12 Concepts You Must Understand Before You Sell Your Business
Selling a company is a thrilling and emotional process for entrepreneurs. In the entrepreneurial world being able to say you lead a company to an exit is a badge of honor we all strive toward. It's the finish line in the race of high risk digital startups.
So far in my twenty year career as an entrepreneur I've sold one business to a private company, one to a public company, I've brokered the sale of my wife's business to a private company, and I've been an advisor and director to two companies that were sold to private companies.
I've also purchased a business, have been a buyer who failed to complete the purchase of another business, and at least 10 times I've been a willing seller who began a process to sell that was not ultimately successful.
Through all these experiences I've developed a blueprint for buying or selling a company based on the common components of every deal.
For the sake of this post I won't get into the legal structural minutia or talk about how companies are valued. I'll instead focus on the important deal factors that affect the value entrepreneurs receive during and after the sale of their companies.
As an entrepreneur it's important to understand the total value you're receiving in exchange for transferring ownership of your business to someone else minus the total cost of what is required of you after the sale of your business is complete.
It's both shortsighted and reckless to consider your position at the moment the deal closes as your final position. The ramifications of actual business acquisitions typically last for at least five years, as I'll explain below.
Additionally, it's easy to become obsessed with receiving the highest dollar number for your business. In fact, buyers know you can be easily distracted with the number that will go in the press release, so they'll typically meet your requirements there while at the same time jockey the terms and conditions of the deal to extract maximum value from you, your company, and your shareholders for the longest period of time possible.
That is, of course, their job as buyers of businesses.
Lucky for you, the important terms and conditions you should understand shake out into two pretty simple categories:
A) things that happen at the moment the business is purchased, and
B) things that occur after the business is purchased (usually for some period of time until they expire).
Let's get started.
Upfront cash
This is the cold hard cash that will be wired to your bank account a few days after the sale of your business closes. It's usually anywhere from 50% to 100% of the total value you receive for the purchase of your company. This is the less risky part of a deal because it's money you receive quickly that generally speaking cannot be taken back (see below about reps and warranties where it can be taken back).
You can also often determine your buyer's ability to pay the upfront cash amount before your business is sold, by confirming the availability of funds in their bank accounts or their ability to borrow the required money from their existing credit lines.
If they fail to pay the upfront cash you can quickly begin a process to take ownership of your company back as the entire sale agreement will be nullified by their inability to pay the consideration they promised.
Seller financing
The opposite of upfront cash, seller financing refers to any payments you'll receive for your business in the future. Sometimes this comes in the form of seller notes which are debt agreements where you agree to loan the buyer some of the money required to purchase your business and they agree to pay you back over some period of time at some interest rate. Other times the seller will receive stock in the buyer's company as part of their total value received. See the section on stock and lock-up periods for more about this.
Unlike upfront cash which is pretty much guaranteed, seller financing is a riskier part of the value you'll receive for the sale of your business because it requires the buyer's business to remain solvent throughout the period of time in which you are to be paid. You essentially become one of their debtors alongside (and probably behind) their current debtors, their bank, and their current investors.
If their company fails, files for bankruptcy protection, or is otherwise unable to meet their debt commitments you may be left holding a worthless sheet of paper.
In some cases the buyer may come back asking to renegotiate the terms of their debt agreement at a lower rate or over a longer period of time if they feel they are at risk of not meeting the obligations they previously promised. This puts you in an extremely tough situation where you have to choose between increasing the odds of receiving any payment in exchange for receiving less overall money.
The longer the period of time the buyer is allowed to pay you the more risk you take, as it becomes harder to predict their future solvency as markets, products, and economies change over time.
Earn-outs
Earn outs are very similar to seller financing in that they are paid over time and rely highly on the future solvency of the buyer of your company, expect that they are even less guaranteed because the amount of the earn-out is usually tied to future performance of your business.
Earn-outs are more common when you remain in charge as the primary leader of your company through some type of employment agreement following the sale of your business. It's not uncommon for entrepreneurs to be asked to remain the leader - usually in a role called a general manager - of the operations of their business for one to three years. See the section about salary compensation and employment periods for more about this.
Buyers love earn-outs because they incentivize selling entrepreneurs to remain engaged in running their businesses at a high level of performance for potentially long periods of time. The larger the percentage of the deal value held over in an earn-out the more motivated the entrepreneur will be. And if high performance isn't met then the buyer doesn't have to pay the earn-out amount.
Sellers love earn-outs when they're confident they can exceed the required level of future performance. Although the downside is always the risk that the required level of performance is not met and the entrepreneur has remained active in the business for many years only to receive no additional compensation for the value of the business they previously sold.
Stock and lock-up periods
Another type of future compensation provided to selling entrepreneurs is stock in the buyer's company. Like any stock, this type of compensation can be vary widely because it's directly tied to the value and marketability of the buyer's stock in the future.
Taking stock in a private company buyer typically means you'll have to wait for the company to have its own exit in the future, because most private companies highly restrict how and when you can sell their stock. And they may choose to sell their company to another private company, which will get you more private company stock with the same type of restrictions.
