Confidentiality Agreements

“Confidentiality Agreement – A pact that forbids buyers, sellers, and their agents in a given business deal from disclosing information about the transaction to others.”

The M&A Dictionary

It is common practice for the seller, or his or her intermediary, to require a prospective buyer to sign a confidentiality agreement, sometimes referred to as a non-disclosure agreement. This is almost always done prior to the seller providing any important or proprietary information to a prospective buyer. The purpose is to protect the seller and his or her business from the buyer disclosing or using any of the information provided by the seller and restricted by the confidentiality agreement.

These agreements, most likely, were originally used so that a prospective buyer wouldn’t tell the world that the business was for sale. Their purpose now covers a multitude of items to protect the seller. A seller’s primary concerns are to insure that a potential buyer doesn’t capitalize on trade secrets, proprietary data, or any other information that could essentially harm the selling company. A concern of the prospective buyer may be that similar information or data is already known or is being developed by his or her company. This can mean that both parties have to enter into some discussion of what the confidentiality agreement will cover, unless it is general in nature and non-threatening to the prospective buyer.

A general confidentiality agreement will normally cover the following items:

  • The purpose of the agreement – it is assumed that in this case it is to provide information to a prospective acquirer.
  • What is confidential and what is not. Obviously, any information that is common knowledge or is in the public realm is not confidential.
  • What information is going to be disclosed? And what information is going to be excluded under the disclosure requirements?
  • How will confidential information be handled? For example, will it be marked “confidential,” etc?
  • What will be the term of the agreement? Obviously, the seller would like it to be “for life” while the buyer will want a set number of years – for example, two or three years.
  • The return of the information will be specified. For example, if the sale were terminated, then all documentation would be returned.
  • Remedy for breach, or determination of what will be the seller’s remedies if the prospective acquirer discloses, or threatens to disclose any information covered by the confidentiality agreement.
  • Obviously, the agreement would contain the legal jargon necessary to make it legally enforceable.

One important item that should be included in the confidentiality agreement is a proviso that the prospective acquirer will not hire any key people from the selling firm. This prohibition works both ways: the prospective acquirer agrees not to solicit key people from the seller and will not hire any even if the key people do the approaching. This provision can have a termination date; for example, two years post-closing.

The sale of a company involves the disclosure of important and confidential company information. The selling company is entitled to protection from a potential acquirer using such information to its own advantage.

The confidentiality agreement may need to be more specific and detailed prior to commencing due diligence than a generic one that is used initially to provide general information to a prospective buyer.

Tips on Maintaining Confidentiality

  • Use a code word or name for the proposed merger or acquisition.
  • Don’t refer to any principal’s names in outside discussions.
  • Conversations concerning the merger or acquisition should be held in private.
  • Paperwork should be facedown unless being used.
  • All documents should be kept under lock and key.
  • Important data maintained on the computer should be protected by a password.
  • Faxing documents should be done guardedly.

The Anatomy of a Deal

The following might be a subtitle for this true account of how one deal was put together: “In spite of everything, you need only one buyer – the right one!” (Although the details are factual, names and financial data are fictional.)

The company (let’s call it ElectroCo) has carved a niche in a billion dollar industry. It manufactures proprietary electronic products and is owned by a private equity firm that wants to sell it for liquidity reasons. At the beginning of 2001, the private equity group retained an intermediary firm (fictional name — United Associates) to take the company to market. The goal was to have it sold by the end of the year.

ElectroCo had annual sales of about $12 million, gross margins of 50 percent, an EBITDA of $1.8 million (15 percent) and a reconstructed EBITDA of $2 million. It also had been growing over the past ten years at a 10 percent rate and had always been profitable. It had a diverse customer base split about equally between end-users and OEM accounts. However, the seller wanted to set a very aggressive full price, with all-cash in a not-so-vibrant M&A market.

On the plus side, however, the seller was cooperative and provided any information that United needed. It also had audited statements, conservative accounting and instant monthly statements. ElectroCo was, in addition to these factors, on the verge of getting a substantial amount of new business.

In preparing to take the business to market, United Associates came up with a basic game plan. For confidentiality reasons, direct competitors were eliminated from the buyer search. Synergistic buyers were targeted-either because they served similar markets or utilized similar manufacturing methods. United also elected to contact selected private equity groups and other intermediary firms.

More specifically, United planned on creating a list of 100 potential buyers. A buyer was defined as an entity that had signed a Confidentiality Agreement, had been pre-approved by the seller, and therefore, had been sent an Offering Memorandum. United anticipated 15 written Term Sheets leading to five Letters of Intent which, hopefully, would lead to the best deal. United was not sure that they could sell the business at the multiples asked by the seller. However, they succeeded, and that success was to be based on the following:

Preparing a thorough and compelling Offering Memorandum and pointing out the positive future prospects. This required the complete cooperation of ElectroCo’s management team.

