The Best Business Sale Transactions are Facilitated in an Environment of Full Disclosure

Guest post from Gregory Kovsky with IBA in Bellevue, WA

Due diligence is a process that benefits both sides in a business sale transaction.  For the buyer, it is an investigative process used to verify the information employed to make the decision to negotiate a letter of intent to purchase the business.  If the information is not verified, the buyer should either exit from negotiations or attempt to renegotiate the terms of the transaction.  For the seller, the goal for due diligence is to create an environment of full disclosure for the buyer, so the buyer completes the transaction with “open eyes” with a clear understanding of the potential and risk associated with the acquisition.  If an environment of full disclosure & knowledge is created, then post transaction liability for the seller will be mitigated because the future success or difficulty of the company after the change of ownership will be tied to the buyer’s management ability and not a lack of knowledge.

There is enough risk in entrepreneurship without adding the variable of making decisions without a good foundation of knowledge.   An experienced mergers & acquisitions professional will outline a strategy & process for facilitating due diligence between the parties.   Many potential transactions are lost in due diligence.  Facilitating due diligence without an experienced intermediary, accountant, or attorney managing the process can have similar results as asking a sailor to circumnavigate the globe without GPS, a sextant, or star map.

As a 24-year mergers & acquisitions professional, I have successfully facilitated 100’s of due diligence processes on the road to completed transactions.   I have also witnessed alarming discoveries related to business practices during due diligence that have amazed me in terms of their sophistication and dishonesty.  In addition, I have seen situations where a buyer ignored information or warning signs and completed transactions to their future detriment.  The following are four examples of unique due diligence situations that occurred in transactions facilitated by IBA.  In the first two situations, there was no way the business broker facilitating the transaction or the buyer purchasing the business would have discovered the situation without a comprehensive due diligence process.  In the final two situations, the issues were presented to the buyer by IBA in the environment of full disclosure created for the transaction and ultimately ignored by the buyer in completing the transaction.  It is also true in all four situations the seller understood the mechanics of business valuation.  It is my hope in sharing these stories that the information can be used by future business buyers to avoid completing a transaction at an inflated value resulting in enhanced entrepreneurial risk.

The Shell Game Playing Entrepreneur

The seller in this transaction owned two companies and operated each under a unique set of tax identification numbers with the IRS and State of Washington.  One company was a mature company with a good customer base making reoccurring purchases and a track record of increasing revenues & profitability.   The second company was a young business that was struggling to reach profitability. The seller in this transaction wanted to sell his mature business to inject capital into the new enterprise to enhance the tangible asset & employee infrastructure, rate of growth, and potential for success of the new company.  Superficially, this was a reasonable narrative regarding the motivation for sale.  The mature company was valued based on its historical financial performance and presented to potential buyers in the marketplace. Market reaction was positive and agreement was reached with a buyer for the sale of the business.  Due diligence commenced and the buyer, their CPA firm, and lender all found the tax returns & historical financial documents justified the value of the business agreed to in the letter of intent.  Funding secured the transaction was targeted for closing.  As a final stage of due diligence, the buyer reviewed the accounting software employed by the business for paying billswith the primary goal of identifying expenses that could be reduced after acquisition through better management and potential vendor migration.   However, the investigation uncovered unexpected information.  The mature company was not paying all the bills associated with its operations.  A percentage of its bills were being paid by the business that was not being sold. The net result of this action was negligible for the seller when the financial performance of the two companies flowed together in the seller’s 1040 tax return.  However, for the buyer the action had significant implications as it resulted in a significantly overstated purchase price for the mature company because every dollar of additional profit was multiplied five times when the goodwill of the business was valued.  The shell game revealed, the buyer exited from the transactions with encouragement & facilitation by IBA.  Shortly afterward, IBA ended representation of the client.  On a positive note, IBA presented another company to the buyer and the party completed the transaction successfully achieving their acquisition goals.

