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Selling A Business: The Business Valuation

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Selling a business is one of the most difficult decisions an entrepreneur will face. Often times, entrepreneurs are emotionally invested in the business that they have created and it is hard to separate their personal feelings and emotions. Having an understanding of how to sell a business, including the business valuation, can make the process much easier, smoother and more efficient.

One of the most common ways to acquire equity in a company is through an earn-out. An earn-out is when part or all the purchase price for a company is payable after the closing date based on performance standards (earn-out targets) set by both parties during negotiations. As opposed to full upfront pricing, this gives some relief to sellers who may not have complete confidence in buyers’ ability to continue running their business at past performance levels or who may not be confident in their own projections going forward.

Earn-outs are becoming increasingly popular as they provide a way for sellers to protect against buyer slippage while allowing them access to needed capital without having to wait years until retirement age and still incurring higher tax rates on capital gains than corporate income taxes (which buyers typically pay).

Why an earn out may be a good idea

Here’s why an earn out may be a good idea for you:

• It gives you the opportunity to ensure your business will succeed with its new owner. Using an earn out can allow you to stay on during post-sale transition, and this time enables you to train your successor and introduce them to vendors, employees, customers and other key stakeholders. This process ensures that the buyer understands how your business operates and helps them see that they’re making a good investment. You can also negotiate for certain consumer elements (like marketing) so you know your brand will continue to be represented well after the sale.
• You can prove that what you’re selling is worth what they’re paying for it. If there’s some question about whether your business is worth its asking price or if it has the potential to grow in value beyond where it currently stands, then an earn out may be the best way forward. It offers a trial period during which both parties can make sure they’re satisfied with their end of the deal before signing any final papers.

How it works

The earn out is intended to compensate the seller based on the future performance of the business being acquired. It can represent a significant portion of a transaction’s value, so it’s important to have a detailed agreement governing this aspect of the deal.

Once you’ve agreed to an earn out, you’ll need to decide how its amount will be calculated. While some sellers may request that it be tied solely to gross sales or profit figures, others may want the calculation method to hinge on several metrics simultaneously—such as revenue and sales volume, for example.

Also take into consideration which accounting practices will be used in calculating these numbers. The buyer’s financial statements? Or those of an independent third party? And what about intellectual property rights or licensing fees? These are just a few examples of intangible factors that can influence how an earn out is calculated and paid out over time.

The importance of due diligence

Once you’ve found a buyer, you’ll need to know how to effectively determine the value of your business and negotiate the terms for sale. This is where due diligence comes in. Due diligence is your friend, and you should embrace it as such. It’s a necessary process to ensure accuracy and appropriate disclosure in both parties’ best interests.

Due diligence helps protect buyers from risk by giving them an overall picture of the business’ financial position, as well as its pros and cons. For example, if there are any pending lawsuits against your business at the time of sale, that’s going to be reflected in a due diligence report. The seller benefits from this because they cannot be charged with fraud or unfair representation later on—the buyer was made aware of all details prior to signing off on the transaction.

To protect yourself and make sure you’re getting full value, do your homework and make sure that the buyer understands how the business works.

If you’re considering an earn out, get professional advice. Make sure that you understand the terms of the deal and include a clause allowing you to withdraw if the buyer doesn’t meet the conditions.

It’s important that the deal is written down, signed and completed before any money changes hands. It may be tempting to leave everything verbal to avoid paying professional fees but this can cause problems later on — especially when it comes time to complete the second part of your sale agreement.

Unless they have been involved in buying and selling businesses before, buyers won’t usually know how your business works from top to bottom. If they don’t understand how it works, it will be difficult for them to reach their performance targets and pay out your earn out. You need to make sure the buyer understands how your business works so that they can meet their targets and get full value for their purchase.

Editorial Team
Editorial Team
Editorial Team
MergersCorp™ M&A International is a leading Lower-Middle Market M&A advisory brand, offering professional M&A services to clients across the world.

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