Taking stock in a public company buyer can come with more options for turning stock into cash and a better understanding of the future value of the stock because of historic data available in the public marketplaces. But public company buyers will also add restrictions to how and when you can sell their stock in order to prevent your trading actions from influencing the value of their stock on the public marketplaces.
A lock-up period is a period of time following the sale of your company - or the date on which you received your shares of their public company if that happens later - that you are legally restricted from selling their shares. This means you'll have to wait and watch the value of their stock fluctuate up or down without any ability to sell the shares you currently hold until your lock-up period expires.
If you become a large shareholder in the buyer's public company in result of their purchase of your business, you will likely also be required to waive your rights to executing a hedged strategy on their stock, which is a technique often used by public company investors to limit their downside risk if a public company's value begins to fall. In result, you will have little to no recourse if the stock you hold in the public company suddenly becomes worthless before you are able to sell it.
Salary compensation and required period of employment
Your ongoing involvement as a leader in your former company is typically up to the leaders of the business that is buying your company. During negotiation for the purchase of your company their future leadership needs will be revealed and you may be offered a contract for employment at their company.
The terms of your employment will be similar to any employee at that company, likely including benefits, vacation and sick leave within normal ranges for other executives in their business. These benefits may be attractive if you've previously kept a tight startup culture in your business, or you may find them extremely restrictive if you've become used to controlling your own schedule and daily requirements in the past.
You may be required to continue working as a leader in the new business for a period of time, and these details may be documented in your employment agreement or in the terms of your sale agreements. Penalties for leaving early could be applied or future earn-out or seller financing payouts could be reduced if you do not meet their expectations.
As with any employee, you can be fired at any time unless the laws of the buyer's country or your sale agreement say otherwise. So it's risky to consider any compensation you might receive for your employment at the buyer's company after the sale closes as part of the overall compensation for the sale of your company.
Technically that's just your salary for working on your business after someone else owns it. And just like any employment, it may not be as solid as it looks.
Non-compete
Your buyer doesn't want you starting another company like the one you've sold them. The last thing they want is to give you a bunch of money to purchase your company for you to then become a well-funded competitor to the business they're now running.
It's common for this period to last anywhere from one to five years after the sale of your business. There will be specific words in the purchase agreements that attempt to define your industry so a judge might later determine if your new business is in or out of that industry.
Find these words and read them carefully. It's in your buyer's best interest for them to be vague and general so they receive the most broad protection. It's in your best interest for them to be very specific so you can start similar or related businesses where you might have the most ability to be successful fast.
Non-solicitation
Similar to a non-compete clause, your buyer wants to be sure you won't immediately begin hiring your former employees, poaching former customers, or coaxing partners to join you at your next company.
Typically you'll be required to avoid any contact with all of these people and companies for at least one year. In some cases you may be required to never contact them for as long as they continue their relationships with your former business, or for at least one year after they cease to work at/with your former business.
Think carefully about the period of time you're willing to leave everyone alone after the sale of your business. If you plan to immediately start another business you may want some of your former teammates to join you as quickly as possible. Or you may hope to rely on the influence or reach of an influential partner that will help promote your new fledgeling company.
Reps and warranties (and liability caps)
These are the representations and warranties the buyer will require you to sign as part of the deal agreements.
Representations are statements of facts both current or historic, for instance the fact that your company has properly paid all of its taxes in the past and is properly authorized to conduct its business in all of the states and countries in which it currently operates. You will probably also be required to represent in writing that you're not currently being sued or have unsettled past legal liabilities to people or companies.
Warranties are similar and speak to the current state of the company's assets including intellectual property, software, and relationships. For instance a buyer might require you to warrant that your company's software is free of major defects that could cause your service to become unavailable for long periods of time.
Reps and warranties may seen like innocent promises but like anything in business they actually have everything to do with cold hard cash. Your liability for violating a representation or warranty is also determined by the sale agreement.
It's in your buyer's best interests to leave your liability uncapped, so they might be able to recover from you up to the entire value they've paid for your company (or more) if something you've promised them is later found to be untrue. For instance, if back taxes for your business are later found to be due, they will expect you to pay those taxes personally, and maybe even additionally reimburse them for any damage to their reputation or legal standing that was caused.
It's in your best interest to have your liability capped, at a minimum at the total value you've received for the purchase of your business, or even better at an amount lower than that. It's not uncommon for your liability to be capped at a large number around 2% to 5% of the total value of your deal, assuming that's at least a few million dollars.
Even with a general liability cap in place your buyer will likely still require you to agree to unlimited liability in the case of fraud where you have knowingly falsified or neglected to disclose information critical to their future success in operating the business they're buying. This clearly seems reasonable. If you have to lie about something to talk someone into buying your business, you don't really have a business worth buying anyway.
Non-disparagement and confidentiality
The company buying your business wants to be able to make decisions about that business in their best interests without worrying about how you feel about it, or what you might say about them. It is after all going to be their business, not yours, after the sale closes.
