7 Pitfalls to Avoid Between LOI and Deal Close

  • By Business Brokerage Press
  • 01 Dec, 2015

Pitfalls to avoid

When selling your business, reaching the letter of intent (LOI) stage is a great indicator of success. But, the process is far from over. There are many steps that still lay ahead that can derail or ruin the transaction. Below are 7 pitfalls to be aware of between the LOI and the closing of the transaction:

1. First, get the letter of intent done well, and read all the legal details.

The first step to moving from letter of intent to closing is to make sure that everyone understands all elements of the letter of intent, and that the letter of intent has a reasonable amount of detail.  Misunderstandings and miscommunications will blow-up a deal very quickly if the parties have different interpretations of the terms.

In the midst of negotiation, it may be tempting to leave a detail for later, or hope the other party didn’t notice some important detail, or leave an open item to later.  There is no one way to do things, but if you truly want the deal to happen, I have had much more success taking the extra time to explain a term or go over something again to make sure that everyone is on the same page.  The LOI sets the pace for the rest of the process, so it is important to do it well.

2. Keep the business on budget and performing well.

Ensuring that the business remains on track is critical during the process from LOI to closing. Although it may take a great deal of focus to close the deal, keeping the business running according to plan is necessary for the transaction. This is the most important, of many things, to balance during the closing process. Among private equity buyers, you will hear wisdom shared from investor to investor with things such as, “95% of all bad deals were off budget during the closing process.” The buyer will be watching every twitch of the business with extreme scrutiny. To a buyer, there is nothing more comforting than seeing the financial results comes in as expected.  Even better for everyone is having the financial results come in ahead of budget.  Yes, this is true even when you are the seller wondering if you could have gotten more for your business because it makes the buyer want to close the transaction even more and maybe some small horse trade will go your way in the end (and, there is always one more horse trade).

When the financial results are not on target, it forces the buyer to spend time and energy trying to figure out if the miss is a short-term blip or something more fundamental.  Better to avoid having the buyer to think twice about anything.

Most deals require the seller to operate the business as usual during the closing process.  This should be obvious and intuitive to all involved.  However, I have seen sellers try to be clever and change some aspect of the business during the last months or weeks to try and tweak the deal to be more favorable to them.  This never works.  First, it is counter to the spirit of the deal to keep operating the business as normal, and it’s very difficult to change any reasonable size organization from their normal operations without creating problems, both intended and unintended.  Furthermore, it is in the seller’s interest to keep the business operating normally just in case the transaction does not close. It is a fact of life that not all deals close after a signed letter of intent. The seller needs to be aware of this and not make any adjustments that they would not make if they were not selling the business.  In particular, do not change a strategy to fit the buyer until after the close.

3. If something bad happens, inform the buyer immediately.

Business results are rarely perfect and on budget.  If something happens, the best policy is to be up-front and inform the buyer immediately, just as you would want to be informed if your roles were reversed.  If done well, this can increase the buyer’s confidence in the seller and the business. If done poorly, it can torpedo the transaction in a heart beat.  In one recent situation where I was not directly involved, the seller lost several clients in late November that was going to reduce their revenue by >20% (probably only for a few months, but it wasn’t totally clear). The seller did not tell the buyer until the December and January financial statements were ready, and it cratered the deal. They may have had a chance to save the deal if they had been up-front immediately. More importantly, they should have done everything in their power to keep those clients and keep the business on track (or presented more conservative financial forecasts that accounted for some potential lost clients).

4. Have scrubbed and analyzed your previously presented financial statements.

Most serious buyers will perform a “Quality of Earnings” accounting due diligence on your company. This means that they will review, in detail, the financial statements that you have previously presented to make sure the earnings presented are high quality. It is inevitable that they will find various adjustments that make the earnings a bit better and a bit worse than expected — that are normal. However, it will save sellers a ton of time if they have performed their own analysis to find the unusual items or the items that the buyer may ask about. It is much more efficient to be prepared up-front than to scramble around trying to understand the questions yourself and to explain what the buyer may be finding.

5. Be organized.

The buyer will need all sorts of information about the financial results, legal, insurance, human resources, major contracts, etc. Of course, the seller wants the information to be strong and supportive of the picture that was painted during the sale process. Almost equally as important is how the information is organized and presented. Buyers appreciate indications that the company is well managed and organized — such indications provide more confidence to the buyer.

6. Manage the lawyers — don’t let them manage you.

The lawyers view their job as doing everything they can to protect you, so they will always take the most conservative path and recommend the most protected, conservative position.   There is nothing wrong with that, but if both parties take that same stance, there is no room to find a middle ground that makes sense. The lawyers work for you — you should have the confidence to tell them what you want, make the final business decisions around the deal, and not let the lawyers manage you. Finishing the Letter of Intent does not mean that all the deal decisions are done. There are many more small details and decisions in the final documents, and both parties need to continue compromising and negotiating the details that are not covered in the Letter of Intent.

