intent may be left open for the parties’ agreementlater in the process. At a minimum theseller should have a general idea or estimate of the amount of working capitalthe buyer is expecting.
The sellershould also understand whether the offer includes payment for a level oftemporary or seasonal work and separate divisions that may be involved in theoperations – such as mobile patrol, investigations or alarms.
llershould know if the offering price is conditioned on the accounts continuing fora period after closing.
If the sellerfinds out that the buyer requires a guarantee of accounts, it should understandthe terms and conditions of the guarantee:
• What is the time period?
• What is the multiple used to compute ashortfall?
• Will the seller get credit for accountsbrought in during the guarantee period?
• How is the credit computed?
• Can the credit exceed any shortfallamounts (resulting in a purchase price increase)?
The sellershould also find out how the company will be run during the guaranteeperiod: Is the seller involved inmaintaining the accounts? Are the keypersonnel going to be hired? Will theseller be protected from a shortfall should an account leave because of poorservice by the buyer or billing rate increases?
Theseller should understand the structure of the transaction.
Is thepurchaser buying the owner’s stock or is the purchaser buying the assets fromthe corporation? There’s a significanttax difference in these two structures determined by whether the seller’scompany is organized for federal (U.S.) tax purposes as a “C” or “S”corporation, limited liability corporation (LLC), limited liability partnership(LLP), or a sole proprietorship.
Also, relating to the structure of thetransaction and the tax status of the selling entity, the seller needs to knowhow the non-compete agreement will be handled in the purchase contract. Will part of the purchase price be allocatedto the covenant? If so, how much? Some sellers will want a low allocation, whileothers may want it as high as possible – both circumstances depending on theseller’s tax status. However, the allocationamount has to be agreed upon by the parties, and the buyer’s policies and taxstatus often counter the needs of the seller. An unfavorable allocation can be very economically disadvantageous tothe seller. It’s for this reason thatthe seller should know those details before signing the letter of intent.
The sellershould understand the conditions that will be put in the non-compete agreement.
While manyowners sell their company in order to retire and are not concerned about theconditions put on a non-compete, there are other sale transactions that mayconcern an owner in what can or can’t be done after the sale.
For instance,the owner may be selling the guard business, but wants to stay in theinvestigative or alarm business. Or theowner may be selling and moving, because of family or health reasons, toanother part of the country and will start another security company. In these instances, or other circumstances,the owner, before signing the letter of intent, should make sure the non-competeagreement will not contain prohibitions from pursuing the activities for whichthe company was sold.
The seller needs to understand how credible theoffer really is.
Before theseller signs the letter of intent, which again requires the seller to take thecompany off the market and start the detailed due diligence process, the sellershould assess the probability of the buyer consummating the transaction. Some of the questions the seller needsanswered are:
• Has the buyer made a thorough examinationof the selling memorandum (the presentation usually prepared by the transactionmanager representing the seller)?
• Are there any issues resulting from thememorandum that need to be resolved before going any further?
• Is the buyer relying on bank financing inorder to complete the transaction? Ifso, the seller needs to make sure the bank is on board with the deal.
• What is the buyer’s approvalprocess?
• Does the transaction have to be formallyapproved by the board of directors – if so, when do they meet to make theapproval? Also, what is the board’strack record of approving or turning down similar transactions?
The sellershould also inquire through the deal manager about the buyer’s performancein prior transactions. Were the sellers satisfied? Were there issues that came up after closingfor which the buyer took an unreasonable position? Has the buyer completed the due diligence stage in negotiationswith other sellers, then did not complete the deal? If so, why?
Thispresentation is not intended to be an all-inclusive list of the points theseller needs to know early in the sale process and before signing the letter ofintent. Some of the above would not benecessary for large transactions. Thereare many other items not listed that are equally important – such as otherterms of the purchase contract, and time period for completing the transaction.
This informational letter does notrender legal, accounting or tax advice. Neither Robert H. Perry & Associates, Incorporated nor its employeesoffer such services, and accordingly assume no liability whatsoever inconnection with the use of the information contained herein. If legal, accounting, or tax advice isrequired, the services of a competent professional should be obtained.
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