Control at Only 1%? Yes.

Can you sell so much equity in your business that you’re left with literally 0.51% but still retain control?  Yes.  As long as we structure your company to allow for control at even extremely low ownership percentages.

Control at 100% Ownership. The most iron-clad method of maintaining control of your business is to be a sole-owner.  Obviously, if you control all of the stock you can vote off any officer or board member who makes a power-play.  But being a sole owner does not prevent you from bringing on investors.  Instead of selling stock, the company borrows from investors.  Some investors have no interest in the day-to-day operations of the business and would actually prefer to lend.  The investors may bring requirements like security interests against company assets, etc. but they do not gain any control over the business by way of simply being a lender.  Properly documenting these lender relationships is critical.

Control at 51% Ownership. A second option is to maintain a 51% majority ownership.  This way you can still outvote all other investors combined but you are able to bring in at least some capital without borrowing.  You need to use caution in this strategy, though, because certain decisions (like the decision to amend articles of incorporation or dissolution) require a greater majority than just 51%.  Also, depending on the number of directors you have in a corporation, you will not be able to control the entire board with just a 51% majority because of a concept known as cumulative voting.  Each of these issues can be addressed in a good set of by-laws and a shareholder agreement.  So the 51% majority is a good strategy, avoids borrowing, but requires good documentation to keep you in control.

Control at 1% Ownership. A third option is to create a non-voting class of stock.  This is easily done in a limited liability company (LLC), but requires care in a corporation.  Most small businesses formed as corporations have made an S-Corp election.  This provides significant tax benefits to the business owners.  But you will lose your S-Corp status (and the tax benefits) if you create two classes of stock with different economic rights.  Voting stock and non-voting stock are allowed, but each class of stock must have equal rights to profits, losses, distributions, etc.  The main advantage of non-voting stock is that you can maintain a 1% ownership and still control the entire company as long as the other 99% is non-voting.  This option requires careful documentation just like the 51% option, and may require amending your articles of incorporation on file with the state.

Each of the options above carries with it certain benefits and certain drawbacks. Ultimately, if you are seeking investors, the plan you go with is the plan that attracts the right investors.  The best plan in the world means little if you can’t get investors to buy shares.  There are many options available to a small business owner seeking to bring in additional capital without losing control of the small business.  When choosing an attorney to help you, it is important that you work with someone who has experience in both corporate formation and corporate litigation.  An attorney who has fought through a power play is much better equipped to help you avoid one.

Have a great day.

JDV

 

Guest Post: You Don’t Always Need a Full Business Appraisal

 

“How much is my business worth?” It’s a question that every business owner agonizes over, especially when it’s time to transition or sell their business. For many business owners, their company is the cornerstone of their individual cash flow and retirement plan. Understanding what a business is worth can help a business owner make the correct strategic decisions to help facilitate a smooth transition or sale. However, when it comes to determining the value of their business, owners are often lost and unaware of the various types of valuation opinions and services that an experienced appraiser can provide.

As a business owner begins to think about transitioning their business, the typical first step is to get a sense of what the business is worth. Many business owners believe that their only option is a Full Appraisal, which can be expensive and take a long time to complete. In reality, business appraisers can provide various levels of advisory services, including a Limited Appraisal, that can be used for informational and planning purposes.

Compared to a traditional Full Appraisal, which provides an unambiguous opinion of value using all applicable procedures and approaches, a Limited Appraisal requires less analyses and can provide an estimate of value for a lower cost and a quicker turnaround time. A Limited Appraisal can give the business owner a sense of current market multiples, their business’s performance relative to industry peers, and an estimate or range of value for their business. This information is intended to be used for internal planning purposes and can help an owner assess various options for transitioning, gifting or selling the business. Additionally, Limited Appraisals can be used to provided estimates of value for:

  • purchases of company shares by management or family members;
  • planning or negotiations related to a merger or acquisition;
  • issuing and selling phantom/restricted stock;
  • establishment of buy-sell, cross-purchase or other agreements;
  • intellectual property or patents; or
  • preliminary estimates of value or damages related to partnership/marital disputes.