7. Communicate well with everyone involved.

Special effort needs to be made to communicate (probably more than you think) among all the parties. And, special effort should be made to think about the best methods to communicate everything. Never take a shortcut by firing off an email when a phone call would be better. Everyone is on edge and making sure to communicate enough— and via the best method possible — pays off big time.
By Jonathan Funk 23 Aug, 2017
On July 18th 2017, The Federal Government announced major tax changes on business owners - triple taxation.
Previously you would have received much more on the sale of the share or assets of your company.
The new legislation taxes could be as high as 75%.

Astra has a proven program that will mitigate this new onerous tax legislation. We would like to have the opportunity to show you how we can do that. To avoid “triple taxation” you must plan your exit strategy through a proven program. Our SuperMax and MiniMax programs will abate these new punishing tax changes. Our financial consultant will review your situation and demonstrate how Astra’s Super or Mini Max programs will work for you to save you many, many thousands. Please contact us at info@abc-astra.com or bhughes@abc-astra.com.


SUMMARY

This note is a summary and clarification of the 27 page announcement by the Minister of Finance on July 18 which has major implications for private business owners in Canada. Please take the time to review this note and give yourself time for reflection. We suggest you read this more than once.

The tax consequences of the NEW Rules could cost you millions of dollars without putting smart tax planning in place.

Scenario A - Under the old rules, you could sell your company’s shares and after it paid the capital gains taxes due, the net cash proceeds could be put into your hands personally with no additional tax to pay on the transaction. Not any more.

The proposed new rules should not impact your company 's ability to pay capital dividends (net after tax proceeds from the sale) to you as a shareholder unless the buyer and the seller are not dealing at arm's length (for example, between family members). With a non arm’s length transaction, the net proceeds are taxed again in your hands as an ineligible dividend at an effective tax rate of between 42 to 57% depending on your province of residence.

Scenario B - Under the old rules, you could sell your company’s assets and after it paid the capital gains taxes due (if any), the net cash proceeds could sent to your Holdco as an after tax intercorporate dividend with no additional tax to pay on the transaction. This would have allowed yo to redeploy cash for other investments. Not any more.        

The proposed new NEW Rules will disallow the inter-corporate dividend as a tax free transfer to your holdco and instead tax it as an ineligible dividend at highest possible tax rates.

Scenario C - Old rules: Shareholder dies, creating a deemed disposition of shares. No tax paid liquidity is in hands of estate to pay tax. Estate uses a capital loss manoeuvre in combination with “stop-loss” rules and acceptance of a promissory note from a corporation to mitigate the amount of actual tax due as a result of deemed disposition of shares when the shareholder dies.

The proposed new NEW Rules will disallow the estate from transferring shares with a high cost base to a parent company in exchange for a tax-free promissory note.    

NEW Rules : Shareholder dies, creating a deemed disposition (CRA considers shares and other personal property to be disposed/sold) of shares. No tax paid liquidity (ready cash (on hand) is in hands of estate to pay tax. Estate raises cash to pay this tax by selling corporate assets with attending cap gains tax "A". Net proceeds are paid off of the balance sheet to pay the cap gains tax on the deemed disposition caused by shareholder's death. This is Tax "B". However since it all came off the balance sheet, CRA wants additional tax as they regard this as a non-eligible dividend or Tax "C". This is "triple taxation". A+B+C=CRA The total tax bill could be as much as 75%!!!

Scenario D- Old and New rules are the same: Shareholder dies, creating a deemed disposition of shares. No tax paid liquidity is in hands of estate to pay tax. However life insurance proceeds come into and out of the corporation tax free by way of capital dividend account (CDA. Sec. 89) to pay required taxes. Estate now transfers shares to whomever it is directed by the Will of the deceased shareholder. No corp assets were sold, no taxable cash came off the balance sheet's current assets yet the cap gains tax were paid. The new shareholder's capital is still on the balance sheet but it is now tax paid or paid up capital (PUC). Dividend income paid at say 8-10% of the tax paid PUC are within CRA's "safe income" rules but taxed at the attending marginal rate.

Here are the main reasons tax practitioner’s advocate the use of life insurance in corporate-estate situations: A) it’s a lot cheaper than paying ANY amount of tax and B) it is already pre-approved by CRA and does not cause any tax burdens.

In summary: either from action or inaction when large blocks of capital are moved into the hands of a shareholder or an estate, the transactions are on CRA’s maximum tax radar. On the other hand if dividend income on capital is employed as a source of income, the tax rates are far less than taxes on salary or high amounts of capital treted as ineligible dividends.

In Brief, CRA does not want you to take capital off a balance sheet, but keep it employed ON the balance sheet, and CRA is satisfied.