  • Developing a complete list of possible buyers both in the U.S. and abroad.
  • Contacting the buyers to see if they would be interested in the company, but still maintaining confidentiality.
  • Administering all of the potential buyer activity and sending the Offering Memorandum to the appropriate parties.
  • Following up with all of the prospects who received the Offering memorandum and arranging tours of the facilities with the serious prospects.
  • Setting time frames for expressions of interest and term sheets, and fielding questions from the serious prospects.
  • Holding the deal together in spite of the tragic events of September 11th, which resulted in a two-month delay that could have been much longer.
  • Making sure that complete confidentiality was maintained and making sure that any future confidentiality leaks did not occur.
  • Constantly reminding ElectroCo’s management to stay focused on maintaining sales and profit goals.
  • Maintaining communications with both the buyers and ElectroCo’s lawyers and other outside advisors.

United was able to develop a list of 85 possible acquirers; however, five would not sign the Confidentiality Agreement. Here is a breakdown of the 85 possible buyers:

Buyer Type                  Number of Buyers
Strategic                      45
Some Synergy              20
Private Equity Groups     20

Of the 85 possible buyers, 15 were companies or divisions of firms with annual revenues of $1 billion or more. 12 of these 15 were foreign or owned by foreign companies. ElectroCo chose not to deal with four of the buyer firms due to negative industry knowledge. Two of the buyers were individuals that had financial backers. Four buyers were just “bottom fishing.” Three of the 85 decided not to move forward due to the events of September 11. One buyer only wanted to acquire assets, not the stock, of ElectroCo. Interestingly, eight of the 85 firms had previously talked to ElectroCo about a possible merger or acquisition.

Of the buyers who elected not to proceed or move forward, the majority felt that acquiring ElectroCo was just not a good fit. Some of the other reasons why other buyers decided not to continue were:

  • Management was too thin
  • Since ElectroCo was a good company, the price would most likely be too high
  • Buyer purchased another firm
  • One potential acquirer was acquired itself
  • Buying company was having its own internal problems
  • Buyer wanted to move company – this was unacceptable to the seller

After all of this, United Associates arranged five visits for acceptable buyers – the target number. Overall, United received:

  • Term Sheets 4
  • Verbal Offers 2
  • Letters of Intent 4

Of the five buyers who visited the business and met with ElectroCo’s management, two wanted to acquire the company. These were the best prospects. There were also two other firms, held in abeyance, in case one of the other two didn’t work out. One of the original two and ElectroCo’s preferred acquirer offered the desired price and terms. The buyer was:

  • A public company that wanted to grow through acquisition.
  • One with a synergistic product line.
  • Unlike some of the private equity groups, not totally focused on the financial aspects.
  • One with an appreciation of ElectroCo’s product lines, its technology and the company’s potential.

United Associates started with 85 possible buyers. The final list came down to just a few and the September 11 tragedy certainly did not help in the sales efforts. ElectroCo was not a company for just anyone. Despite all of this, United got the deal done – proving once again, that you need only one buyer – the right one!

Representations and Warranties

From the buyer’s point of view, “the critical aspect of negotiations is what is stated in the representations and warranties such that the document reflects the following:

Everything you know, you told us.
Everything you told us is true.
Everything you didn’t know, you should have known.”

Nelson Gifford, former CEO of Dennison Manufacturing Company

Both parties and their advisors must understand that Representations and Warranties are not a measure of anyone’s honesty, sincerity or integrity, but a method of allocating some of the risks inherent in any transaction. After all, buyers and sellers are entitled to all the benefits of their bargain – nothing more and nothing less.

In almost any sale of a business, the seller makes certain representations. Their purpose is to insure that the seller, and the buyer, are truthfully and accurately representing themselves and their business. These representations and warranties may focus on various legal, financial or environmental aspects of the sale such as: undisclosed liabilities, pending litigation and tax issues. Their purpose is that the seller is warranting that none of these issues will impede the closing or impact the new ownership. The purchasing entity also represents and warrants, for example, that it has the financial capability to purchase the business. These are usually included in the final agreement between the buyer and the seller. They can be as simple as the seller warranting to the buyer that there is a clear and marketable title to the business being sold. Representations and warranties can also be a lot more complicated. For example, they may not only contain a warranty or representation, but also provide for a remedy if things aren’t as stated or certain future events happen. These are much more important in a stock sale than one of just assets. In the stock sale, the buyer is assuming all of the outstanding issues, risks and, if any, future problems. The seller might warrant that there is no pending litigation and then a disgruntled customer files a post-closing lawsuit. The final agreement might state that an agreed-upon dollar amount would be set aside to cover such contingencies. This remedy is known as an indemnification. The purpose of an indemnification is to provide a solution to a breach of the representations and warranties.

Representations and warranties should be discussed and agreed upon in the early negotiations of the sale. These early discussions can clear up future misunderstandings and provide a safety net for both parties. There is probably little point in continuing negotiations if the representations and warranties can’t be mutually agreed upon at the outset. Intermediaries generally prefer to get agreement on them prior to a Letter of Intent being prepared. From a seller’s standpoint, the company should not be taken off the market prior to a general understanding of the Representations and Warranties.

