Understanding Your Buyout Offer

By Todd Liles Understanding Your Buyout Offer

Part 3 of 4: How to Sell Your Business for What It’s Worth

When it’s time to sell your service business, you will receive a buyout offer.   There are several ways in which buyout offers should not be constructed.

It’s important that you understand what the buyout offer is actually offering for your business. And, you need to be comfortable with the legal implications of your buyout offer.

Understanding your offer is critical! Understanding could be the difference between living your dream, or your worst nightmare.

Your Dream or your Nightmare

Let me tell you a story about Bob. He worked forty years of his life to build a successful HVAC business. He poured his heart and soul into his company.

For 40 years he did everything right when it came to building a company with a great reputation.

In the year before Bob sold his company, he:

  • produced $3.2 million in replacement and service.
  • was operating at a respectful 17% profit before tax. And,
  • his business had been operating between 15 to 20% for the last five years.
  • He had 3,200 service agreements.
  • His field employees were happy, loyal, and well trained.
  • In short, he had what many would consider to be the ideal business.

Almost. See, Bob’s HVAC company was missing one critical component: management.

Bob had been operating Bob’s HVAC as the business’ primary leader and manager.

Kathy, his wife, kept the books. She had an eagle eye on the money.

Together, Bob and Kathy were great at running the business. But they were missing this critical component of additional leadership and management. It was all Bob and his wife Kathy.

Eventually, Bob and Kathy decided to sell the business. They were ready to retire into the sunset.

Bob and Kathy believed that Bob’s HVAC was going to supply them with all the retirement money they would need for their Golden Years.

However, Bob and Kathy couldn’t find a “fair” offer. They received 3 offers, and each one was far below what they believed they would receive.

Buyers simply didn’t want to pay top dollar for a service company without proper management and leadership. And in Bob and Kathy’s example, the management and leadership team would be retiring if the purchase happened.

So, Bob’s HVAC was on the open market and wasn’t valued to their expectations.

This did not sit well with Bob, so he decided to look in-house. What he found were two loyal employees who raised their hand and said, “We will run the show.”

“This is tremendous news!” thought Bob. It sounds like the perfect conclusion to a great dream. The loyal team members will step in and keep the business running on its original path.

“It’s like family continuing the business.” Or, at least that’s what Bob thought.

The first problem was money or lack thereof. It wasn’t long until Bob realized that these two employees didn’t have the money to buy the business. And, the two employees couldn’t get a loan from the bank to pay Bob and Kathy.

The Dreaded Pitfall: Owner Financing

Bob and Kathy had to make a tough decision. They had to decide to take what they considered to be a “bad” offer, or they were going to owner finance to their two team members.

The “Bad” Offer from a prospected buyer

  • $650,000 in cash up front, and
  • an additional $200,000 at the end of 5 years if the business survived.
  • Total: $850,000 in total cash after five years, and $650,000 guaranteed.

This offer didn’t sit well with either Bob or Kathy. They wanted $2,700,000 as a minimum offer. So, they looked inward.

The “Good” Offer from a prospected buyer

The two loyal employees offered to buy the company over 5 years. Bob and Kathy would have to owner finance the buy-out over five years.

Bob and Kathy came to an agreement with the two employees. Here were the details:

  • Bob and Kathy had agreed to a selling price of $2.2 million over five years.
  • The two employees would pay back $440,000 a year for the first 5 years.
  • At the end of the 5th year, the employees would pay a final payment of $500,000 in cash.
  • Total: $2,200,000 in total cash after five years, and $500,000 paid at the end of year five, for a total of $2,700,000.

Bob figured that the business was making $544,000 in profit, so the two team members should be able to float the $440,000 yearly payment.

Even after paying Bob and Kathy, the new owners would get to split a healthy $100,000 per year in profits.

Or at least that’s what Bob and Kathy thought.

It didn’t take very long for Bob and Kathy to realize the terrible outcome of this decision.