Moreover, if a Full Appraisal is necessary in the future, the time and cost associated with updating a Limited Appraisal can be lower. A Limited Appraisal may not be appropriate for every situation or purpose. In certain circumstances, such as estate and gift tax filings, a Full Appraisal may be required and it is essential that a business owner work with legal counsel and an experienced appraiser to determine the type of appraisal that best suits the business owner’s needs. When appropriate, however, a Limited Appraisal can be a powerful tool that can provide clarity for the business owner and help with a smooth and successful transition.

By Henry Kaskov, ASA ( hkaskov@sphvalue.com )

______________________________

Henry is a Senior Associate with Sanli, Pastore & Hill, offering business valuations, forensic accounting, and a variety of other services.  I’ve had the pleasure of working with Henry with a mutual client and their firm does an excellent job.  The firm has office throughout the United States and globally.  Henry works out of their Geneva, Illinois office.  Thanks for contributing Henry!

If you are interested in guest-blogging, send me an email at jdvoigt@lavellelaw.com or ExitStrong@gmail.com.

Have a great day, as always.

JDV

Post-Closing Escrow Explained

When you sell your business, the buyer is worried about things that may have happened before the closing that cost the buyer money.  For example, you didn’t pay all of your taxes and the government seeks to collect against the buyer.  This is especially worrisome in a stock deal.  But even in an asset deal, pre-closing liabilities can end up costing the buyer money after the sale.

The tool used to protect the buyer is “indemnification.”  Indemnification means that one person agrees to pay for any losses that another person incurs.  In the sale of the business, the seller indemnifies the buyer, promising to pay for any losses the buyer incurs that result from something the seller did wrong.

It’s a simple concept, but there is a problem.  The buyer just sold the company and has a lot of money.  But where is that money going?  What guaranty does the buyer have that the seller will still have cash available to actually pay for the indemnification provided?  Indemnification is great… unless the person protecting you is broke.  And the four hundred thousand dollars you just paid them may not be there when it comes time to pay up.  What to do?

The buyer is going to ask for an “escrow holdback”.  People call them different things, but the idea is that a portion of the purchase price is set aside into an account and held for a while until the buyer can be more comfortable that the likelihood of incurring a loss is diminished.  The money is held by a third party called an “escrow agent”.  Sometimes that is one of the attorneys for buyer or seller.  Other times it is a totally unrelated party like a title company.  A document is prepared for the rules on how the money is accessed if the buyer has a claim.  And at the end of the escrow period, the escrow agent cuts a check to the seller for whatever is left in the account.

The main points of negotiation are how much to hold back, and now long to hold it.  The seller does her best to hold back as little cash as possible, and for as little time as possible.  The buyer of course tries for exactly the opposite.  There is really not a good rule of thumb as to how much or how long, because every deal is so different.  But you can expect a buyer to be looking for about ten percent of the purchase price, to be held for at least a year.  But I’ve see numbers much higher and lower, and times much longer and shorter.  There really is no “typical” in this situation.

One good tool to consider for a seller is “tail insurance”.  One of the things the buyer is looking for protection from accidents that may have happened, like a slip and fall or some other issue that would have been covered by insurance if the business had never been sold.  For these types of losses, the seller can pay a one-time insurance premium to buy “tail insurance” that will keep insurance in place for these types of issues for a period of time after the closing.  A year or two is typical.  Essentially the buyer decides that would rather pay a little out of pocket today on an insurance premium rather than take the risk of fighting over escrow funds with the buyer for two years.  Tail insurance doesn’t cover all types of losses that an escrow fund might cover, so the buyer will still be looking for some amount to be held back.  But it can be used to negotiate down the amount held back from the purchase price.