Therefore smart planning will open doors for tax efficient succession planning for your family and provides options to negate asset sales triggering double or even triple taxation.
And, smart planning utilizes the Income Tax Act’s rules to get your hard earned capital into shareholders hands while you're alive either tax free or with a lot less tax paid during your lifetime and after death.

Bottom Line: Smart Planning will get you:
  • a strong balance sheet 
  • a company that will not be hurt or destroyed because of tax
  • happy shareholders 
  • a happy estate
  • satisfied CRA
  • Everybody wins!

Smart planning starts with us. Contact us now.

TIME IS NOT YOUR FRIEND – WE HAVE WAYS TO HELP
By Robert Hughes, Astra Business Corporation President 22 Jan, 2016

Astra, with their associates, have developed exit strategies using major banks and insurance companies to transfer ownership of your company in a manner similar to a department store ‘lay-a-way’ plan. There are two programs to choose from - MiniMax and SuperMax.

These programs offer a customized succession plans, which enable business owners to hand the reins of their business to a new generation or investor, while securing a TAX FREE retirement income stream, reducing risk, eliminating volatility and creating an estate legacy.

This is a strategy that has a stated time frame to transition the operation, and eventually, the ownership of the business. This succession plan maximizes the net cash flows for the remaining lives of the owner and spouse and if possible, creates a legacy for the surviving family members or investors.

Whereas you are looking to obtain a sale price of up to 4 to 5 times multiple, buyers have been reluctant to provide you with an acceptable purchase price with terms satisfactory to you. These alternate programs will provide you with an acceptable exit strategy with a financial benefit of  many times over what you had originally wanted  and while you are young enough to enjoy your retirement income.

I trust this is of interest. If so please advise and we will introduce you to our associate and start the process with a conference call where an in-depth detailed discussion will reveal how this program works.

Looking forward to working with you.

Click here for more information.

By Paul Woodhouse, MNP 15 Dec, 2015

A non-compete agreement is a covenant to the purchase and sale agreement that restricts the seller of a business from competing with that business in the future. Such covenants usually last for a specified period of time and may apply to a specific geographic area (generally the area currently being served by the subject company).

Non-compete agreements provide buyers with a measure of comfort in that the expected stream of earnings from the business being acquired will not be disrupted by competition from the former owner. The seller benefits because the buyer has confidence that the anticipated earnings will materialize and therefore the seller can maximize the purchase price.

In some cases, they receive an annual payment for a specified number of years. In others, the amount the seller receives is included as part of the total purchase price. In either case, the seller is granting a promise to the buyer that may have considerable value in terms of preserving the future earnings potential of the acquired business. Thus, a non-compete agreement represents an important (though intangible) asset for the buyer, quite apart from the operating assets.

Why put a value on non-compete agreements?

If the consideration paid to the seller for entering into a non-compete agreement is included as part of the total purchase price paid for the acquisition, there are three good reasons to assign a separate value to it.

Accounting Standards and Reporting Requirements
If the purchaser is a corporation, generally accepted accounting principles (GAAP) require the parent company’s financial statements to be consolidated with those of its subsidiary. Depending on the jurisdiction, these accounting rules have specific standards that require a purchaser to allocate the total purchase price paid in a business combination to the fair market value of all the tangible and identifiable intangible assets acquired (which would include the non-compete agreement). This provides stakeholders with more information on the true nature and cost of the acquisition.

Compliance with Income Tax Rules
Proposed changes to the Income Tax Act mean that any amount the seller receives for granting a restrictive covenant will be treated as ordinary income for income tax purposes. The buyer will generally treat the expense as the seller treats the income; in this case, it would be a deductible business expense. There are some exceptions to this general income inclusion rule. One exception is where the grantor and grantee jointly elect, in prescribed form with their tax return for the year, that the amount is an eligible capital expenditure to the buyer and an eligible capital amount to the grantor. Therefore, it is necessary for the parties to determine the value of the non-compete to ensure there are no unintended tax consequences.

Possible Future Damage Claim
In the event the seller breaches the covenant not to compete, the purchaser may have a claim for economic damages. The fact that a valuation was prepared at the time of the transaction demonstrates that the parties contemplated that real damages would arise if the seller was allowed to compete. This helps support the purchaser’s legal claim against the seller.

How should a non-compete agreement be valued?

There are two generally accepted approaches used to determine the value of a non-compete agreement:

Differential Valuation Approach
The differential approach involves valuing the business under two different scenarios. The first valuation assumes the non-compete agreement is in place and the second valuation assumes that it is not. The difference in the value of the business under each approach is attributed to the non-compete agreement. Because the differential approach involves a rigorous business valuation analysis under two scenarios, it allows for more flexibility in determining the net impact on future cash flows arising from potential competition from the seller. The downside is that this approach is more complex and time consuming.

