Bias Toward Overvaluing the Business

How do you think a real estate agent might persuade you to engage them to sell your house? Their number one tactic would most likely be to convince you that they can fetch a higher price then the next guy. They might tell you that they can get $1 million, for example, when they know that the value of the house is really in the range of $900 thousand to $950 thousand. You then execute a six month exclusive agreement, and now they own you. The agent then brings multiple offers that are all in the $900 thousand to $950 thousand range and gives you all sorts of reasons why you house is not fetching the $1 million price tag. In broker lingo, they call this “bringing you to school”. The broker knows that if you are motivated to sell you will eventually lower your price to meet the market’s valuation. So, the broker misled you in order to convince you to hire him, and he was not even asking for any upfront fee. Now imagine how he might mislead you if he were asking for a $50 thousand upfront engagement fee!

Accepting Low Probability Engagements

According to a information published by the International Business Brokers Association, the average closing rate among US intermediaries representing transactions valued in the range of $10 million is approximately 30%. This just does not make any sense to me. Why would someone pay a $50 thousand engagement fee for a 30% chance of success? Not to mention that there is generally significant work required by the Owner in any exit process, as well as a risk of a confidentiality breach which can harm the business. Wouldn’t one just be better off to put their $50 thousand on red at the roulette table! When the business broker or investment banker can make a living from the engagement fee it’s not hard to imagine that they may not be very selective. Our experience at LockeBridge, a registered Boston based Investment Banker, is that about half of the businesses for sale are not saleable; with the reason often being that the typical sell-side broker will take any engagement in which they can earn a $50 thousand upfront fee.

In addition to the above, large upfront fees can also result in several other potential conflicts such as a low commitment to success and low investment in resources devoted to the engagement. So what’s the alternative? Unfortunately the de facto standard among seasoned investment bankers is to charge a significant engagement fee. Contrary to the legal profession, which has been around for thousands of years, mid-market investment banking has only been around in any formal way for less than 50 years, and the demand for seasoned, unbiased representation has simply not been met with an adequate supply of investment banking services in the lower end of the mid-market. In fact, at the sub $20 million transaction size it is difficult to find truly seasoned expertise even if you are willing to pay a hefty upfront fee. If one is seeking both seasoned expertise and an engagement agreement without potential built-in conflicts (i.e. no substantial upfront fee) then be prepared to look for a long time. In our experience the combination of high expertise and no engagement fee in the lower end of the mid-market is practically non-existent. This situation is not an issue in the legal profession, which seems to have worked out the demand and supply gaps over the last thousand years. In the legal profession, everyone knows that the standard contingent agreement, with no upfront engagement fee, is accompanied by a success fee of 30%. Hopefully it won’t take hundreds of years to meet the demand for high level, uncompromising mid-market investment banking representation.

The major issue for the Purchaser to consider will be:

Is it worth a savings of five hundred thousand dollars to expose their $200 million business to all the potential liabilities of the target acquisition?

Imagine that the ski manufacturer made a defective binding a year prior to the acquisition? Subsequent to the acquisition the binding failed and the skier fell and seriously injured himself. The Purchaser will be liable for the damages!

Product and environmental liabilities are two of the most concerning issues to potential Purchasers of corporate stock.

While a strong intermediary may be able to overcome such liability issues and subsequently structure a sale of corporate stock that will work for both parties, corporations should review the current pros and cons of the “C” corporation status and consider converting to an LLC or S corporation well in advance of the sale of the business. If converting to an S corporation is not possible, don’t lose sleep yet. It may be possible to structure a transaction that will allocate the purchase price so not to be exposed to double taxation. For example, professional service businesses may be able to allocate a substantial portion of the price to personal goodwill, which bypasses the corporate level tax. Additionally, retainers and non-compete agreements may be negotiated which will also bypass the corporate tax.

It is critically important to hire a strong transaction team (accountant, attorney and intermediary) that has substantial negotiation and structuring experience. When it comes to selling a “C” corporation the transaction can become much more complex and the team’s structuring tactics even more crucial. An effective deal structure will maximize the amount the Seller will have to show for a lifetime of sweat equity. Note: A strong intermediary will advise you on required skill se of the team members and coordinate the team member’s activities.

Conversion from a Subchapter S to a “C” corporation is not a problem from a tax perspective. However, going from a “C” corporation to an S can be a taxable event if the value of the corporation has appreciated since its formation. Note that generally, you cannot convert a corporation to an LLC. You will need to dissolve your corporation. Once having done this, generally one may form a new LLC using the same name.

When an existing “C” corporation converts to an S corporation, only the post-conversion appreciation in the corporation’s assets will qualify for single level tax treatment, unless the corporation’s assets are sold more than 10 years after the date of conversion. This 10-year “look back” period prevents a “C” corporation with appreciated assets (and subject to double taxation on the sale of those assets and subsequent distribution of proceeds to its shareholders) from converting to an S corporation in order to achieve a single level of taxation.

If your company is a “C” corporation seriously consider a conversion that will lower the taxable impact on your business. If you plan to sell the business prior to ten years from the time of conversion then hire a strong team that will be able to assist in structuring a tax efficient transaction.