I got a call from a guy – let’s call him Steve – who has a twelve-million-dollar-a-year heating and air conditioning (HVAC) business. Steve, along with his sister and mother, inherited the business a year ago when his father died at age 70 after 35 years of building the business.

Steve was looking for advice because he had been approached by a much larger HVAC business looking to expand. Although Steve hadn’t been looking to sell, getting an unsolicited offer of $11.5 million (just shy of 5 times their EBITDA last year) got his attention.

After talking to his controller, a few key installers and his HR manager, Steve signed a Letter of Intent (LOI), giving the potential acquirer 60 days to do their due diligence, during which time Steve is restricted from negotiating with anyone else.

Steve’s reaction was natural, but he is regretting his haste. Now that the LOI is signed, one of the partners from the buying firm says their offer of $11.5 million was too rich and the business is actually worth around $9.5 million.

In my view, Steve made some serious mistakes. Here are four things to do when you get an unsolicited offer to buy your business:

1. Slow down.

Steve’s business has been around for 35 years, so there’s no rush. It’s typical for acquirers to create a sense of urgency; once they have their target in sight, they want to go in for the kill, which is to get you to sign an LOI, giving them exclusivity to pick over your business without other acquirers applying pressure to the price or process.

2. Do not sign anything until all the fine print has been discussed.

Once you sign an LOI, you lose your negotiating leverage. One reason Steve’s deal is melting away comes down to the bonuses on the P&L. Steve’s argument is that the employee bonuses paid last year should not be treated as expenses on the P&L (thereby increasing the EBITDA line) because the larger company would not need to pay bonuses, given that it has a rich pension scheme. I’m not sure I agree with Steve’s logic, but in any case, this is an issue Steve should have discussed before signing the LOI.

3. Do not tell your employees.

Would you tell your kids the family is going to Disney World if there was only a one-in-three chance you would actually go? Once you tell your employees, your business can spin out of control on a sea of innuendo. It’s legit to allow the would-be buyer access to a couple of senior people, but not to the rank and file employees.

In Steve’s case, the acquirer wanted to talk to all of his hourly employees before closing the deal. Why would the acquirer want to do that? 1) to find out if they have concerns about the transaction; 2) to get access to employees they would like to hire if the deal falls apart; and 3) to rob Steve of even more negotiating leverage – once his employees know, it will be very hard for Steve to walk away from the deal when the acquirer drops their original offer price, which they will most certainly do if they sense Steve has to sell.

4. Get representation.

A good M&A professional would charge Steve 4 or 5% of the deal, and I would suggest the $500,000 is money well spent (I’m not an M&A professional so I can say this in good conscience). Steve has now lost his negotiating leverage because he has signed an LOI and told some of his employees. The buyer is threatening to drop the price to $9.5 million and will likely drop it further as Steve struggles to juggle the roles of company CEO and M&A professional. Would you spend $500,000 to save $2,000,000? A good intermediary would have gotten a couple of competing offers (there are hundreds of private equity firms salivating for deals like Steve’s business) to gin up the price and ensure the price stuck through due diligence.

It’s both flattering and intoxicating to get an offer from someone who wants to buy your business. While the offer is a great first step, there is still a lot of chess to play and avoiding some of Steve’s mistakes will allow you to hang on to as much leverage as you can in the negotiating process.

A few weeks ago, Google announced it had acquired Clever Sense, a small company that has developed a neat application called “Alfred” that helps you pick a restaurant (or hotel etc.) using your mobile phone. Google wants Android to beat Apple’s iPhone operating system and, having made 26 acquisitions last year, this was just the latest in a long line of Google takeovers designed to compete with Apple et al.

Getting bought by a big company like Google (or Coke, or Procter & Gamble, or Johnson & Johnson or Amazon…) is usually the entrepreneurial equivalent of winning the lottery. This is not like selling to a bean counting private equity firm.  With a strategic acquirer, the value is less about you and more about what you might be worth if they duct taped you onto their platform.

So how do you get bought by a strategic? One way is to talk to a guy named Steven Popell. Popell has been a management consultant for the last 40 years and has recently developed a process for positioning a business for a strategic (as opposed to financial) sale.

I asked Steve to share his philosophies and approach with you:

Warrillow: Can you give me an overview of your process?

Popell: The ExiTrak® process is based on the time-tested principal that, if you want to determine if a new product line or suite of services will sell, at what price, etc., talk with customers and prospective customers. This process asks key acquisition executives in prospective buying companies which strategic assets they find most valuable when acquiring a company in this industry today. When we have interviewed 15-25 of these key executives, and collated and analyzed the results, we have the profile of the valuable strategic acquisition candidate from the perspective of the buying marketplace. Then, the management of the company that wants to position itself to be sold makes decisions regarding which strategic assets to acquire and/or enhance in order to get the company’s strategic profile as close as possible to what the marketplace has said it finds valuable. That’s the process; and no one else does this.

Warrillow:  How would you describe the difference between a strategic sale and a financial sale?

Popell: In a financial sale, the entire return on investment (ROI) comes from the earnings and cash flow generated by the seller as an independent entity. Big Company A acquires Small Company B and sets it up as a wholly owned subsidiary. Company B then continues to operate essentially as it did before it was sold.
In a strategic sale, the ROI for the buyer also includes the increase in earnings and cash flow to seller and, especially, to buyer because they are together.  If, for example, the buyer is 10 times bigger than the seller, and the buyer increases its earnings by a mere 10% as a result of acquiring the seller, that figure represents the same dollars as if the seller had doubled its earnings. A 20% increase is the same as the seller tripling its earnings.

Warrillow: Can you illustrate an example of the math if Big Company A is a $100,000,000 company with 15% profit margins before acquiring Small Company B, a $10,000,000 company with 15% profit margins?

Popell: Big Company A has a pretax profit of $15 million. Small Company B has a pretax profit of $1.5 million. If Company A increases its earnings by 10%, that is $1.5 million – the same as if Company B had doubled its earnings. If Company A increases its earnings by 20% or 30%, that is $3 million or $4.5 million – the same as if Company B had tripled or quadrupled its earnings.

Warrillow: How do you see the difference between financial value and strategic value play out in the real world?

Popell: In 2011, we conducted the first and only statistically reliable survey on this topic. The results reflected deals under $5 million. Overall, about 2 out of 5 financial sales yielded prices at or above the owner’s target. In strategic sales, this figure was about 3 out of 5. In those deals in which the business broker had the greatest experience, the results were even more compelling. Strategic sale multiples exceeded those of financial sales by at least 25% about 53% of the time.

Warrillow: Operationally, how can business owners make their business more attractive to a strategic acquirer?

Popell: The best way is to learn what constitutes the valuable strategic acquisition candidate in this particular industry, and then undertake initiatives to bring the strategic profile as close as possible to what the prospective buyers have indicated they find valuable.

Interviews with key acquisition executives in prospective acquiring companies, utilizing a questionnaire customized for the client and the industry, will yield this information. However, irrespective of the strategic value of a prospective seller, it is critical to have an attractive P&L history and current financial condition. Positive numbers will enhance the price; negative numbers will, at a minimum, decrease the price and can cause the prospective buyer to walk because of concerns about management competence.

Warrillow: Can you give us an example of the questions you ask strategic buyers when interviewing them on behalf of a client:

Popell: While each questionnaire is customized for the client and industry, two questions are common to all:

1. If you were to acquire a company in this industry today, which strategic assets would be most valuable to you: location, key customers, market niche, technology, technology infrastructure, etc. – and for each choice can you give specific examples?
2. How are these preferences likely to change, if at all, over the next five years?

Warrillow: Can you provide a real life example of when you did this with a strategic buyer and something interesting they revealed?

Popell: For an electronic packaging company that does business in both military and commercial markets, interview responses indicated clearly that the three most critical technological characteristics were power, cubic area and temperature control – elements that are inherently in conflict with one another. In other words, if you increase the power of a component and reduce the size of its package, temperature control becomes very difficult. It’s very much like the aphorism: “I can give it to you good or fast or cheap. Pick two.” The details of the interview responses provided the basis for the company’s strategic product development program.

Warrillow: How can business owners get up on to the radar screen of a strategic acquirer without revealing to the market they are for sale?

Popell: Be the best in your industry. Take a leadership role in the trade or professional association. Write articles that demonstrate unique and valuable expertise. Have a first-rate website that reflects well on the company and on management. Find out what constitutes the valuable strategic acquisition candidate, and proceed to become that. When you are ready to sell, ensure that the broker’s first communication with prospective buyers is a non-confidential memorandum that describes your company well enough to smoke out interested parties, but not so well as to allow your company to be identified. After that, all communication with prospective buyers occurs after the signing of non-disclosure agreements.