Direct Valuation of Economic Damages Approach
The direct approach involves determining the present value of the potential future economic damages that would occur as a direct result of not implementing a non-compete agreement. The direct approach is somewhat simpler since it involves estimating the direct damages from competition, usually in the form of a percentage of income lost. This method is more widely used because of the need for only one estimate of future operating results, which makes the analysis less time consuming. Both methods, if properly applied, should arrive at a similar conclusion of value.

 

A Framework for Using the Direct Damages Approach

When using the direct damages approach, the first step involves a risk analysis to determine the maximum potential damages that could arise if the seller competes with the acquired business.

The second step is to determine the “expected value” of the losses based on a probability assessment that considers the likelihood that the seller would compete with the acquired business.

The third step involves determining the present value of the economic damages avoided over the term of the non-compete agreement.

 

Step 1: Estimate annual economic losses, assuming competition from the seller.

This step involves the following stages:

1.  Estimate future earnings or cash flow, assuming a non-compete agreement is in place. This will generally incorporate the same set of assumptions that a hypothetical market participant would use in estimating future operating results for the purpose of pricing the acquisition.

2.  Quantify the potential damages (in the form of reduced earnings or cash flow) if the vendor(s) were free to compete with the business post sale. This generally involves a two-step process:

1.  Perform a risk assessment that considers the key factors that could negatively influence the business projections determined in Stage 1. Depending on the nature of the business, the following questions should be asked:

Does the former owner have significant personal contact with customers?

If so, are these customers loyal to the former owner? How many customers could the former owner take to a new business and what is the profit related to these accounts?

Are the other employees loyal to this person and do those employees have strong relationships with customers?

Does the former owner have access to trade secrets that are critical to the company’s success?

Depending on the circumstances, financial damages may take the form of one or more of the following:

Lost sales to existing customers recruited by the former owner

Lost sales to new customers through the use of trade secrets taken by the former owner to provide a similar product or service

Lower gross profit margins due to reducing selling prices to compete with the former owner

Higher marketing expenses incurred in an attempt to mitigate damages (i.e., recoup the lost sales)

2.  Based on the above risk analysis, estimate the percentage of projected earnings or cash flow that would be lost due to seller competition. We have seen estimates ranging from 10% to 50%, depending on the nature of the business and the industry in which it operates.

3.  Apply this percentage to the annual projected cash flow determined in Stage 1. This represents your estimate of how much of the future earnings the former owner could take from the company if he or she decided to compete after the sale.

 

Step 2: Adjust the losses determined in Step 1 based on the probability that the seller would compete in the absence of a non-compete agreement.

This step involves performing a probability assessment to determine the likelihood that the former owner would compete in the absence of agreeing not to. It is likely to be the most difficult and subjective part of the analysis. Some of the factors that affect the probability of the former owner competing include:

The age of the former owner . Is the individual near retirement age or is she too young to retire and physically able to compete?

The former owner’s employment status. Has he entered into a management contract to stay on with the existing business? If so, this reduces the likelihood of competing with the purchased business, particularly if a significant part of the purchase price is held back and paid out over time, or is contingent upon business performance. Does the individual have other skills in a different industry in which he could find work that is unrelated to the purchased company’s industry?

The former owner’s financial resources. Is the individual wealthy or does she need to work?

Competitive entry barriers. Are there significant barriers to entry in this industry? If the business is capital intensive, does the individual have access to sufficient capital resources? If not, is it likely that the individual would be hired by a competitor?

The former owner’s track record. Has the seller sold a business in the past and subsequently started up a similar competing business?

The strength of legal agreements. Is the protection term and market area defined in the non-compete agreement reasonable and enforceable in a court of law? Are there other pre-existing legal obligations in place to help prevent the seller from competing?

Based on the above factors, estimate the probability that the former owner would compete with the purchased business if there were no restrictive covenants. The estimated probability factor is then applied to the losses calculated in Step 1(c) to determine the “expected value” of the losses.

 

Step 3: Determine the present value of the expected annual losses.

  This step involves determining an appropriate discount rate with which to calculate the present value of the expected losses. Consider using, as a starting point, the weighted average cost of the capital (WACC) used to finance the acquisition. Generally speaking, the cash flows associated with intangible assets have greater risk than those associated with tangible assets. This additional risk would generally support a higher rate of return to compensate the investor. However, since much of the risk in the cash flows was already removed through the probability adjustment (in Step 2), a significant risk premium (applied to the WACC) would likely not be appropriate.

Once a discount rate is determined, apply the appropriate present value factors to the expected losses (determined in Step 2) to quantify the value of the non-compete agreement. For accounting purposes, the value of this intangible asset would be amortized over the term of the agreement.

A simplified example of the valuation analysis described above is provided in the following table:

More Posts
Share by: