Don’t Get Screwed Over When You Sell Your Business: Purchase Price

Welcome to part one of Don’t Get Screwed Over When You Sell Your Business. Over and over, I’ve seen smaller companies, without an army of lawyers, overlook crucial issues during the sale of their businesses. These issues may sound like arcane legal mumbo-jumbo, but they have a real effect on the bottom line. Imagine missing one of these issues and suddenly you’re out thousands of dollars — and you signed the agreement that let the buyer screw you over.

For this first post, I’ll look at the purchase price and how it’s calculated. You should be able to answer one crucial question: how much money are you actually getting?

The Earn Out: What Target Do I Need to Reach?

Many people are under the impression that when they sell their business, they just get a check when the agreement’s signed and that’s that. It rarely works that way.

A buyer often wants to hold back some of the purchase price and require the seller to “earn it” by hitting a certain financial goal. A buyer might say, “I’m willing to pay $500,000 for your business — but only $400,000 now. You get another $100,000 only if EBITDA [a financial measurement based on earnings before interest, taxes, depreciation and amortization] next year reaches a certain amount.”

First, make sure that you’ll actually be able to influence the operations of the company during the earn-out period. Don’t let a buyer take over the company and intentionally miss the earn-out target so it doesn’t have to pay the entire price.

Second, make sure you put restrictions on what the buyer can do during the earn-out period. You don’t want to allow the buyer to incur a huge expense that hurts EBITDA during the earn-out period, even if the buyer can argue that the expense helps the business in the long run.

Working Capital: How Do I Measure What My Company’s Worth?

A working capital “peg” is an adjustment (like the earn out) based on the working capital of the company. For example, the buyer and seller say that the target working capital is $500,000. If the actual working capital of the business is $400,000, you’d have to pay the buyer $100,000. If actual working capital is $600,000, the buyer would owe you additional $100,000.

This is a simple example, and the mechanics can get really complicated, but that’s the idea. The reasoning is that if actual working capital exceeds the target working capital amount, the buyer has basically underpaid for the business because it’s getting more capital than it thought, and vice versa.

One thing to look out for: what exactly is “working capital”? The definition might end up being a page long. But you want to make sure you understand it, because you don’t want the buyer to define “working capital” in a way that calculates it to your disadvantage. It should be calculated the same way you calculate working capital in your business.

Complications in purchase price calculations can end up costing you real money when you sell your business, even if the initial purchase price looks like a great deal. Don’t let a buyer fool you.

Stay tuned for more on selling your business, and subscribe below to make sure you don’t miss a post.