They are one of the most important aspects of any final agreement. The buyer obviously wants to have as many of them, and as broad in scope, as possible. They create a sort of built-in insurance policy. The seller, on the other hand, would like there to be none, or as few, and as restricted, as possible.

Problems can develop when the buyer, for example, inserts among the representations and warranties an item that is open-ended or beyond the seller’s control. For example, the seller warrants that there are no equipment leases or equipment rental agreements other than described in Schedule F. The buyer doesn’t want to be responsible for any equipment agreements that have not been mentioned. However, the seller wants to limit the company’s exposure. Keep in mind that in privately held companies, the owner is usually responsible for any indemnification of the representations and warranties, so he or she is very concerned with them. The seller’s lawyer might limit the exposure to a dollar amount along with a time period – say three years. Or, as is most common, the buyer agrees to absorb any of the leases up to a dollar amount, anything over which the seller must cover. This means that if some equipment leases do turn-up after the closing, assuming that there has not been any fraud or deception, the method of handling them has already been covered in the agreement.

This time period on the Representations and Warranties is a big concern for sellers. The time periods for the Representations and Warranties surviving the closing can be a deal-killer in the seller’s eyes. How long should a seller be responsible for them? Obviously, this is a critical area and has to be carefully negotiated between the parties. Some that might survive the closing would be matters of litigation, insurance and employee issues. Today, an important post-closing issue can be the intellectual property that may be included in the sale. The buyer entity wants to protect itself from any attack on the ownership of the intellectual property, as it may be a key ingredient of the acquisition. By placing a cap on the dollar amount that the seller and/or his or her company is responsible for and placing reasonable time frames on this section of the agreement can usually resolve this sensitive area.

Sellers often want to couch their Representations and Warranties by using the term material in them. In other words the defect must be material to be considered for any type of remedy. Some sellers even want to limit their exposure by stating that the representation is to the sellers’ best knowledge. Experts feel that the buyer is buying the business and anything that makes the deal riskier threatens the sale. The seller’s claim that to the best of his knowledge there is no other litigation, except that stated on Schedule K, doesn’t provide the buyer the protection that he or she needs. Since the words material or sellers’ best knowledge might be considered vague or ambiguous, placing dollar limits can usually resolve them.

What all this means is that the Representations and Warranties are a big part of the deal. They should not be left to the last. Many sales have fallen apart because a Representation or Warranty and Indemnification were just not acceptable to the seller, or to the firm’s board of directors. The buyer’s due diligence should uncover many of the issues that will be subsequently incorporated in the agreement as Representations and Warranties, and be addressed prior to the drafting of the agreement. The drafting of them should be left to the pros.

Too many deals have fallen apart, or been delayed, because the buyer or his advisors decided, at the last minute, to insert a “surprise” representation or warranty, that the seller not only did not agree to, but had not even seen – causing the seller to become disillusioned with the buyer. Representations and Warranties should be discussed early in a transaction, perhaps be part of the deal structure items, and any changes after the due diligence period disclosed (or proposed) well before the final draft of documents is circulated.

Note: The above article is not intended to provide legal advice. It is designed merely to offer some insight into the subject of Representations and Warranties. For more information, the reader is advised to consult an attorney, intermediary or other competent advisor.

"Red Flags" in the Sunset

Unlike that poetic title of an old-time standard song, Red Sails in the Sunset, red flags are not a pretty sight. They can cause a deal to crater. Sellers have to learn to recognize situations indicating there might be a problem in their attempt to sell their business. Very, very seldom does a white knight in shining armor riding a white horse gallop up, write a large check and take over the business – no questions asked. And, if he did, it probably should raise the red flag – because that only happens in fairy tales. Now, if the check clears – then fairy tales can come true.

Sellers need to step back and examine every element of the transaction to make sure something isn’t happening that might sink the deal. For example, if a company appears interested in your business, and you can’t get through to the CEO, President, or, even the CFO, there most likely is a problem. Perhaps the interest level is not what you have been led to believe. A seller does not want to waste time on buyers that really aren’t buyers. In the example cited, the red flag should certainly be raised.

A red flag should be raised if an individual buyer shows a great deal of interest in the company, but has no experience in acquisitions and has no prior experience in the same industry. Even if this buyer appears very interested, the chances are that as the deal progresses, he or she will be tentative, cautious and will probably have a problem overcoming any of the business’s shortcomings. Retaining an intermediary generally eliminates this problem, since every buyer is screened and only those that are really qualified are even introduced to the business.

Both of the above examples are early-stage red flags. Sellers have to be focused so they don’t waste their time on buyers that are undesirable. If a buyer appears to be weak, does not have a good reason to need the deal, or is otherwise unqualified, the red flag should be raised because the chances of a successful transaction are diminished. The seller might seriously consider moving on to other prospects.

