When You’re Sunk You’re Sunk

Forbes.com reported bankrupt Chucky Cheese is spending $2.3 million dollars to destroy 7 billion prize tickets, which would fill 65 cargo-shipping containers. Why? Because it’s about 25% of the $9 million cost if they were redeemed for prizes. 

We all deal with sunk costs. Buy a new car, decide you don’t like it, you’re out the 20% they say is the immediate market discount. Invest in a new machine, it’s not what you really need, you’re out.

Things like above always remind me of a past client who bought a (what turned out to be) great business for next to nothing (and this is not a pitch like the books and courses on how to buy a good business with little to no money – which doesn’t happen). 

How did this happen? The company expanded from Seattle into Portland, it wasn’t going well, and they got stubborn, as in, “We’ll sell our way out of this.” They didn’t. And, at a peak of the real estate market they bought a building. The buyer got the Seattle operation by paying off the State Department of Revenue, the phone company, and the top supplier. He later told me, “I knew it was a good business, I just didn’t know it would be this lucrative.”

About 8-10 years ago I came up with what I thought was a compelling idea for a line of service to potential clients. It wasn’t as compelling to them as it was to me, so I dropped it. The costs (mostly time and energy) were sunk, gone, and that was okay. I learned a lesson, picked up one client (five projects, none for this idea), a few good marketing tactics.

I mention these things because in the buy-sell world I see all the time owners (and their intermediaries) trying to convince buyers the failed advertising campaign is really profit because it didn’t work. Or, the ops manager who wasn’t as good as he or she claimed is really profit because it was a bad hire.

No. That’s business. That’s life. If you don’t try things you won’t learn what doesn’t work. Not every decision is a good decision (meaning didn’t live up to its potential). The good businesses often just have made more good decisions than not-so-good ones.

“It is inhumane, in my opinion, to force people who have a genuine medical need for coffee to wait in line behind people who apparently view it as some kind of recreational activity.” Dave Barry

What Exactly are You (Personally) Guaranteeing?

In the 1990s, President Trump nearly ruined himself by personally guaranteeing many millions of dollars in loans, and then said he regretted guaranteeing them. But it seems he has not followed his own advice. With the NY Times releasing some of his tax records and other financial information, he allegedly is personally responsible for loans totaling at least $421 million, most of which is coming due within four years.

What does all of this mean? Realize when you get a mortgage or a car loan you are signing a promissory note, guaranteeing you will pay it back. These loans have collateral so the lender can go after your house or car to help repay the debt if you don’t pay. Where it gets “sticky” is when there’s no collateral, which is rare when it’s a personal loan, other than credit cards, which don’t have collateral.

When an individual or small-business owner wants a loan they usually personally guarantee it. When the loan is to an individual, say an executive buying a business, if the loan is to the person it is a legal obligation on that person an in affect, they are guaranteeing it. If the lender makes the loan to a corporation or LLC, which most are, they ask the borrower to personally guarantee it. 

When a private equity firm or similar investment firm borrows money, the partners won’t sign a personal guarantee. The same with larger corporations. So one has to wonder why lenders asked the president to personally guarantee all the loans. Not knowing the details, I can only guess it’s because they were risky loans, there was worry about non-payment, and hiding behind the corporate veil. 

I asked my friend Greg Russell with PRK Livengood Law in Bellevue (www.prklaw.com) about personal guarantees and here are his comments:

  • He reiterated a bank will want a personal guarantee when the loan is made to an entity.
  • Business sellers will want a personal guarantee as they are unsecured creditors, coming in after any senior debt, personal home equity, etc.
  • A borrower with a personal guarantee must report it for any financial dealings and this contingent liability may impact the availability of credit.
  • A personal guarantee can hold for a long time. There is a statute of limitations of six years, which starts from the time of breach. Within this time the lender can get a judgment to keep the debt alive.

Lenders, of all types, have the most interest in personal guarantees so I discussed them with Bill Barclay, Regional Manager of Commercial Banking with Columbia Bank. Here’s what Bill had to say:

  • 95% of Columbia Bank’s loans have a personal guarantee on the borrower. He said, “If things hit the fan, we want them walking down the aisle with us.”
  • Those not having a guarantee are generally larger firms with diversified ownership and management along with private equity firms.
  • If there’s not a guarantee expect tighter loan covenants that may create a personal guarantee if triggered.
  • An existing personal guarantee (from a different lender) won’t have much impact on future credit if there’s only one. The bank will look at all contingent liabilities and multiple guarantees may require a closer look.

