The Art Of The Deal For Independents Selling Their Firm

By

It is said that what you see is what you get. But, as we all know, this is often not the case, even under the best of circumstances. For those of you who read my first two articles on opportunities for independent advisors and guidelines for those considering a sale (see NU, 9/23/02 and 11/18/02) and want to move forward with a prospective buyer, lets discuss how to make sure you get the deal you see and that it is the best deal for you and your future.

There are two parts to a sale: the economics and the terms. If your desire is to stay in the business, then the most important principle is to avoid pushing valuation beyond sustainable performance realities. If you do, you will be under tremendous pressure to make it work under any set of circumstances, and that can be difficult. This is particularly true in an entrepreneurial business where circumstances change and results do not occur in a linear fashion.

Assuming the economics are fair and you desire to stay in the business, the most important aspect is the terms of the deal. Generally, you need operating and acquisition agreements. What are the buyers rights and obligations and what are yours? Is there an earnout payable based on the performance of your firm after the closing? Whats negotiable and whats not? For example, do you have the right to operate the business like you did before the deal closed? Do you have the right to select successors with the buyers approval? How long is the noncompete? Can you be terminated for cause? What constitutes cause?

Dont ignore the possibility that the buyer may want to turn around and sell your firm someday. Does he have the right to re-sell it? How does it affect your rights and obligations? If the company is sold, what happens? Does your earnout accelerate?

The most important of all the terms is who has operational control following the transaction. Does the buyer have the right to tell you what to do, what carriers or other manufacturers to use and how to do business?

If so, then you have a problem. The reality is that no one knows how to run your business better than you do. The buyer should have a right to be intimately involved, but if you want to survive, you need to run the business day to day. If you dont, you wont have a level playing field.

The buyer will, by nature, impose itself, and chances are the results will be less than positive for both you and the buyer. You need to maintain leverage–or at least a level playing field–in the relationship for the benefit of both sides.

Deal points that drive economics have to do with how the multiple is calculated. If the buyer pays four times, under what set of circumstances would he pay five or six times? If you have 70% of your income in recurring revenue, would he pay more? If not, theres less reason for you to do the deal. The higher your recurring revenue, the lower the risk for the buyer.

What if your earnings have been diminished by investment in the business that is now going to produce a handsome return? Can you normalize expenses and calculate the multiple on the normalized results? Or, could the buyer pay an extra multiple for the results you did create in recognition of the investment that you made?

How are earnouts calculated? If a portion is in stock, can it be structured as part of the original transaction to qualify for capital gains? Beyond the initial earnout, is there an incentive plan for succeeding periods? If so, do the growth targets change? For example, if the successive earnouts are based on doing so much business with certain providers, that contradicts the stated objective of letting you run the business and make those decisions.

So, the agreement must say, for example, that future earnouts and incentive payments are based on revenue results, not where the business is produced. If there are incentives for placing business in a certain fashion, then they must be in addition to incentives based on profitability and growth.

Frequently, entrepreneurs focus on the upfront multiple and are overly optimistic about how much and how fast they can grow the business. This is a “trap” because if the firm falls behind early, you can forget about maximizing the earnout. So, when considering the upfront multiple and the earnouts, how do you maximize the deal overall? One way is to “sandbag.”

For example, what if the upfront multiple was based on a lower number than you currently produce. The net result may be that you have a head start on the earnings that will count toward the calculation of your earnout. If thats the case, lower upfront consideration, combined with a better earnout payment, produces significantly more dollars in aggregate than a higher upfront number and a much lower earnout.

Remember, youre still in the deal; youre not going anywhere soon. Therefore, you are better off maximizing the overall payout as opposed to the upfront payout.

By the way, sandbagging is fair game because the buyer wants to minimize risk and wants to show same store sales growth. Buyers will pay more for better, more predictable results. Paying more upfront, and having a greater risk of no growth, is a lose-lose scenario.

At the end of the day, independent financial service firms have created attractive entities today that can be capitalized; understanding the rules of engagement with potential buyers is critical; and, negotiating the best deal is both science and art.

is president & CEO of Summerville Advisors, a financial services consulting firm located in Portland, Ore. Tom was also the co-developer and former managing partner of M Financial Group. He can be reached at tspitzer@summervilleadvisors.com.


Reproduced from National Underwriter Edition, April 14, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.