Red flags do not necessarily mean the end of the deal or that it should be aborted immediately. It simply means that the seller should pay close attention to what is happening. Sellers should keep their antenna up during the entire transaction. Problems can develop right up to closing. Here is an example of a middle-stage red flag: The seller has received a term sheet from a prospective buyer and is then denied access to the buyer’s financial statements in order to verify their ability to make the acquisition. As a reminder, a term sheet is a written range of value for the purchase price plus an indication of how the transaction would be structured. It is normally prepared by the would-be purchaser and presented to the seller and is non-binding. A buyer who is not willing to divulge financial information about his or her company, or, himself, in the case of an individual, may have something to hide. Due diligence on the buyer is equally as important as due diligence on the business.

If a proposed deal has entered the final stages, it doesn’t mean that there won’t be any red flags, or any additional ones, if there have been some along the way. If there have been several red flags, perhaps the transaction shouldn’t have gone on any further. It is these latter stages where the red flags become more serious. However, at this point, it makes sense to try to work through them since problems or issues early-on apparently have been resolved.

One red flag at this juncture might be an apparent loss of momentum. This might mean a problem at the buyer’s end. Don’t let it linger. As mentioned earlier, at this juncture all stops should be pulled out to try to overcome any problems. If a seller, or a buyer, for that matter, suspects a problem, there might very well be one. Ignoring it will not rectify the situation. When a red flag is recognized, it is best that it be confronted head-on. It is only by acting proactively that red flags in the deal can become red sails in the sunset – a harbinger of smooth sailing ahead.

The Confidentiality Myth

When it comes time to sell the company, a seller’s prime concern is one of confidentiality. Owners are afraid that “if the word gets out” they will lose employees, customers and suppliers. Not to downplay confidentiality, but these incidents seldom happen if the process is properly managed. There is always the chance that a “leak” will occur, but when handled correctly, serious damage is unlikely. Nevertheless, a seller should still be very careful about maintaining confidentiality since avoiding problems is always better than dealing with them. Here are some suggestions:

  • Understand that there is a “Catch 22” involved. The seller wants the highest price and the best deal, and this usually means contacting numerous potential buyers. Obviously, the more prospective buyers that are contacted, the greater the opportunity for a breach of confidentiality to occur. Business intermediaries understand that buyers have to be contacted, but they also realize the importance of confidentiality and have the procedures in place to reduce the risk of a breach. Another alternative is to work with just a few buyers. This, however, does reduce the chances of obtaining the best price.
  • Another way to avoid this breach is to try to keep a short timetable between going to market and a closing. The shorter the timetable, the less the chance for the word to get out. One way to keep a short timetable is to gather all of the information necessary for the buyer’s due diligence ahead of time. Create a place where all of this material can be consolidated. This can be as simple as a set of secured file drawers. Such documentation as: customer and vendor contracts, leases and real estate records, financial statements and supporting schedules (assets, receivables, payables), conditions of employment agreements, organization charts and pay schedules, summary of benefit programs, patents, etc. should be gathered. It is not unusual for due diligence examinations to look back 3 to 5 years, so there could be a lot of records.
  • The above means that the seller has to get organized. Selling one’s business is fraught with paperwork. Set up some three-ring binders so all of the relevant paperwork and resulting documentation has a place. These binders should be kept in a secure location.
  • The seller’s employees should be conditioned to having strange people (potential buyers) walk through the facility. One way to avoid suspicion is to arrange to have unrelated people, for example – customers, suppliers, advisors – tour the company facilities prior to placing the business on the market.
  • If sellers have not prepared their employees for strangers walking through the facilities as suggested above, awkward situations can develop. A valued employee may question why tours are being conducted. The seller is then placed in the position of explaining what is happening or covering the question with a “smokescreen.” A seller could reply by saying that the strangers are possible investors in the company. If asked directly if the business is for sale, the seller could respond by saying that if General Electric wants to pay a bundle for it – anything is for sale. Once in the selling process, it is also important to minimize traffic by only allowing serious, qualified prospects to tour the operation.
  • Keep in mind that confidentiality leaks can emanate from many sources. For example, an errant email ends up on someone else’s email. A fax gets sent to the wrong fax machine or UPS or FedEx deliveries go to the wrong people. Establish methods ahead of time on how to communicate with potential buyers or an intermediary.
  • The key to handling confidentiality may be for the seller to retain a third party intermediary. They will insist that all potential buyers sign a confidentiality agreement. They will also be able to advise the seller on how to handle the “company tours” and can insure that only qualified buyers are shown the facilities.
  • The “myth” is that confidentiality issues can make or break a deal, or cause serious damage to the seller’s business. The reality is that breaches seldom occur when an intermediary is involved, and if they do occur and are handled properly, there is little damage to the business or a potential transaction.

Does the Deal Fit?

“The most successful integrations were directed by people who placed the common good of the combined organization and its customers before all else.”

From: The Mergers & Acquisitions Handbook.