This is one of those topics that proves the point that purchase price isn’t the only issue that is negotiated during the sale of a company.  Escrow hold-back is just one of the other issues that may tip a seller to choose one buyer over another.

Have a great day,

JDV

3 Ways to Structure Your Sale

When selling a business, there are a few ways the purchase price can be handled.  For this post, assume the business being purchased has an agreed value of $1,000,000.

  1. Cash at Closing.  The simplest transaction is cash at closing.  The buyer writes a check to the seller fro $1,000,000 and the deal is done.  Most often the buyer has actually obtained a loan for the purchase price.  But from the seller’s perspective, she doesn’t care if the check is from buyer or his lender.  The seller is paid in full as of the closing, and the deal is done.  Simple.
  2. Seller’s Note.  The seller is often asked to provide part of the financing for the sale of their own business.  So the buyer brings $800,000 to the closing as a check (either their own money or from a lender) and executes a promissory note to the seller for $200,000.  The key to negotiating for the seller is to get the amount of the note as low as possible (thereby getting more cash at closing), keep the duration of the note as short as possible (the long the duration, the more risk of default), and secure the note with the assets of the business, buyer’s personal guarantee, or both.  Seller’s notes are common when the buyer is paying by way of an SBA loan.  Often these loans require a certain portion of the transaction to be paid as a seller’s note, and often with a full two year waiting period before payments to seller even begin.
  3. Earn Out.  The highest risk for seller is an earn out.  This is similar to the seller’s note above, but the amount the seller is financing is not fixed.  It’s based on the success of the business after the sale.  So the buyer brings $800,000 cash to the closing.  But instead of setting the remaining amount of $200,000 in stone, the buyer agrees to pay a percentage of revenue or profits for a period of time.  Perhaps buyer agrees to pay seller 5% of revenue monthly for two years.  Seller takes the risk that the buyer won’t earn as much as expected, thereby reducing the amount paid to seller.  Like the seller’s note, sellers should try to reduce the amount dedicated to an earn out, and reduce the time the earn out will be paid.  The only time when this is not true is when the seller has strong confidence that the buyer will actually grow the business after the sale.  If so, the seller would enjoy that growth through his percentage of revenue.  Finally, seller’s should always seek to have the earn out calculated based on gross revenue and not based on profits.  Profits are far too easy to manipulate and disagreements are almost certain as to how to calculate the amount to be paid to seller.

Each of these types of transactions could be a series of posts on their own.  There are far more details and nuances.  And there are also several far more complex transaction structures out there to maximize tax advantages, etc.  But these cover the basic three concepts behind selling your business.

Make today a great day.

JDV

Getting both feet across the finish line.

Today is just a quick note on completing a transaction, all the way.  Clients are busy people, and tend to move very quickly when forming an agreement.  The agreement is then documented, usually by a lawyer.  There is some back and forth to get the language just right, and then it is sent to the client for signatures.  Often, these documents are not related to a specific deadline. And these can often go unsigned for weeks or months, or (worst case) forever.

If you are purchasing a business, you will certainly be signing those documents, or the seller won’t turn over the keys.  But there are many documents that need to be signed, but there is no pending transaction looming over everyone’s head ensuring that signatures actually happen.  A good example is a shareholder agreement.  Yes, we know it needs to be signed.  But in all honesty, it doesn’t really need to be signed today.  It can wait until tomorrow.  But then tomorrow becomes next week, next month, next year.  Or never.

One of the toughest calls we can make as an attorney is telling a client that this document they badly need was never signed, despite a flurry of reminders from the attorney. Eventually, the attorney will give up and will probably send a letter saying, essentially, “I did my best, but this is on you now.”  The very worst is when an agreement was never signed, and one of the parties has now died.

So the takeaway today is to be sure you get both feet across the finish line before calling a transaction “done”.  Don’t stop short of the ultimate goal, and be sure to set reminders to gather those important signatures and really tie up the loose ends.  You’ve spent the money to get the document completed.  Be sure you finish it off!

JDV