The cockpit suddenly went quiet. The pilot called air traffic control to request an immediate emergency landing, but it was too late.

With no thrust and only a few hundred feet of altitude, Capt. Chesley (Sully) Sullenberger decided his only option was to ditch US Airways flight 1549 into the Hudson River.

As it turned out, he greased that landing back on Jan. 15, 2009, but there was no rulebook for landing an Airbus A320 on the Hudson River. Nor did he get to practice a few times with an empty plane to get the hang of it. He had 155 lives in his hands and one shot to get it right.

In a lot of ways, I think selling a business is a little like trying to land a passenger jet on a river:  you’ve probably never done it before, you don’t get to practice, and there’s a lot riding on the outcome.

To help give you a sense of what to expect from the process of selling your business, I asked Brad Bottoset, an eleven-year veteran of selling companies, to answer some common questions I get from readers….

Warrillow: Can you explain the role of seller financing in selling a business? How common is it? How exactly does it work in layman’s terms?

Bottoset: It is estimated that 80 to 85% of all business transactions carry seller financing.  Why?  Many potential buyers don’t have the capital or lender resources to pay cash.  Even if they do, they often want to leverage it into buying a larger business with greater cash flow.  Buyers interpret the seller’s insistence on all cash as a lack of confidence in the business, the buyer’s chance to succeed, or both.  Of course, every transaction is different, but typically a seller should expect somewhere around one year’s cash flow as the down payment.  Just like banks use formulas to determine what someone can afford as a mortgage on a home, knowledgeable business brokers use formulas too – which generally point to the Note being paid off in 5 to 7 years.

Warrillow: Isn’t the whole point of selling your business to get liquid? Why would you lend someone the money to buy your business? If you’re not getting the cash upfront, why not just hold on to the business?

Bottoset: For most sellers, getting all cash upfront is their preferred route.   However, it may not be possible.  And there are a number of positives with seller financing:

• Making the terms attractive and attainable increases the pool of qualified buyers;
• Offering terms will command a higher price (buyers paying cash often demand a discount);
• Tax consequences can be advantageous.  Instead of being taxed in the year that the sale occurs, the seller’s capital gain is taxed over the life of the Note;
• With interest rates currently at their lowest in years, sellers can get a much higher rate (6%) than they can get from any financial institution.

Warrillow: What is the typical interest rate of a seller-financed deal these days?

Bottoset: Six percent.

Warrillow: I know one of the steps in getting a business ready for sale involves dressing up the Profit & Loss statement to show as much profit as possible. Can you give me some examples of things business owners often overlook?

Bottoset: When determining the value of a business, one of the key steps is understanding what levels of discretionary, non-business expenses the current owner is expensing through the business.  There are many standard types of “add backs” such as the owner’s car expenses, personal health insurance, etc….  However, we also have seen a number of examples of creative bookkeeping, such as trips to Europe classified as a “market research” expense, owner divorces identified as “legal fees,” etc.    One common area that is often overlooked is when the business owner also owns the facility out of which the business operates. Depending on the situation, they may be charging themselves fair market value (FVM) rent, or they may not.  If they are charging the business more than FMV, a positive add back would be appropriate.  If they are charging themselves less, a negative add back must be accounted for.

Warrillow: You use “social desirability” as one of the factors that can drive up, or down, the value of a business. What do you mean by “social desirability,” and can you give some examples of either desirable or undesirable businesses? How big an impact is social desirability on the value of a business, and can you give an example?

Bottoset: I can’t say I’ve come across a lot of businesses that will generate a significant premium, but I do know of a few that have been adversely affected by a lack of social desirability.  For instance, in our portfolio, we have a national trucking company that transports live animals for medical research.  We’ve had a number of qualified buyers (both from within the transportation industry and from outside) look at the business but they have shied away because of perceived issues with animal rights organizations like PETA.

Warrillow: What other factors drive up, or down, the value of a business? Can you give a real life example?

Bottoset: The basic value drivers are management depth, proprietary product, customer diversity, etc….  Unfortunately, many clients don’t fully understand some of these principles. A few months ago, we had a manufacturing client approach us to find a buyer for his business.  He was particularly proud of two aspects of his business:  firstly, that all decisions go through his office as he is the point of contact with the clients; and secondly, in preparing the business for sale, he had whittled down the client base from 20 to two clients.  In his eyes, the new buyer was going to have 18 less headaches and personalities to deal with.  Yikes on two counts!  Unfortunately, this is a true story!

