One owner sold his restaurant/marina business for $1,200,000, payable $325,000 cash at closing and $125,000 each year over seven years. The $875,000 installment note did not carry an interest rate. The owner felt the total $1,200,000 was a fair price even if paid over seven years.

However, he didn't compute today's value of the $875,000 installment note. With a 10% interest rate (present value) applied to the payments, the $875,000 note was worth only $608,500 today, which is $266,500 (30%) less than its $875,000 face value. (Present value is today's value of a future stream of cash inflow based on an applied present value/interest rate. The 10% present value rate is high because of the risks of not being paid.)

Bigger mistake. The owner did not get the personal guarantees of the three doctors who bought his business. When they failed at running the business, the seller was forced to foreclose on the property (he did have a first lien on the assets) 19 months after he sold it. Now, after another 12 months of legal proceedings, he is out of retirement and back to full-time work running the business.

The settlement: He kept the $325,000 cash paid at closing and 15 months of installment payments, totaling $156,250, less legal expenses.

Important: When the buyers are passive investors, as these doctors were, it is especially important to get personal guarantees. Otherwise, passive investors are free to simply cut their losses and walk away from the deal with no further liability. That's what happened here, at the expense and inconvenience of this business owner.

Relevant Resources:

• Resource Report #06: Selling a Business: Structuring and Negotiating the Best Deal
• Resource Report #16: Buying a Business: How to Do It with a Case Study
  

Whenever you sell, gift, or transfer common stock, or issue options to buy an ownership position in the company, be sure to protect yourself and the company by doing the following:

• Execute a formal investment agreement and refer to that agreement on the actual stock certificate.
  
• Restrict the sale or transfer of the option or stock.
  
• Get the right of first refusal to repurchase the shares.
  
• Restrict encumbrances (liens) on the stock or options.

The right of first refusal is particularly important. For example, when you issue a stock option, say, to a key executive, you should assume that he or she will exercise the option. That makes him or her a potential stockholder; if he has four children, you potentially have four more stockholders, in fact, four minority stockholders whose rights are protected by the courts and state laws.

That’s why it’s very important to restrict the transfer of the stock and get the right of first refusal to purchase it when/if the executive decides to sell the stock.

Relevant Resources:

• Resource Report #15: How to Protect Against Misuse of Business Ownership
• Resource Report #23: How to Prepare Your Business for Sale
  

You want the end result to be a weighted value of the business using several balance sheet and income statement valuation methods.

But your first step is to adjust the financial statements to reflect the company’s true profitability and the market value (not cost basis) of the company’s assets. Those adjustments are critical, particularly for family and closely-held businesses where the numbers and values are usually understated.

For more information on this subject, you have free access to our Resource Report #02: How to Determine the Value of a Business (26 pages). It includes a Case Study of an actual business, the financial statement adjustments, the valuation methods used, and computation of the final weighted value.

To review Resource Report #02, please visit our Home Page, see Free Review of Products.