Your Practice Is A Success; Now Sell It Successfully!
September 18, 2008
An Introduction To Legal And Business Issues Involved In Selling A Professional Practice
When you sell your car, with the exception of certain Corvette owners, you usually don’t care what happens to it after the check clears. Whether the owner drives it into a tree, or changes the oil every three thousand miles doesn’t make a difference, so long as the check is good. But what if you are not allowed to drive another car for three years, or what you are paid for the car depends on how well the car performs after you sell it, or the car is something you have spent your entire career developing? That’s what can happen when you are selling your business rather than a car. Non-competes, earn outs, sale of goodwill and intellectual property can all make it truly important what happens to your company after you sell it, unlike that ’94 Ford Taurus you just unloaded on Craig’s List.
This article will discuss some of the basic financial issues in selling your practice, and introduce you to some of the legal issues involved. This article can only touch on some of the more important issues involved, and is not intended to be a comprehensive review of everything you need to know to sell your company. It is aimed at those who work full time in their own professional consulting practice.
What Is Someone Going to Pay?
You may get a decent living out of your business, but that doesn’t mean anyone else will be interested in buying it. A business that exists to pay you the same salary you could earn somewhere else has little real intrinsic value. No one is likely to pay you money to buy a job in which they earn the same as they could make elsewhere. To figure out what someone might pay, figure out the cash flow your practice generates above what you would have to pay someone to do what you do. For instance, if you earned $200,000 from the business in a year, and you would have to pay someone $190,000 to do the work you are doing, then the earnings of the business that someone else would be interested in is really only $10,000.
Other rules of thumb for valuation of a practice are one year’s revenues, or two and a half times the owner’s pre-tax income, plus net asset values. The seller usually keeps the account receivable and is liable for the accounts payable through the closing.
This calculation is a rough place to start in valuing a business. If you have great customer contacts and relations, or goodwill, or some IP that would cost a lot of money for someone else to develop, the right purchaser might be interested in your company. But if your business basically exists to pay you a salary, you are going to have to develop some other value to get anyone interested in paying a substantial amount for your practice.
How Are They Going to Pay it?
When is the following equation true: $400,000 > $400,000 > $400,000? It is true when the first means the $400,000 is paid at the closing; the second equals $100,000 in cash at closing and a note for $300,000 secured by a mortgage on a house; and the third equals $100,00 and an earn out of $300,000 over three years, depending on the result of the acquiring company.
Payment of the full purchase price at the closing is the easiest and most certain, and the most like selling a car, but there are costs to it. Since all the risk of the business is on the purchaser, you can usually count on an all-cash offer being the lowest price available. If you have intrinsically valuable IP, such as software that would be expensive to develop, or long-term consistent cash flow from a wide base of customer that does not depend crucially on you, you can expect to get a decent all-cash price. If you are selling potential, you probably are going to get substantially more money with an earn out, discussed below.
Taking debt back can be almost like cash, or more like an earn out with limited upside depending on how any debt is collateralized. If the note you take back is well-secured, whether by real estate (such as the purchaser’s house), a company of substantial size, or a personal guarantee from a high net worth individual, there is probably not going to be a lot of credit risk. So long as you are getting a good rate of interest, there may not be much difference from an all-cash offer. In this circumstance, it is like selling a car; it’s likely you’ll get your money, so you don’t really need to pay much attention to how your buyer runs the company after you are gone. If you do take any type of note back, cross default the note and any non-compete (discussed below) so you aren’t bound by the non-compete if they have defaulted on the note.
If you don’t have good security note, you really are sharing the risk of how the company does after the sale. If the company doesn’t do well, and the buyer doesn’t pay, you can get your company back. Of course, getting your company back after your purchaser has abandoned it is unlikely to be must benefit to you, though you should get your intellectual property back. When you take back paper with inadequate security, your upside is limited (the most you are going to get is the amount of the note), and you have substantial downside (you might not get paid anything on your note). Particularly if you would not be getting back any valuable intellectual property, you might want to consider an earn out, discussed below, rather than take poorly collateralize paper. While you are sharing the downside risk in an earn out, you also have the opportunity to participate in the upside, as is discussed below.
In most professional service businesses where the owner is an important part of the value of the company, you can expect to have an earn out. An earn out is when a portion of the purchase price is conditional on the company achieving certain financial measures after the closing. For instance, $500,000 might be paid at closing, with $250,000 due on the first anniversary of the closing if gross revenues exceed $2,000,000 for the year with a 20% margin, and another $250,000 after the second year if gross revenues exceed $2.5 million, with a 20% margin. With an earn out, you are sharing the risk of the success of the company after the closing with the buyer: if the company succeeds, you get more money. You can even have tiers of an earn out. For instance, in the earlier example, the payout could be $300,000 if the first year gross is $2.5 million.