By now, most business owners are familiar with the problems created by the merger of Daimler, the German automobile company, and Chrysler, the American car maker. Here is the classic case of cultural friction adversely impacting what was originally promoted as the merger of “equals.” If any deal can point out the importance of a cultural fit in a merger or acquisition – this is it. The officers of Daimler took complete control and the executives of Chrysler left in droves. Not only were the management styles completely different – centralized versus decentralized, quick decisions versus decisions by committee, supplier rivalries versus supplier partnerships — but, in addition, the American management team received huge compensation packages, while the Daimler people worked on small salaries, but huge “perks.”

Mergers and acquisitions are supposed to produce synergies that bring results.  If they don’t, the culture is too often the reason. John Chambers, the CEO of Cisco Systems, who has been involved in some seventy acquisitions, says that he will not do a deal unless there is a cultural fit. Culture according to one dictionary is defined as the “customary beliefs, social forms, and material traits of a … social group.” The word “compatible” may be a better choice defined by the same dictionary as: “able to exist or act together harmoniously.” Regardless of the semantics, if both companies can’t work well together, the deal is a bad one. The importance of this cultural fit may be influenced by the nature of the deal and the desires of the seller. Here are some examples:

  • The seller sells the company on an all-cash basis and doesn’t really care what happens to the employees, the customers or the new owners. In other words, the seller takes the money and runs.
  • The seller receives sufficient cash that he or she is secure about the transaction. Despite this almost all-cash deal, or the quality of the security for the balance, there is serious concern for the employees and their future with the new ownership.
  • The seller merges the company and/or receives stock in the acquiring firm. Further, the seller’s compensation, to say nothing of any increase in the equity, may be determined by the success or failure of the cultural fit of the merged companies.

Obviously, in the first example, the question of a cultural fit, or any fit, for that matter, is moot. Assuming, however, that the prospective seller fits into one of the two latter situations, how does one determine the compatibility of the two firms? It may be a non-issue if the seller’s company is going to remain autonomous. Or, the acquiring firm may have been through several similar situations and is experienced in the assimilation process. These two examples do not necessarily mean that the companies will mesh perfectly, but they do help. However, if a cultural fit is of concern, what can be done to help assure an orderly blending of the two firms?

It can be as simple as the seller having a casual dinner with the owner or CEO of the acquiring or merging company. Much can be learned one-on-one about how the other company is managed and about its owner’s business philosophy. Is it based on teamwork? Is it entrepreneurial or hierarchical? Is the company customer or policy driven? If the CEO of the acquiring company is reluctant to share a social occasion, then the seller may have already received the answer to the cultural fit question.

Other areas that should be considered: how are the employees of the other company compensated? Or, for example, something as mundane as the company’s product return policy may provide insight into the successful integration of the two businesses. How far apart are the companies’ mission statements?

Absorbing smaller companies can be a lot easier than two firms of approximately the same size merging. There are few companies whose cultural styles are so similar that integration is an easy matter. In many cases, where there may not be a perfect cultural fit, proper communication can resolve most of the issues. Unfortunately, there are some situations, like the Daimler Chrysler example, in which the two companies may never be integrated successfully.

Sellers who are concerned about the right cultural fit should investigate this before the deal gets too far along and, obviously, prior to closing. An intermediary has the knowledge and experience to work with both buyers and sellers on this all-important issue. The right culture may be a “soft” issue when it comes to mergers and acquisitions, but just may be one of the most important.

Selling Your Company -- Some Key Points

  • Settle all litigation and environmental issues before putting the company on the market.
  • Hire a good transaction lawyer, because the buyer will also.
  • If company owners are totally inflexible, the buyer may walk away from the transaction.
  • Be prepared to accept a lower price for lack of management depth, dependence on a small number of customers or clients, and lack of geographical distribution.
  • When a buyer indicates he or she may be ready to submit a Letter of Intent, tell them up front what items you want included. For example, price and terms; what assets and liabilities are to assumed, if an asset purchase; what contracts and warranties are to be assumed; and time schedule for due diligence and closing.  (These are just some of the items a seller might want included.)
  • Be advised that many buyers will view the value of Sub Chapter S corporations to be worth less than if the company is a C Corporation.
  • Make the company more visible by attending trade shows.  Tie up patents, copyrights and trademarks.  Create a public relations program.  These areas all create perceived value.
  • Selling a company involves sometimes-inconsistent objectives: speed, confidentiality and value – pick the two that are the most important.
  • Keep in mind that companies get stale after sitting on the shelf for awhile.
  • Don’t expect your lawyer to win every point of contention – you want a dealmaker, not a dealbreaker.

A Selling Memorandum

A sellers memorandum includes all those points one would normally expect to see in any business plan, to wit: an executive summary, a business description, financial requirements, target market niche, identification of top management, an operations review, analysis of strengths and weaknesses, and current financial statements and projections.