Warrillow: Can you explain the difference between an asset sale and a share sale? Why does it matter to business owners?

Bottoset: In an asset sale, the buyer essentially acquires selected company assets, consisting of the company’s equipment, inventory and “goodwill.”  In a stock purchase, when purchasing the company’s stock, they are acquiring all of the company’s assets, including its cash and accounts receivable, and are assuming responsibility to pay off the company’s debts (i.e., accounts payable) while assuming all “off the book” liabilities (i.e., pending or future lawsuits).  Buyers typically prefer to buy the assets of a company for two reasons.  Firstly, they are able to re-depreciate the value of the fixed assets and therefore acquire a larger depreciation tax shelter.  Secondly, they are not responsible for any “off the book” liabilities (i.e., lawsuits). Most business transactions are completed as asset sales.

I’ve asked Brad Bottoset to spend an hour with the 20 people coming to my Built to Sell workshop on January 16 & 17, 2012. There are three spots available – grab one here.

(photo Eric Thayer  /  Reuters)

I didn’t like Basil Peters the first time I saw his name.

Basil’s book “Early Exits” had a huge display at the Books for Business store in downtown Toronto. I sheepishly asked the clerk if she had a copy of a book with a similar theme called “Built to Sell”. She looked puzzled and turned to her computer terminal to search the title.

“Sorry sir, we don’t seem to have that book”.

I left the store cursing this Basil Peters fellow.

Then, begrudgingly, I got to know Basil.

What I discovered was one of the smartest, most experienced entrepreneurs I have ever met. Starting in school, he scaled a business up to a couple of hundred employees. He sold it and took his cash and invested in some start-ups. He promptly lost a bunch of his winnings but learned a lot in the process. He went on to be involved in a hundred or so deals –as an entrepreneur, angel, investor and/or advisor.

I’ve asked Basil to come to Las Vegas and spend a half day working with the 20 entrepreneurs selected for the Creating a Sellable Service Business Workshop on January 16 &17, 2012 (there are still a couple of spots if you’re interested – you can register here).

To give you a quick peek inside Basil’s mind, here’s a recent exchange between the two of us:

What exactly do you mean by an early exit?

There isn’t a precise definition. “Early exits” refers to a strong trend in the 21^st century economy, driven by buyers who want to acquire companies in the $10 to 30 million range. With “internet acceleration,” entrepreneurs can often create values in that range just 2 or 3 years from startup. The combination of those values, and that timing, are what I think of as an early exit.

What are the telltale signs that a business (or entrepreneur) is ready for an early exit?

Exit timing is one of the things I wish I had done better in my first five or six exits.  Now having watched about 100 exits reasonably closely, I am convinced that in the very large majority of situations, entrepreneurs wait too long to start working on their exit. They end up ‘riding it over the top’ and selling for much less than they could have. Or even worse, missing the optimum time often means the company never exits.  This phenomenon has not been discussed very much and is something that I am working hard to illuminate for entrepreneurs and investors.

What are the signs that it is too early/soon to exit?

It’s actually relatively easy to tell if it’s too early. I think the best indicator is that the price isn’t high enough to satisfy the shareholders. And it’s reasonably easy to determine the price (within a reasonable range of certainty.)

A lot of business owners are planning to wait until the market for privately held businesses recovers, banks are willing to lend more aggressively, and multiples start going up again. Is it worth waiting?

In my opinion, that time is now. Interest rates are lower than they have been in our lifetime, the private equity funds are back, and the corporate acquirers are very receptive. With everything going on in Europe, I wouldn’t wait.

What if you have a really small business, maybe only $500,000 in revenue with some promising technology, should you still think about selling early?

I don’t think of it as a question of selling “early” or not. I believe it’s a matter of the best time to sell. Often the best time is well before the company is profitable or hits $1 million in revenue. Recently, Google said: “we prefer companies that are pre-revenue.” How’s that for early?

Can you explain the structure of the typical early exit? Are businesses owners walking away with a check or are they selling a part of their business to a private equity firm with hopes of taking a “second bite of the apple” in 3-5 years, or are you seeing a lot of earn-outs?

Most of the exits I see these days are all cash, or possibly cash with a portion of vendor financing. Buyers know that if they try to reduce risk with earn-out formulas or risky structures, the sellers will just go somewhere else. The problem for most buyers today is that they have too much cash. So if the transaction is fairly priced, the structures today tend to be cash, or ‘near cash.’