The structure of the earn out will be determined by what the parties want to accomplish. Is the earn out to be like a bonus in the event of extraordinary results? In that case, the intended purchase price would be paid at the closing, and the criteria for the earn out would be on the high side of probable results. Is it to make sure a seller who will continue to work for the company will keep results consistent? Then, the earn out would be considered part of intended purchase price, and the criteria for the earn out would be based on the company’s current results.
Structuring the terms of earn outs is complex. Will the purchased company be a subsidiary (that is, a separate entity with separate accounting) or will it be a division of a larger entity, in which case the accounting may not be separate? How much will the subsidiary or division be charged for overhead services (such as accounting, HR or legal) that the parent provides to the subsidiary or division? By sticking your subsidiary with a high bill for overhead, the buyer can make sure you don’t meet a margin criterion for payment of an earn out. If you will personally be performing services for the larger entity, aside from running the division, such as service on the Board of Directors or consulting for other divisions, will the subsidiary be credited with this? Will R&D you spend be counted as a cost, even though it is probably something the buyer wants you to do and will benefit the buyer? If your salesperson cross sells product for another division or subsidiary does your subsidiary get credit for the revenue, or at least get credit for the time the salesperson spends cross selling for the parent? If you don’t have a margin requirement, is there anything preventing you from selling at a discount to pump up revenue? Due to the incredible complexity of earn out formulae, you must ultimately be depend on the good faith of the buyer. If you have reason to doubt that, you may want to settle for a smaller guaranteed cash payment, or cash plus well-secured paper instead of the risk and complexity of an earn out.
Depending on your business, there may be other structures for paying consideration for the purchase. You can expect some of the purchase price to be allocated as payment for the non-compete. You can enter into a long-term consulting or employment agreement. If you are depending on these amounts, make sure that conditions under which they can terminate you for cause and cease to pay under the agreement are extremely restrictive. Do you own your building and lease it to the business? You either sell the building, or hold on to it and enter into a lease with the buyer to give you another revenue stream. In structuring purchase price allocations, work closely with your accountant at an early stage. Your individual tax situation, such as whether you have operating losses to use in subsequent years, how you are depreciating your equipment, can make a huge difference in how the deal should be structured to result in the smallest tax bite possible.
What Are They Buying?
Almost all business acquisitions are structured as an asset purchase, rather than a sale of the stock or the interest in the limited liability company. If the buyer bought the actual company, it would succeed to all the liabilities as well, whether for past malpractice, employment claims, etc. By buying the assets, the buyer is getting a clean slate. There are some reasons to purchase stock, such as if the company has non-transferable licenses or contracts, or has net operating losses that the buyer can use. This is uncommon, though, so this article will assume an asset sale rather than a purchase of equity.
The buyer is going to buy everything that you use in your business. The hard assets, such chairs and computers are the least of it. What they are really buying is your intellectual property, the good will of your business, and, possibly, the work of you and your key employees.
Goodwill. Good will is the legal term for the following: all your customer relationships, past, present and prospective; the brand value of your name or company’s name (just from knowing the name of your company, do people in the industry think well of you?); and any vendor or supplier relationships. How does anyone buy an intangible like this? By having you, and key employees, sign a covenant not to compete, where you agree not to solicit business from any past, present or prospective customers for any other company, and not to compete in the industry. We have extensively discussed non-competes in other sections of these materials. As discussed in those sections, the definition of a competing business, the geographical area covered, and the length of time of the covenant are crucial. Small differences in wording can make a big difference in your ability to work for another company or to set up your own new company. One thing you must remember is that no matter how unreasonable the non-compete may be in the extent of the restrictions and the geographical and temporal scope, it is highly likely that the restrictions will be enforced. With non-competes in employment agreements, courts will frequently not enforce unreasonable non-competes on the basis that the employer has so much greater negotiating advantage than an employee that the courts need to protect the employee. When, however, you are negotiating at arms-length to sell a company, courts consider that the parties have equal bargaining power, and so will not let a seller out of an ill-considered non-compete. Make sure you know what you are getting into.
Intellectual Property. Your intellectual property is any ideas or concepts you use in your business that other businesses do not. If your work consists of application of standard professional analysis, you may not have any intellectual property to sell. However, if you have software that you have developed, or even have developed an application using off-the-shelf software, the buyer is going to want to own it all. That means that if you leave the company, you can no longer use it.
Key Employees. The buyer may not be willing to do the deal unless your key employees, particularly sales people, sign non-competes. If you are one of the key employees and your boss needs you to sign a non-compete to make a sale go through, you can ask for a part of the purchase price on closing. As a seller, you may want to agree to pay them retention bonuses out of your sale proceeds or have the buyer kick in some money for them, payable over time so long as the employees stay on for the closing and for the transition.
What’s the Process?
Sales of businesses follow a traditional process that has been largely unchanged through years of technological developments, and is generally the same no matter the size of the transaction. How each stage is done has changed by technology, and each stage can take a lot longer with a big deal, but the structure is pretty consistent.