Within a year, the business had major setbacks:

  • Sales volume had dropped by 50%.
  • Seven key team members quit.
  • The two new “owners” gave themselves big salaries,
    • started taking draws,
    • and racked up huge vendor bills that weren’t being paid.

What took Bob and Kathy 40 years to build value on, only took two people 1 year to destroy!

Bob and Kathy would get their business back, but it was in shambles. They would work the rest of their golden years just trying to get their company back on track.

The moral of the story is:  Don’t let one bad decision set you back.

I tell you this story because Owner Financing is one of the most common ways contractors will try to sell their business.  And, Owner Financing produces the most common disaster story in the world of Buyout Offers.

You need to understand the implications of your buyout offers before you sell.

Here are the most common buyout offers that you will be presented with:

#1: The owner financed offer. AKA the story of Bob and Kathy.

 #2: The cash offer.

#3: The stock offer.

#4: The cash plus stock offer. 

#1: The owner financed offer.

I’ve already unpacked one nightmare with Bob and Kathy. The nightmare is the most common end result for the owner financed offer.

I feel it imperative to let you know that while owner financing is not the preferred method of a buyout, there are times when it works.

We actually have a current client that is working through an owner finance deal. We work with the current owner and transitional owner to make sure that all promises are being kept.

The arrangement has been working great for the last two years, and there’s no sign of it failing over the next three-plus years.

Owner Financing can be successful, but it has the greatest risk potential.

A successful owner financed offer hinges on:

  • Trust,
  • Protection in legal documents, and
  • An amazing leadership team that can run the company without the owner.

#2: The cash offer.

The cash offer is the easiest offer to understand.

With the cash offer, you agree to sell your business for a certain amount of money. You get that money deposited into your bank account. The associated expense of due diligence, taxes, and legal fees are paid by you.

I really like this approach because you understand exactly what you’re getting.

Here’s an old adage when it comes to selling your business:

“Be happy with the cash you are going to get, because that may be all you’ll get.”

#3: The stock offer.

I recommend staying away from stock only offers.

This is an offer where you will essentially give your company away in exchange for stock in a larger entity.

This could sometimes work in your favor over the long-haul. However, it can also put you at great risk.

  1. What if the stock becomes worthless?
  2. What if you can never sell it when you need the money?
  3. What if the company files for bankruptcy?

The bottom line is this: a stock offer is risky. Unless you’re independently wealthy and can take the chance, I wouldn’t do it.

#4: The cash plus stock offer.

This type of offer can actually be beneficial. The cash plus stock offer’s real value depends upon the current value of the stock, and the ratio of cash you’ll receive.

This type of offer will require you to do a little bit of work to understand the value of the stock you’re receiving.

In this scenario, the risk is in the stock.

So, I’ll repeat the golden rule stated above:

“Be happy with the cash you are going to get, because that may be all you’ll get.”

The cash plus stock offer could be very attractive to you if you really believe in the organization that’s buying your company. So, don’t rule out this offer from your sell equation. Just make sure you do the math and understand the risk.

Here’s my preferred order, best to worst, when it comes to buyout offers:

Best to Worst Buyout Offers

#1: Best: the cash offer.

#2: Better: the cash plus stock offer when cash is +70% of the offer.

#3: Good: the stock offer when the business is public, and you can sell stock at will.

#4: OK: owner financed as long as you maintain control until buy-out is complete.

#5: Worse: the stock offer when the business is private, and you cannot sell stock at will.

#6: Worst: owner financed and you give up control before buy-out is complete.

 #5 and #6 are almost tied for the worst spot. They could swap spots depending on the leadership that will be taking over your company.

You never want to put the odds against you. If you’re considering selling your business, and every business owner reading this should be considering selling their business, then you need to understand the details of the buyout offer. Don’t be the victim of a bad deal. Start seeking guidance today and be prepared for the future.

Read Part One: How to Sell Your Business for What it’s Worth

Read Part Two: The 3 Methods of Establishing Your Business’s Value

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