Guide to Mergers and Acquisitions published by PPC

A proposed sale of a middle-market company almost always begins with a selling memorandum. This document is called many things, including offering memorandum, confidential descriptive memorandum or simply the book. Regardless of what you choose to call it, its purpose is to encourage prospective buyers to take a further look at the company.

For the seller, it has a secondary side benefit. It forces them to take a hard look at the company, its strengths and its weaknesses. Upon reviewing the information necessary to prepare a selling memorandum, the seller may, in fact, decide that it’s not such a bad company after all and elect to keep it. On the other hand, the seller could decide that the current condition of the company needs to be improved before attempting to sell it. Looking at the company through the eyes of a buyer, could also prompt the seller to try to increase the value prior to selling. This may be done, for example, by building a stronger brand loyalty, by entering into employee contracts with key managers, or perhaps by diversifying the customer base.

Assuming, however, that the decision to sell has been made, the importance of the selling memorandum can not be emphasized enough. It is like a strong advertisement for the company and it must tell a good story. It should highlight the positive parts of the company, add value for the buyer, and show the negatives as opportunities. The selling memorandum has to make a good first impression. A seller wants to attract qualified buyers and bring value to the company being sold. This means that the selling memorandum has to be prepared and written by a professional. It is too important a document to do it any other way. It is also the basis of a strong marketing program to attract the best buyer at the best price.

What makes up a strong selling memorandum? It includes quite a few different elements. But, first a few caveats:

  • Don’t include confidential company information or reveal trade secrets. Although the document may be intended for qualified buyers only, once it is disseminated it really becomes a public document. Professional intermediaries and investment bankers do make prospective buyers sign a confidentiality agreement, which does help in this area. Still, with copy machines and email services readily available, it never hurts to maintain confidential information until much further in the negotiations.
  • Make sure that a prospective buyer knows exactly what you are selling. It is assumed unless otherwise mentioned that it is the entire company that is for sale. You don’t want prospects to think that they can purchase just the most profitable portions of the company. Obviously, a seller wants to show-off the excellent parts of the company, but this should not be done at the expense of the not-so-good parts. These can be presented as excellent opportunities.
  • The selling memorandum should not be aimed at the right prospects. If the business requires technical language to best explain it, use it. A buyer, who doesn’t understand it, probably isn’t a buyer.
  • There should be an explanation of how the company works so a prospective acquirer can read through the lines about the selling company’s corporate culture. This element can make or break a sale and it’s best to discover it at the outset.
  • There is always a tendency to include too much information – don’t. Don’t over-sell. You don’t need to include the names of customers and vendors and the names of all the employees.
  • Be sure to also include the blemishes. If there is a pending lawsuit, include. The bad news should be revealed early on – no one likes surprises, especially later in the negotiations.
  • And, finally, and probably, most important, the selling memorandum should be easy to read.

Now, what about the various elements of the selling memorandum. Here are the areas that should be covered in it.

Business Profile (or Executive Summary) – This may be the most important element of the selling memorandum. The entire offering should be covered in brief – no more than four-pages, at most. Many are done in one page. Remember, the sole purpose of the business profile is to generate excitement and interest. It is a selling piece! It should include:

  • Ownership
  • The Business
  • Financial highlights
  • Products and/or services
  • Markets
  • The opportunities
  • Reason for sale (Why is it for sale?)

This business profile is usually sent to possible purchasers. If the prospect is interested further, they sign a confidentiality agreement before receiving the entire selling memorandum. The selling memorandum includes detailed information on the key elements of the company and usually covers the following:

  • Business overview – In other words, who and what is the company? This is the place where everything about the company is summarized: it’s history, the employees (in general), the management team, the locations, any important intangible assets, and the outlook for the business.
  • Company strengths – What does the company do well? This should cover those strengths that bring value to this particular company.
  • Markets – Who are the customers/clients? What and how does the company sell its products or market its services.
  • The Risks – What are they? If there are risks in the business, they should be described and then an explanation of how the company solves them.
  • Financial data – Is the company making money? Cash flow statements are important. Current thinking is that the seller doesn’t have to include all of the available financial data – which the prospective buyer will go through all the financial history as the deal moves forward.

The selling memorandum should include any relevant corporate and/or product brochures as attachments. Prior to putting the business on the market, it is important that an outside valuation be performed. However, the price and terms are not usually a part of the selling memorandum – the marketplace will dictate the price. The purpose of the entire selling memorandum is to generate sufficient interest so that a prospective acquirer will make an offer.

Building Value

Prior to putting a company on the market for sale, the question of value has to be addressed. Increasing the value should, in fact, be considered a year, preferably two, prior to sale. Value is based on profitability, cash flow, management and the overall quality of the operation itself. Here are some considerations in building value, whether the business is going to be sold or not.