The first stage is to negotiate a letter of intent to set forth the basis deal, for instance: the purchase price; how it will be structured (cash, financed, earn out); the terms of the non-compete; assets sold and any assets withheld; and require confidentiality of the negotiations. The prospective buyer may ask the seller to agree not to look for other purchasers, called a standstill agreement. The letter will provide that consummation of the deal is conditional on the seller being satisfied with its due diligence review of the company, which is further discussed below. The letter will also provide that is it not binding; that other than to maintain confidentiality and any current duties, such as any standstill agreement, neither party is bound to go through with the transaction. Why do the parties bother to negotiate a document that is not binding? The reason is that the next steps, negotiating a binding purchase and sale agreement and conducting due diligence, are expensive and time-consuming, so everyone wants to know that they are on same page before starting theses other processes. By the closing, the deal will change from what is set forth in the letter of intent, but the letter of intent does provide for a structure for the deal to proceed.
The next steps frequently happen simultaneously: the buyer commences due diligence and the parties begin to negotiate and draft the Asset Purchase Agreement.
Due Diligence. The buyer is going to want to review everything material to the operation of your business: all client contracts; all leases; all employee benefits plans; loan documents; insurance policies. The buyer will make sure that any claimed backlog of work is real, and that continuing customer relationships are strong. Any threatened or potential litigation must be discussed. Their accountants will drill down through your financial statements. Complying with due diligence requests is a huge job for the seller, and if your practice is of any size, you can expect your office manager to work full-time on it for quite awhile. Complying fully with due diligence is crucial for you. In the Asset Purchase Agreement, you will be representing and warranting that you have disclosed everything material to your business. If you neglect to disclose something and any of the representations are untrue, the buyer can sue you for any damage they suffer from it, including attorneys’ fees and costs of defense.
Asset Purchase Agreement. This is the actual binding contract for sale, sometimes called a Purchase and Sale Agreement. In smaller deals, this may be signed at the closing. For larger deals with financing or where consents for transfer of a contract have to be obtained from existing clients, it is common for it to be signed prior to the closing, after financing commitments have been obtained. Asset Purchase Agreements in the smallest deals are long, so a comprehensive review is beyond the scope of the article. The guts of the agreement, though, are the provisions for payment of the purchase price (cash, debt or the terms of an earn out), and representations and warranties by the seller that they have disclosed everything material for the business. A significant part of the agreement is the schedules, where the disclosures of facts discovered in due diligence are listed. These would include lists of clients, accounts receivable, accounts payable, vendor lists and contracts, assets, intellectual property, taxes paid, or anything else material to the business. It is common for the attorneys to spend a considerable amount of time negotiating the terms of the representations and warranties, as the seller wants the buyer to promise that nothing bad will happen in the future, and the seller wants to buyer to rely on its due diligence.
After the asset purchase agreement is signed, it is common for the buyer to require that the seller obtain consents from the buyer’s significant clients for the transfer of the business to the buyer. Even if there is not a formal contract, the buyer will insist that the seller do whatever it can to transfer the client relationships. The closing might be conditioned on obtaining consents of the most important clients.
The closing, where the actual assets are transferred to the buyer and the seller pays the price, is now an anti-climatic part of the process. Closings usually happen electronically now rather than having all the parties around a table. If all the due diligence and preparation of the asset purchase agreement and schedules has been complete, the closing should go smoothly.
What Happens to Me?
Many business owners are unhappy after they sell their company. Some have not reconciled themselves to working for someone else. Others ignored their growing realization that they really did not like the buyer’s personnel, and are now forced by an earn out and non-compete to work for them for several years. Like a couple that has a furious argument about wedding invitations but get married anyway, don’t ignore your gut feelings about your buyer. If you don’t like them, either find another buyer, or take a lower cash price.
By being aware during the process, and by having a carefully considered and structured transaction, you will have a best chance of being the happiest of sellers: somebody pays you for your Corvette, you get to keep driving it, and the better it performs, the more you get paid.
 Robert B. Scott, “Practice Valuation: Thumb Rules and Common Sense,” Journal of Accountancy 174.6 (1992). This article also has a longer explanation of the point made in the first section that no one is likely to buy your practice simply to buy a job.
 For a definition of cause strongly oriented to the employee, consider the following definition of “cause”: (i) the Executive’s willful and continued failure to substantially perform his duties under this Agreement, other than any such failure resulting from incapacity due to physical or mental illness, which failure has continued after a written demand for substantial performance, signed by a duly authorized member of the Board, is delivered to the Executive, specifying the manner in which the Executive has failed to substantially perform; or (ii) the Executive’s willful engagement in any malfeasance, fraud, dishonesty or gross misconduct, each of which must (x) be in connection with his position as the President and (y) materially damage the Company economically or otherwise;