Your sale agreements will likely include a non-disparagement clause which prevents you from saying anything negative about your former business or decisions made by its new owner in the future.
As an entrepreneurial founder in the public spotlight this becomes extremely tricky as friends, peers, and the media will surely want your opinion on the buyer's handling of your former baby.
Legally you will be required to say nothing bad about them, so if you're unhappy with something they've done your options will be to lie or to say nothing at all. Say something bad and you can be sued for the negative impact your words have on their business.
The confidentiality component of a non-disparagement clause can go as far as not allowing you from even admitting to anyone that your comments are restricted by a non-disparagement clause. Which makes it even trickier. Technically if you are asked if you are able to speak freely about your former company, you would be required to lie and say yes because admitting that you aren't would be a violation of your sale agreement on its own.
This is probably the part of sale agreements I like the least. I understand the need for a buyer to control the dialogue about the business they just purchased as much as possible, but I think the confidentiality component is unreasonable and downright icky.
Stock and option vesting acceleration
Depending on how you structured your vesting agreements with shareholders and employees, or yourself, some tricky things may happen when you agree to sell your business, or materially all of your assets, to another company.
Typically stock grant and stock option grant agreements will specify a period of time over which someone will unlock up to 100% of their stock in your company. Good startup attorneys and savvy investors will also require founding entrepreneurs to vest their own stock ownership over multiple years. This protects the company if one of the founders is fired or leaves before providing their full value to the company over time.
Employee vesting typically has a six or twelve month cliff which means their stock or options don't vest for the first several months, then they receive the stock or options in bulk when the cliff date is passed. This protects the company from the risk of new employees who aren't yet proven to be great contributors and may not last six or twelve months.
This protects your business if you fire someone a few months in, or if they leave before delivering the entire value you expected from them. They will only receive the percentage of the stock they were promised that is commensurate with the percentage of the expected time they spent with your company. In some cases vesting may be based on tangible milestones delivered instead of just time in months or years.
It's also common for vesting agreements to accelerate to some number percentage, often 100%, when a business is sold. This means that a new employee you hired yesterday and gave them 5% of your company vesting over five years would be treated as if they had already worked for you for five years if you sold your business tomorrow.
It's just something to keep in mind so you don't get surprised when you see the final version of your company's cap chart - a table of each shareholder and the number of shares they own - and prepare to distribute the proceeds of your sale to your shareholders.
Working capital adjustment
Working capital refers to the money that your business needs to pay for its operations within a period of time, usually around a month. It's essentially the cash that floats in your checking account as you receive revenue from customers and pay vendors on a daily basis. But it can be more accurately measured over a period of time like a month or a quarter of a year.
When selling your business it's not reasonable to assume you can keep all of the cash in your bank account because that cash is there to pay your immediately due bills and thus is part of the critical assets of your business like your intellectual property or your employees.
If you happen to have a lot of cash in your bank account it may be reasonable for you to keep some of it while leaving a reasonable working capital amount as an asset to be received and owned by the buyer.
To determine this amount the buyer may ask to review the operations of the business for up to 90 days after they purchase it, to calculate what they consider is a reasonable working capital amount. This number may differ from the approximate number both parties agreed upon during the sale of the business and thus an adjustment in the sale price may be required at that time.
Typically when less than 100% of the value of the deal is paid with upfront cash, the buyer can simply adjust the remaining cash due to sellers based on the working capital adjustment, in cases where 100% of the value of the purchase is paid in cash upfront the sellers may be required to withhold some cash as a reserve or to write checks back to the buyer if it's later determined that the working capital adjustment is favorable to the buyers.
Participation preferences
Another little detail likely to surprise you during the sale of your business has to do with investors who previously gave you money to begin or grow your business. It's an often overlooked, ignored, or forgotten part of equity financing agreements with investors and it's called a participation preference.
This hunk of seemingly meaningless words does something quite simple but extremely powerful. At the time they agreed to give you money, your investors wanted a bit of extra protection for themselves in case of the future liquidation or fire sale of your company, or a bit of extra gravy in the case you sold your company for a lot of money.
A participation preference is a number which refers the number of times an investor is allowed to get their money back before they then participate alongside other shareholders to receive their due percentage of the remaining proceeds of the sale of your business.
For instance a 5x participation preference from an investor who invested $1M in your company means that investor is entitled to the first $5M dollars of proceeds you receive for the sale of your business, then they are also entitled to receive the proceeds for their percentage of ownership in your business just like any shareholder.
So if you sell your company for $10M and the investor who previously gave you $1M got 20% of your company for that investment, at the time of the sale of your company they would first get their $5M, then 20% of the remaining $5M, so a total of $6M of your $10M proceeds.
In this example that gives the investor 60% of the proceeds of the sale despite them only owning 20% of your business. So as you consider selling your business make sure to review your former agreements with investments very carefully so you understand how they'll be paid when the buyer starts wiring money your way.