Once a business owner makes the decision to sell, what are some of the mistakes you see them make in approaching a transaction?

The most common mistakes I see are:

1.       CEOs trying to do it themselves, and

2.       Selecting the wrong M&A advisor (i-banker)

Do you believe in running an auction for a company, or do you try to negotiate with one strategic at a time?

I believe multiple bidders are always desirable. In some cases, that’s not possible or isn’t what the sellers want to do. But in my opinion, it’s almost always a good strategy.

What are the idiosyncrasies of selling a service business?

These days, in North America, almost every business is a service business, or has a large service component. Software as a service (SaaS), for example, is probably the hottest sector of the M&A market. Non-service businesses – in other words, manufacturing and asset businesses – are harder to sell today.

How does having money change your life?

I think it’s a little like having your first child. Everyone will tell you what it’s like, or what it was like for them. But until the reality is right there in front of you, it’s actually pretty hard to describe. For me, having money created a lot of freedom. I enjoyed it a lot and strongly recommend it to everyone.

What were the mistakes you made after your first exit that you would like to take back if you could?

That’s another easy one. I could tell a long story, but I think the most common mistake, and I certainly made it, is to go out and make two really bad investments. When I sold my first company, a couple of my friends in YPO warned me that was what most of us do. But like all good entrepreneurs, I ignored them. So I learned that lesson with an education that cost about 20 times more than my Ph.D.

Basil Peters will be leading a half-day session at my “Creating a Sellable Service Business” workshop on January 16&17, 2012 in Las Vegas. Register here.

The main character in my book owns a marketing agency. I picked a service business intentionally because, with so much of the value tied up in the owner’s relationships, service businesses are notoriously difficult to sell. The founders leave and so do the clients, making service businesses next to worthless unless you can figure out how to make the clients stay when the owner(s) want to go.

David C. Baker is one of four people in the United States that knows this better than anyone. In addition to being an author, David has made his living over the last few years selling agencies. He’s done 140 deals and along with two or three other M&A professionals, David is considered the guru of building and selling a successful agency.

I’ve been doing some research in preparation for my Creating a Sellable Service Business Workshop and I had a chance to interview David. I thought you might like to read our exchange:

John: What are the unique challenges of selling a marketing agency?

David: Mainly it’s the fact that there are no outside non-participating investors for smaller firms. I can’t think of one, actually. And that’s typically because the firm trying to find a buyer has grown up around the principal and his or her desires and hasn’t been viewed primarily as a business.

John: What attributes are buyers looking for in the agencies they are buying these days?

David: Specialized focus is always first. Second is financial performance. Third is client list that they will have access to. Gone are the days when someone buys a firm just to have a presence in some market. And very few transactions are initiated simply to add capacity instead of building it.

John: How are agencies being valued?

David: The more typical agency is being valued at 3-5 times EBITDA after normalizing principal compensation. Interactive firms are going at significantly higher multiples.

John: What proportion of the overall deal is “at risk” in some form of earn-out? (I’ve heard big agency holdcos are now paying 3 times upfront cash with up to 7 available in an earn-out; can you verify or refute?)

David: Usually one-third is paid upfront at closing; about one-third is paid in a longer-term note (not tied to any type of performance) over 3-5 years; and the remaining one-third is tied to earn-out goals.

John: What is the biggest mistake you see agency principals making when it comes to selling their firm?

David: Thinking it has value just because they’ve worked hard for many years, even though the financial performance has been meager; along with thinking that their company name has some sort of tangible value.

John: What proportion of the agency principals who sell last the full length of their earn-out? Why or why not? And do you have some survival tips?

David: The answer to that depends quite a lot on the terms of the sale. If most of the transaction value is in the earn-out, they are likely to stay. The typical scenario is that the principal DOES remain for the entire earn-out, especially since the typical earn-out has now dropped from 5 years to 2-3 years.

John: What other things do agency owners need to know about selling a service business?

David: They shouldn’t expect any money from it. I’ve participated in 140 deals, but the four of us who are active in that space for smaller marketing firms still find deals for a small percentage. The value of the firm is primarily in the cash it throws off to the owner on an ongoing basis, and not in a pot of gold at the end of the rainbow, unless all the stars align properly.

If you’d like to meet David in person, he runs a New Business Summit every January in Nashville.