The Doctor Who Wanted Just a Little More than Market Value

The seller in this transaction was a doctor who wanted to retire and sell his practice.  It was a good practice in a good location with an excellent staff.  The seller was happy to sign a robust non-competition agreement, as retirement would start with the sale of his practice.   The practice was valued based on its historical financial performance and presented to potential buyers in the marketplace.  Market reaction was positive and agreement was reached with a doctor for the sale of the practice.  Due diligence commenced and the buyer, their CPA firm, and lender all found the tax returns & historical financial documents justified the value of the business agreed to in the letter of intent.  Funding secured the transaction was targeted for closing.  As a final component of due diligence, a reconciliation of monthly revenues was conducted between QuickBooks and the bank statements.  It was identified during this process that the company had an abnormally strong revenue day.  Curiosity demanded investigation.  The buyer for obvious reasons wanted to know what had occurred and whether it could be repeated.   Unfortunately, what was discovered could not be repeated.  The seller had deposited an inheritance check in the business account and counted it as business revenue in the most recently completed tax year. This action had increased the value of the practice significantly when a multiple was applied to the additional net profit in the subject year when calculating the value of the practice. The inappropriate action revealed, the buyer exited from the transaction with encouragement & facilitation by IBA. Shortly afterward, IBA ended representation of the client.  Like in the previous example IBA eventually facilitated the sale of another practice to the buyer.

The Business Owner Who Worked Days, Nights, and Weekends

The seller in this transaction was a highly skilled, hard-working, financially motivated entrepreneur.  As is the case with many business owners, she managed the company to maximize the income personally derived from the company on an annual basis.  One of the ways she enhanced her income was by working long hours in the business at a high level of productivity reducing the need for support employees.  This labor contribution to the business and the resulting low labor costs made the business look like a “cash cow” on its tax returns.  As is often the case when business owners sacrifice work/life balance for dollars, the owner of this business started to “burnout” and contacted IBA to sell her company.  The seller was honest with IBA related to her labor contribution to the business and two full-time labor equivalents with the seller’s experience & skill set were incorporated into our evaluation of the business to determine its “fair market value” prior to taking the business to market.  Properly valued, the business was brought to market.  Market reaction was robust as buyers valuing the business using standard multiples believed they had identified a value proposition. The business owner & her IBA professional intermediary consistently conveyed when meeting with potential buyers that the business was not a value proposition when labor was “right-sized”. It was a good company offered at a “fair” price.  A buyer believing he could personally replace the seller’s labor contribution eventually bought the business at its full asking price.  Several years later, he shared with me that his personal hubris regarding his abilities made him believe he could fill the seller’s shoes. This ended up not being the case. He ended up having to add 1.50 employees to the staff, in addition to himself, to replace the business owner. He acknowledged and appreciated the honest presentation of the company by the seller & IBA.  A presentation of historical facts (tax returns) could have been facilitated without comment regarding the seller’s labor contribution, but this is not the way IBA does business.  IBA has a reputation in the marketplace for facilitating transactions in an environment of full disclosure with integrity employing “best practices”. This is one of the reasons that annually entrepreneurs who purchased businesses from IBA in the past return to IBA for representation in the sale of their companies.  This return for sale is the best testimonial a buyer can provide IBA related to the quality of the representation services we provide our clients.  It is also the reason quality buyer brokers like, John Martinka, regularly encourage their clients to evaluate IBA represented businesses as acquisition opportunities.

The Business Owner Who Overpromised & Underdelivered

The seller in this transaction had a business model that generated cash sales.  He elected to not include a portion of the cash sales in the revenues he reported to the IRS and Washington Department of Revenue.  The business owner made a persuasive case to IBA regarding the annual amount of unreported revenue.  IBA elected to represent the business for sale for a value between what could be verified through tax records and what was conveyed by our client as the ‘true” picture of business profitability.  A willing & able buyer with relevant industry experience was identified and agreement reached between the parties on a Letter of Intent.  Due diligence commenced and it became apparent that the information conveyed earlier by the seller during the business valuation process was not accurate and the seller was continuing down a road of dishonest communication.  IBA’s professional intermediary representing the business for sale decided he could not be party to the transaction without jeopardizing his personal integrity and the integrity of the firm.  IBA’s representation agreement was terminated and the seller advised that he was welcome to proceed with the transaction without financial liability to IBA.  The IBA intermediary also conveyed to the buyer that he was ending his representation of the business, would not be receiving a commission, and encouraged the buyer to walk away from the deal.  Unfortunately, the buyer ignored this advice and completed the transaction. Several years later I learned from the buyer the business was closed, that he had lost his investment, and was back working as an employee.  He ended the conversation by saying how much he respected the integrity of his intermediary as a professional with the comment, “I was an idiot not to walk away when a business broker who was two weeks from getting paid walked away from the transaction and his commission, there could not have been a clearer warning side of a bad transaction.”.  As a general rule, IBA does not represent businesses for values that incorporate unreported income.  It is our philosophy that if a party would lie to the IRS and Washington Department of Revenue that they would lie to IBA and a potential buyer for the business.

George Bernard Shaw famously said, “The most tragic thing in the world is a man of genius who is not a man of honor”.   History is full of geniuses who made the world a better place and people who used their intelligence to find shortcuts to fame and fortune.  Over time sunlight will generally reveal the truth about any situation.  IBA is pleased to employ “best practices” in the sale of privately held companies.  It is our goal in every transaction we facilitate to create an environment of full disclosure & transparency between the parties during the due diligence process.  The knowledge & experience of how to facilitate a due diligence process correctly is one of the reasons why IBA has successfully sold more businesses to entrepreneurs in the Pacific Northwest than any other business brokerage firm since 1975.

Gregory Kovsky, the President & CEO of IBA, is available as an information resource to the media, business brokerage, and mergers & acquisitions community on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  Professionally, as an intermediary, he specializes in the sale of manufacturing, distribution, technology, industrial, marine, and winery businesses. Mr. Kovsky can be reached directly at (425) 454-3052 or .  Additional information on IBA, the Pacific Northwest’s oldest business brokerage firm, can be found at www.ibainc.com.

 

 

It’s Always the Little (Unseen) Things

We had a perplexing problem with one of our garage door openers, as in it wouldn’t close, which usually means the safety beam is out of whack. My friend and I tried all kinds of stuff after trying to move the sensors in case they were out of line.

So I cleaned out the lenses with a wet Q-tip, and it worked. Then it didn’t, cleaned it again, it works, doesn’t work, repeat, etc. Finally, I took off one of the sensors to clean it and voila, there’s some stuff in the lens that looks like a little caterpillar cocoon. The Q-tip pushed it aside, but it would fall back into place, blocking the lens. Once removed, no problems.

It’s often the unseen things that get in the way.

  • One of my clients had a professional evaluation of the business (not a valuation but an operational assessment). One of the items in the report was, “the employees have an informal union,” meaning they were setting their own work polices, rules, etc.
  • A company thought their top customer (25%) was in love with them. In fact, it was the opposite. They were interviewing other providers and didn’t even ask for a quote from their existing vendor.
  • A rep firm did 80% of their business with one manufacturer, they switched firms, he almost went bankrupt, we turned it around, and guess what? Ten or so years later the same thing happened (although closer to a 50% manufacturer). Blinded by success he couldn’t see the risk.

There are too many techniques (to go over here) to see most of what has been unseen. It just takes the effort to peek behind the curtain.

“You’ve got to tell the world how to treat you. If the world tells you how you are going to be treated, you are in trouble.” James Baldwin

 

Due Diligence and The Supreme Court

We all know what’s in the headlines. Behind the headlines we see the Republicans saying how great Kavanaugh did while testifying, there’s no backup to the allegations, and why did Feinstein sit on it for six weeks and go public when Ford wanted it private? The Democrats say why would she come forward to take all the abuse if it wasn’t true, what’s his fascination with the Clinton’s, and why are you trying to rush this through?

There was a huge and late surprise. In buy-sell deals (and in job interview situations or investments) the last thing anybody wants is a last-minute surprise. Diligence is a time for confirmation not surprises, much less shocking surprises.

But then people who are buying a business, selling a business, hiring, or being hired are playing with their own money. It’s not tax dollars or the hope to elect or confirm someone who will grant your side favors. It’s real money coming from or going to personal accounts.

It’s the reason buyers ask so many questions it sometimes frustrates sellers. They’re taking a drink from the firehose and want the information overload that comes with it.

Here’s my personal opinion – the politicians and extreme fringes of any political party or issue don’t care about due diligence, they care about getting their way. Those of us working to do better in the world while betting ourselves do care.

“Lies, damned lies, and statistics.” Attributed to Mark Twain, Benjamin Disraeli, and others

 

Due Diligence Does Not Mean Analysis Paralysis

This post was originally written for the blog on www.ibainc.com, a Bellevue, WA business brokerage firm.

The seller nicknamed the buyer “Columbo” after the TV detective who had a habit of, when leaving the room, always saying, “One more question.” To this buyer, questions were his security blanket and as long as there was another question (and there can always be another question) he didn’t have to make a commitment.

One of my favorite sayings is, “The bigger the spreadsheet the less chance of a deal.” Spreadsheets can be a form of analysis paralysis. I remember sitting with a client who had a massive spreadsheet we were going through. It has links to numerous other spreadsheets and more formulas than most engineers use.

Unfortunately, it also had some erroneous assumptions, the most blatant being he kept overhead expenses at the same percentage of sales as sales grew (for example, rent stayed at 10% of sales even when sales doubled while actual rent would have increased by CPI). So of course, he concluded the business wasn’t worth owning because it had maxed out its profit level.

Finally, I pulled out a legal pad and started writing the company’s big picture numbers. We then discussed when there would be the need for new employees, new equipment, larger space, and related items. The conclusion was the company would make a lot more money as it grew.

Harry had a spreadsheet rating his top 10 factors for a business. They included the standard things plus if the business environment was dog friendly. He told me there was one business he really wasn’t attracted to, but it scored high on his spreadsheet. My reply was, “I’ll bet that means there’s a dog run behind the facility.” The spreadsheet was his focus, not the traits of the business.

Nice stories, but what do they mean to a buyer and seller? As there are no perfect businesses or perfect deals it’s a way for a buyer to stay mired in the weeds and avoid deciding. Here are some ramifications:

  • Both buyer and seller will experience “deal fatigue.” Usually the seller will experience it first, wondering if the buyer is wasting his time. And if it keeps going the tipping point will be when the seller figures there can’t be any more questions and then the bank will ask their questions. Amplifying this is the fact many sellers think their business is the greatest thing since sliced bread and cold beer combined and wonder why there has to be more than a few big-picture questions.
  • Deal fatigue also happens when the seller gets overwhelmed. She’s running a business, answering questions, dealing with her lawyer and CPA, and starts wondering why it’s not as easy as selling a house. One of the best techniques I’ve seen is a buyer who broke the diligence process into categories. I think there were seven areas including financial, marketing, customers, and employees. Questions were segregated, and every meeting and conference call covered only one area.
  • The seller will perceive a lack of confidence in the buyer (and is probably correct). Being organized, keeping good notes, and prepping for every meeting prevents covering the same thing multiple times, which often happens because the buyer is “taking a drink from a fire hose (of information).” That said, buyers will often ask the same question more than once, often with a slightly different spin on it, to see if they get the same answer.
  • If the buyer gets too worried over why the phone bill is up $150 from last year they’ll lose focus on growth strategies. And I’ve not met any buyers who don’t use the words scalable or growth when they discuss business attributes.
  • Amiable personality types aren’t known for their analytical prowess. So when an amiable gets too deep into the analysis it means they’re looking for a way out. One buyer had a very nice deal, about $4 million, exactly the type of industry he wanted, and in a location that was perfect for him. He then beat the heck out of his spreadsheet and called to tell me he wouldn’t have income any higher than about $50,000 a year. No matter that a conservative banker had allocated a mid-six-figure salary before debt service and the deal was above the bank’s debt coverage ratio floor (and even above my floor, which is noticeably higher than any banks).

A good question is, how can sellers or advisors prevent this? Here are three ideas:

Have a due diligence schedule – Categorize by topic, try to stick to one or two topics per meeting, and check off topics when done. Have a shared folder like Dropbox or Box so buyer and seller, and their teams, are always up to speed.

Build a great relationship – A great relationship makes things a lot easier. A buyer who doesn’t completely trust the seller will be more suspicious, ask more questions, have doubt, etc. Seller’s come across as having “An open kimono” it will speed up the process.

Make and enforce deadlines – This goes both ways. The seller needs to provide information when requested and the buyer needs to check-off topics on-time. They need to hold each other accountable.

It’s awfully easy to get buried in the weeds and lose sight of the ultimate objective

Revisiting an Old Friend – The Importance of Employees

I read a short article recently where the writer was describing his frustrating experience when making a food and beverage order, which he repeated twice, had it said back to him, and it still was wrong. His sub-headline was, “It’s hard to get good help these days.”

I’m sure he was being somewhat sarcastic, but it’s true. It’s really hard to find good people and keep them. Almost every business owner or executive I talk with tells me the same story, which is, they could grow faster if they could find more employees. Notice I didn’t write “good” employees.

I know businesses that have stopped doing drug tests for positions not requiring one (like for a commercial driving job where it’s a requirement). A friend was surprised last year when his new employer told him they don’t do drug testing (and this was not in a state which legalized marijuana, which adds its own set of issues).

On July 30, 2018 the Wall Street Journal had a front-page article titled, “Employers Eager to Hire Try a New Policy: ‘No Experience Necessary.’” This is a big swing from the post-Great Recession era when talent was abundant, and employers could be fussy. This covers a wide range of industries from mechanics, to programmers, to management and everything in between. The article also mentions reduced drug testing and reduced background checks.

Which bring us to the situation facing most business owners, which is, “How do I attract and retain good people.” In fact, I have added this as one of the first few things an owner should do when preparing their business for an exit.

One of my favorite stories is about a business buyer who, when the seller said he couldn’t talk to the key people prior to the deal closing, said to the seller, “You may think I’m buying your business but I’m really buying your people.” Private equity groups buy management teams and individuals buy an operation having capable people with diverse responsibilities.

What this means to an ongoing operation is invest in your people because they’re hard to replace. The tech firms get this with all the amenities they offer on and off campus. Most people work for small companies because they don’t want to be one of thousands. My friends at Pacific Tool have monthly BBQs, at Pacific Studio they have regular “Beer Fridays,” and Spectra Labs has Tacoma Rainiers tickets for their staff.

But it starts with hiring good people. Another of my favorite stories is about when a client almost gagged when I recommended he hire two new salespeople with a monthly base salary double the highest they had ever paid before. He smiled three months later when both of those salespeople were into commission (and in record time). They were worth it!

Finally, all of the people who can help you grow don’t have to be employees, especially if you don’t need them full time. You can outsource bookkeepers, controllers, CFOs, IT experts, HR, sales experts, C-level management, and more.

Conclusion

Computers, machines, and artificial intelligence can replace some people and improve productivity. But you still need people, good people. Find them and keep them. The cost of replacing them is incredibly high.

Getting the Owner Out of the Way

I posted recently about seeing a rash of mangled financial statements. I wrote it’s my top item owners should fix to increase value, and just behind this is getting him or herself out of the way.

In the last couple weeks I ran into companies where the owner:

  • Is the only one who does the bids.
  • Spends over 80% of his time doing “billable hours” work (a professional firm).
  • Makes 90% of the sales.

Who wants to walk into these situations? What you want is a company, like the one whose owner I met last week, that has the structure to allow the owner to take three or four boating vacations (a week or so each) in the middle of their busy summer season.

The three items above are what’s known as a serious dependency. The boating-owner company is an example of management depth and successful delegation.

Wanted: Accurate Financial Statements

Once again I’m in the middle of a deal where the seller treats accounting like a weak little step-sister. Garbage in-garbage out syndrome, co-mingling businesses, no controls, blending of the business and personal checkbooks, etc.

Solid financial systems and (therefore) accurate financial statements are one of my four top things an owner can do to increase value and prepare for a sale. After the run of mangled financial statements I’ve seen this year it’s my number one reason, with a bullet. Set the accounting up correctly, keep in under control, and you’ll spend less money than having your accountant correct it every year and have to adjust it when the business is sold.

FYI, my other top things business owners/sellers should do are 1) Show you can grow, don’t just say it, 2) Get rid of dependencies, especially on the owner (lots of those this year too), and 3) Prove you can attract and retain good people.

Moving a Deal Along with Empathy

When working with business buyers and sellers I’ve found those who demonstrate empathy to those on the others side get things moving faster (than those who simply approach it as a transaction).

This was recently highlighted by the actions of a client of mine. They noted how the other side wanted to proceed in the areas of pace, disclosure, relationship, and more. They quickly changed their process and focused on how the other side wanted to proceed.

And guess what? The relationship is incredibly solid and we’re ahead of schedule.