  • Are the company’s pricing policies set too low, creating low margins? Perhaps they were set some time ago in order to boost sales. Now might be a good time to review them to make sure they are in keeping with current market conditions.
  • Is the inventory level too high? How about work-in-progress or finished goods? Increasing the turns in inventory can increase cash flow.
  • Are you paying too much for raw material? Talk to your vendors and suppliers, you might be able to get some better prices or terms. Take a look at all of the expenses: utilities, telephone, technology, office expenses – it all adds up.
  • Are there services that could be outsourced for increased savings?
  • Increasing the quality of customer service may entice customers or clients to pay their bill promptly.
  • Are all the employees working together to improve the operation and profitability of the company?

These are just a few of the areas that can and should be reviewed. Although profits are important, there is an old expression that cash is king. The time to take a look at the overall company operations is now.

Measuring the Value of a Company

Consider the following important areas of a company. How does your company stack up in these critical areas? If you were to rank them on a 1 to 4 scale, for instance, what would your score be? The higher the score the more valuable the company! They are considered value drivers – in other words, they are important to a prospective buyer.

  • Profitability
  • Type of business
  • History of company and industry
  • Business growth
  • Customers/Clients
  • Market share
  • Return on investment
  • Quality of financial statements
  • Size
  • Management
  • Terms of sale

For example, in looking at a company’s financial data – are the statements audited or merely compiled? Is the growth of the company slow or is it growing quickly? How about the customer base – is it based on several major ones, or is it spread out over many customers? The time to consider these critical value drivers is now!

Common Seller Questions

How long does it take to sell my business?

It generally takes, on average, between five to eight months to sell most businesses. Keep in mind that an average is just that. Some businesses will take longer to sell, while others will sell in a shorter period of time. The sooner you have all the information needed to begin the marketing process, the shorter the time period should be. It is also important that the business be priced properly right from the start. Some sellers, operating under the premise that they can always come down in price, overprice their business. This theory often backfires, because buyers often will refuse to look at an overpriced business. It has been shown that the amount of the down payment may be the key ingredient to a quick sale. The lower the down payment (generally 40 percent of the asking price or less), the shorter the time to a successful sale. A reasonable down payment also tells a potential buyer that the seller has confidence in the business’s ability to make the payments.

Why Is Seller Financing So Important To The Sale Of My Business?

Surveys have shown that a seller, who asks for all cash, receives, on average, only 70 percent of their asking price, while sellers who accept terms receives, on average, 86 percent of their asking price. That’s a difference of 16 percent! In many cases, businesses that are listed for all cash just don’t sell. With reasonable terms, however, the chances of selling increase dramatically and the time period from listing to sale greatly decreases. Most sellers are unaware of how much interest they can receive by financing the sale of their business. In some cases it can greatly increase the amount received. And, again, it tells the buyer that the seller has enough confidence that the business can, indeed, pay for itself.

What Happens When There is a Buyer for My Business?

When a buyer is sufficiently interested in your business, he or she will, or should, submit an offer in writing. This offer or proposal may have one or more contingencies. Usually, they concern a detailed review of your financial records and may also include a review of your lease arrangements, franchise agreement (if there is one) or other pertinent details of the business. You may accept the terms of the offer or you may make a counter-proposal. You should understand, however, that if you do not accept the buyer’s proposal, the buyer can withdraw it at any time.

At first review, you may not be pleased with a particular offer; however, it is important to look at it carefully. It may be lacking in some areas, but it might also have some positives to seriously consider. There is an old adage that says, “The first offer is generally the best one the seller will receive.” This does not mean that you should accept the first, or any offer — just that all offers should be looked at carefully.

When you and the buyer are in agreement, both of you should work to satisfy and remove the contingencies in the offer. It is important that you cooperate fully in this process. You don’t want the buyer to think that you are hiding anything. The buyer may, at this point, bring in outside advisors to help them review the information. When all the conditions have been met, final papers will be drawn and signed. Once the closing has been completed, money will be distributed and the new owner will take possession of the business.

What Can I Do To Help Sell My Business?

A buyer will want up-to-date financial information. If you use accountants, you can work with them on making current information available. If you are using an attorney, make sure he or she is familiar with the business closing process and the laws of your particular state. You might also ask if their schedule will allow them to participate in the closing on very short notice. If you and the buyer want to close the sale quickly, usually within a few weeks (unless there is an alcohol license or other license involved that might delay things), you don’t want to wait until the attorney can make the time to prepare the documents or attend the closing. Time is of the essence in any business sale transaction. The failure to close on schedule permits the buyer to reconsider or make changes in the original proposal.

What Can Business Brokers Do – And, What Can’t They Do?

Business brokers are the professionals who will facilitate the successful sale of your business. It is important that you understand just what a professional business broker can do — as well as what they can’t. They can help you decide how to price your business and how to structure the sale so it makes sense for everyone — you and the buyer. They can find the right buyer for your business, work with you and the buyer in negotiating, and work with you both every step of the way until the transaction is successfully closed. They can also help the buyer in all the details of the business buying process.

A business broker is not, however, a magician who can sell an overpriced business. Most businesses are saleable if priced and structured properly. You should understand that only the marketplace can determine what a business will sell for. The amount of the down payment you are willing to accept, along with the terms of the seller financing, can greatly influence not only the ultimate selling price, but also the success of the sale itself.

You Can Help!

You, as the seller, are an integral part of the total marketing program. We would like to offer a few friendly recommendations that will help in the marketing efforts.

It might also be helpful if you took a good look at your business from the perspective of a buyer. Try to put yourself in the place of a prospective purchaser of the business. What would you do to make it more attractive or more saleable? Obviously, the financial records of your business are critical to the sale of your business, but how it looks is also important. First impressions really count! If a potential buyer doesn’t like the appearance of your business, the rest of it may never get a chance.

Here are some suggestions. Check the following to see if any of them are applicable:

Keep normal operating hours. There may be a tendency to “let down” when you put your business up for sale. However, it’s important that prospective buyers see your business at its best.
Repair signs, replace outside lights, etc. You don’t want your business to look as if it has been neglected.
Maintain inventory at a constant level. If you let your inventory slide, your business will look neglected. If anything, increase it so your business will look busy.
Remove items that are not included in the sale or unnecessary items, especially if inoperative.
Repair non-operating equipment or remove it if you are not using it.
Tidy up outside premises.
Spruce up the inside of the business.

Are You Ready to Exit?

If you’ve gone this far, then selling your business has aroused enough curiosity that you are taking the first step. You don’t have to make a commitment at this point; you are just getting informed about what is necessary to successfully sell your business. This section should answer a lot of your questions and help you through the maze of the process itself.

Question 1
The first question almost every seller asks is: “What is my business worth?” Quite frankly, if we were selling our business, that is the first thing we would want to know. However, we’re going to put this very important issue off for a bit and cover some of the things you need to know before you get to that point. Before you ask that question, you have to be ready to sell for what the market is willing to pay. If money is the only reason you want to sell, then you’re not really ready to sell.

*Insider Tip:
It doesn’t make any difference what you think your business is worth, or what you want for it. It also doesn’t make any difference what your accountant, banker, attorney, or best friend thinks your business is worth. Only the marketplace can decide what its value is.

Question 2
The second question you have to consider is: Do you really want to sell this business? If you’re really serious and have a solid reason (or reasons) why you want to sell, it will most likely happen. You can increase your chances of selling if you can answer yes to the second question: Do you have reasonable expectations? The yes answer to these two questions means you are serious about selling.

The First Steps

Okay, let’s assume that you have decided to at least take the first few steps to actually sell your business. Before you even think about placing your business for sale, there are some things you should do first.The first thing you have to do is to gather information about the business.

Here’s a checklist of the items you should get together:

  • Three years’ profit and loss statements
  • Federal Income tax returns for the business
  • List of fixtures and equipment
  • The lease and lease-related documents
  • A list of the loans against the business (amounts and payment schedule)
  • Copies of any equipment leases
  • A copy of the franchise agreement, if applicable
  • An approximate amount of the inventory on hand, if applicable
  • The names of any outside advisors

Notes:
If you’re like many small business owners you’ll have to search for some of these items. After you gather all of the above items, you should spend some time updating the information and filling in the blanks. You most likely have forgotten much of this information, so it’s a good idea to really take a hard look at all of this. Have all of the above put in a neat, orderly format as if you were going to present it to a prospective purchaser. Everything starts with this information.

Make sure the financial statements of the business are current and as accurate as you can get them. If you’re halfway through the current year, make sure you have last year’s figures and tax returns, and also year-to-date figures. Make all of your financial statements presentable. It will pay in the long run to get outside professional help, if necessary, to put the statements in order. You want to present the business well “on paper”. As you will see later, pricing a small business usually is based on cash flow. This includes the profit of the business, but also, the owner’s salary and benefits, the depreciation, and other non-cash items. So don’t panic because the bottom line isn’t what you think it should be. By the time all of the appropriate figures are added to the bottom line, the cash flow may look pretty good.

Prospective buyers eventually want to review your financial figures. A Balance Sheet is not normally necessary unless the sale price of your business would be well over the $1 million figure. Buyers want to see income and expenses. They want to know if they can make the payments on the business, and still make a living. Let’s face it, if your business is not making a living wage for someone, it probably can’t be sold. You may be able to find a buyer who is willing to take the risk, or an experienced industry professional who only looks for location, etc., and feels that he or she can increase business.

*Insider Tip
The big question is not really how much your business will sell for, but how much of it can you keep. The Federal Tax Laws do determine how much money you will actually be able to put in the bank. How your business is legally formed can be important in determining your tax status when selling your business. For example: Is your business a corporation, partnership or proprietorship? If you are incorporated, is the business a C corporation or a sub-chapter S corporation? There are some tax rules, implemented January 1, 2000, that impact certain businesses on seller financing. The point of all of this is that before you consider price or even selling your business, it is important that you discuss the tax implications of a sale of your business with a tax advisor. You don’t want to be in the middle of a transaction with a solid buyer and discover that the tax implications of the sale are going to net you much less than you had figured.