How to Structure Takeover of Small Private Company

[adt2]

Hi, folks. New user here looking for a little advice. My father and I are meeting with a guy tomorrow who is interested in exiting his small business. It's a family-owned construction company that's been around for 20 years or so. The seller is a "serial entrepreneur" and wants to step away from this business to concentrate on several other small companies he runs.

I've read up on how to valuate a small business (0-3x discretionary earnings) and think I have a handle on that. What I don't have a clue about is how to structure the actual deal if we all decide to move forward. Based on prior discussions with the seller (we have history), we think he'd be open to some kind of royalty payment for some length of time, as opposed to a lump-sum payment up front.

If we went that route, would it be a percentage of sales? A percentage of something else? What kind of percentage? For how long - fixed term? Until an agreed amount is paid? Is there some other arrangement that would serve better (that doesn't involve an up-front payment; my dad is retiring, and I'm recently laid off)?

Thanks in advance for your input.

[Freelancier]

What specific things are you buying? Is it existing projects, existing long-term customers, goodwill in the market... or what? All those have some value. The equipment (if any) has some value. For a royalty to work, he has to be sure you're not going to screw this up, so he might instead want a promissory note that's paid off monthly.

[Business Attorney]

A "royalty" is probably a misnomer for what you have in mind. What you are really talking about is some type of earn out payment.

The amount and timing of the earn out depends on a lot of factors. It sounds like you are not paying anything up front, so the entire purchase price will be based on an earn out. That is usually a tough sell for the current owner unless one of two things is true: (1) the business has very little liquidation value so that the seller is not really risking much on the downside by selling it to you on a wing and a prayer; or (2) the purchase price includes a substantial upside so that the seller is compensated for the risk he is taking.

Without knowing more, it is really impossible to give you much input.

[adt2]

What specific things are you buying? Is it existing projects, existing long-term customers, goodwill in the market... or what? All those have some value. The equipment (if any) has some value.

This is a service business; we'd be buying everything you mention above, except equipment. As a service company, there's not really any equipment to speak of. Additionally, we'd be "purchasing" his expertise (for some period of time) to train us.

[adt2]

Without knowing more, it is really impossible to give you much input.

It's a sports court business. He sells volleyball, basketball, etc. courts to high-end residential clients, schools, large business campuses, etc. His father started the company several decades ago and the son took it over years ago. He says it's all referral and word-of-mouth business, but that business is down this year "because of the oil & gas crunch." We don't really buy that; I used to be a custom builder, and I still have lots of contacts in that business (plus I can read a newspaper), and I know the residential construction market is booming.

Our suspicion is that he's lost all interest in this business (he's what my dad calls a "serial entrepreneur") and wants to focus on his other businesses. Our feeling is that the earn-out payment setup is low-risk for all parties involved: the seller isn't risking much (since he's already checked out anyway) by letting us take a stab at the business. We have a ton of combined sales and construction experience and think we can make this thing go. It's low-risk for us because we would only pay if the business works (seller claims about $300k/year in net sales; we haven't verified yet). If we produce, we make money, he makes money, and everybody's happy. If not - whether it's our fault or just market conditions - then nobody is any worse off than when we started, except for the time/effort we've put into giving it a go. Worst case, we fail to make a go of it and the seller either keeps on keeping on, or sells to another buyer.

Again - these are all my best uneducated guesses, which is why I'm posting here...:) Thanks for your input.

[Freelancier]

So what exactly would you be purchasing? Does he have yearly service contracts, something that's a guaranteed cash flow? I'm really unclear on what you would be buying, since you could start the same business without his business and I don't see huge start-up costs involved... unless there is, in which case, hopefully you're buying at a discount what those start-up costs would have been.

[adt2]

So what exactly would you be purchasing?

You know, frankly, I'm not sure. I've had this same thought myself. To be perfectly honest, for me (not speaking for my dad), some hand-holding up-front is worth something to me. How do you market this product? Who are your subs? What's the building schedule? Where do you get volleyball nets/basketball goals/badminton sets/sports team logos/etc? What's the selling price? How much money do you make on each one? How do you approach colleges/universities/business campuses/schools/etc?

All of these things are important, and some help up-front makes me feel better than going off on my own and figuring them out. Now, are they worth what the seller thinks they're worth? Are they worth anything, in fact? I don't know, but I'd be willing to pay *something* for them, even if it's a monthly earn-out payment for a year or two or whatever (depending on how much it is). We'll know more today after lunch; I'll update this thread later.

[adt2]

So we met with the seller today and I have more information, although I don't think much of it will pertain much to this particular thread. He answered nearly all the questions I posed above, with the exception of the "what it's worth" questions, which we felt were better left to a subsequent meeting. Our next steps are to approach him with the earn-out payment idea and then, if he's open to it, to request his financials and make a determination of what we're willing to offer.

Based on previous conversations my dad has had with him (the seller is a long-time customer of my dad's, and they have a good relationship), we are already pretty confident that he's open to the earn-out payment idea. Sticking point is going to be what he thinks it's worth versus what we think it's worth.

[Business Attorney]

From what you described, this is probably a rare situation that is well suited to a pure earn-out formula, with no upfront payment. In other words, if you get business, he gets paid.

Generally, he should want (and expect) a payment based on gross revenues. It is up to you to control the pricing and your costs. As far as the amount of the earn-out, I would figure out the percentage you would be willing to pay a sales person as a commission on new sales, and that would be the absolute cap you would be willing to pay him for the stream of revenues generated by the word-of-mouth and goodwill of the business. Then you need to bring that number down to a more reasonable number because his goodwill is never going to account for 100% of the sales; you are going to still have to engage in sales activities.

For example, let's say as a start up with no goodwill, you would need to pay a salesman 15% to bring in new sales. Let's say that reputation of his business might account for 80-90% of business in the first year, 50-60% in the second year and 30-40% in the third year. After that, most of the referrals are based on what you did in years 1 through 3. Based on those assumptions, I might say that an earn-out of 7% of gross sales for 3 years might be reasonable. I would argue that there should be no minimum payments but perhaps an overall cap based on recent annual sales figures so that if the business really takes off during your stewardship, you are not paying him for your own efforts.

To put that in an example, if his annual sales for that last three years were $350K, $300K and $250K, you might offer him an earn-out of 7% of sales for the next 3 years, not to exceed $21,000 in any year (7% of average annual sales of $300).

Alternatively, since the contribution of existing goodwill will decrease over time, rather than offer 7% across the board, you might consider a percentage that starts a little higher but declines over the three-year period, such as 10% of year 1 sales, 7.5% of year 2 sales and 5% of year 3 sales. Again, I would either cap the annual payments under that formula or cap the overall payments, or both. For example, you might say that each calculation is only based on the first $300,000 of sales in that year (his 3-year average in my example).

There are obviously many other ways to structure an earn-out but these are some thoughts to get you started.