Fool Me Once Or Fool Me All The Time

On June 2, 2018 Jason Zweig’s article in the Wall Street Journal was titled, “The Fanciful Alphabet Soup Companies Use to Fool You.” The premise of the article was most of the financial jargon used to provide insights into companies’ health are make-believe and don’t reflect actual conditions, i.e. true profitability.

First, five points from the article I found interesting and then some comparisons to other areas of business.

  1. This goes back to before the stock market crash of 1929. A 1932 research paper showed firms had loaded up with cash and post-crash, “companies were flush with cash and investors beleaguered,” which they wouldn’t pay out.
  2. Investors have always looked at net income as a way to assess businesses. But companies have come up with new measures of “modified” profit with the chief culprit being the term Ebitda (earnings before interest, taxes, depreciation, and amortization). Zweig writes that any form of modified profit isn’t cash flow.
  3. Fifteen years ago, Charlie Munger, Warren Buffett’s business partner, called Ebitda, “bulls*#t earnings. For more, just Google the terms Warren Buffet and Ebitda. My favorite is when Buffett compares people who buy into the term Ebitda to those who think capital expenditures are funded by the tooth fairy.
  4. There’s now a plethora of Ebitda clone terms including those showing “profit” before things like stock-based pay, marketing, business development, and administrative expenses. Zweig asks, “Can “Ebidtdaft” be far behind?”
  5. So far this year there have been over 450 documents filed with the SEC with suffices tacked on to Ebitda. One analyst wonders if pretty soon companies will start multiplying earnings as a measure of performance (yes, it’s sarcasm).

So let’s look at the above in the context of other areas, starting with advertising. A perfect example is car dealers who advertise free oil changes for life. Well, if it sounds too good to be true…. A car guy told me about the hitch in the program. You’ll get the oil change plus a list of work you need to do on the car. If you don’t have them do that work the extended warranty and oil changes go away. Like the above, it’s knowing the details (in the fine print).

Now for what I see every day in the buy-sell world. First, most of the creative Ebitda terms in the public market have nothing on the creativity used when selling businesses. Adjusted Ebitda or adjusted earnings are the norm. I get the feeling many people, even in my industry, don’t understand the difference between profit, Ebitda, and cash flow.

There’s a tendency to “add-back” almost any expense deemed “unnecessary” to running the business. To some people, this list includes:

  • Owner salary (really interesting when adding back the salaries of multiple, departing owners).
  • Medical insurance expense.
  • Marketing expenses (the marketing didn’t work so it’s really profit).
  • Owner “perks” like cell phone, car, travel to conferences, etc. (as if all owners don’t deduct these).
  • And a recent one I’ve seen, the expense for research and development (for a company with a patented propriety product).

Conclusion

The magic of inflated earnings is all around us, and not just in the financial world. Misleading ads, inflated resumes, stories about high school athletic accomplishments (Glory Days as Bruce Springsteen called them), and many other things. The good news is most people see through these things. The problem is some don’t see through the fog and make decisions based on false information.

When It’s Your Own Money….

A few months ago the Wall Street Journal’s Business section’s headline was, “China Conglomerate Gets Lifeline.” The sub-headline was, “Government is helping HNA Group right itself after acquisition spree loaded it with debt.”

The lesson here is simple, don’t over-leverage yourself. It’s good advice for us personally and in business.

But notice how they got in trouble; an acquisition spree. I’m a big fan of growth by acquisition, when it’s done right and for the right reasons. Heck, it’s why in my book, Company Growth By Acquisition Makes Dollars & SenseI cover 19 reasons to consider this strategy.

Here’s a big tip – if the deal only makes sense if the acquired company grows, it’s a bad deal.

There’s a lot of money out there, especially in the private equity and family office world. In my world, where bank financing is the primary source of funds we have my favorite two sanity checks:

  • It’s the buyer’s money (not a fund).
  • The banks have debt coverage ratios and good bankers want the debt coverage to be well above the minimum requirement.

My tip doesn’t only apply to company acquisitions. It applies to other things as well. If you get a new customer at a discounted price hoping to show them your quality and then raise prices, you’ll (usually) be disappointed. If you hire someone who isn’t qualified hoping they’ll improve, you’ll be disappointed.

Optimism is necessary and important. Optimism without common sense gets us into trouble.

“No matter how cynical you become, it’s never enough to keep up.” Lily Tomlin