Conclusion

Personal guarantees are something business owners, business tenants, those of us in the buy-sell world, and others deal with all the time. Business buyers and other borrowers do their best to avoid them, but those with the money make the rules. I always come back to a client from about a dozen years ago who didn’t like what the bank was doing. He didn’t think they were creative or flexible enough. I commented to him, “The bank’s not in business to be creative or flexible, they’re in business to be paid back.” I know if I lent someone money I’d want as much security as possible. 

Businesses and Workers – It Must be Teamwork

Two interesting articles appeared on September 6. The Seattle Times published a Los Angeles Times article titled, “Instacart shoppers face unforgiving metrics: ‘It’s a very easy job to lose’” and American Compass released an essay titled, “Conservatives Should Ensure Workers a Seat at the Table.

The Times article covers the harsh metrics imposed on Instacart shoppers including ongoing tracking of order filling, notices to employees via an app when they’ve earned a 10-minute break, and monitoring the words employees use with customers to make sure they use the preferred script. They offer low wages, keep employees from getting enough hours to have benefits, and drive them hard. These are the jobs people leave regularly creating turnover and training costs for employers.

The American Compass is a conservative organization so it’s a bit surprising they wrote what they did about unions, including, “Rather than cheer the demise of a once-valuable institution, conservatives should seek reform and reinvigoration of the laws that govern organizing and collective bargaining…” They make the case it’s a mutually beneficial relationship when owners, managers, and workers work together.

Compare the above to most small businesses. Talking to business buyers, I regularly hear about how they like building teams, helping employees grow, and improve. Business sellers often seem to care more about their people keeping their jobs than the price they get for the business (as in, I’ll take a little less from someone I feel I can trust to take care of my people).

Unions came about because of horrible working conditions. In my opinion, one reason they’ve lost membership is they became too rigid and too political (for private sector workers). 

It’s interesting to see how things could swing back with influence from both sides of the political spectrum. It’s also fascinating to see how some technology-based service companies (like Instacart) are returning to the employment practices reminiscent of 100 years ago.

There has to be a balance between management and workers because animosity hurts all.

“Take a rest; a field that has rested gives a better crop.” (Roman poet) Ovid

Time Change – Life Change

Our dogs have been affected ed by the change from Daylight Savings to Standard Time. They get up at the same “time” in the morning, but the clock says it’s an hour earlier, so we get up earlier also.

Change is tough for a lot of us, people and dogs. Change of a job, home, school, and especially when it comes to business ownership. It’s why I tell people half of what I do falls into the intangible’s category, because we deal with big change.

One client told me the ability to share his thoughts and questions with someone on a peer level was the most important part of our relationship. Knowing the right questions to ask and the right answers to get is what most of us want.

The buying or selling of a business is often the biggest life-changing and financial change for business buyers and owners/sellers. An experienced guide with a proven plan adds a lot of value (whether my firm or another reputable firm).

When City Slickers Go Camping

I was reminded of the Billy Crystal movie City Slickers when I saw the following, which would be funny if these people weren’t damaging our planet:

  • A Seattle Times article on how the Cascade wilderness areas are being trashed (organic and inorganic waste) by city people deciding to get outdoors during the pandemic but not knowing how to act (as in, carry out their waste).
  • A neighbor who loves the isolated outdoors said a deep-woods campground that usually has half of their 30 campsites available was filled with large RVs the last time he went there.
  • A recent Wall Street Journal human interest article about city dwellers experiences in the outdoors. The two best stories are about the young lady who didn’t bring a sleeping bag because it was hot out, camped in a valley, and said she had never been so cold in her life and another lady who was appalled by campsite restrooms (an outhouse I’m assuming) and drove over a mile to a gas station to relieve herself.

So what does this have to do with business? The analogy is there are a lot of people who get into business with the same amount of preparation as the city slickers described above. I get calls regularly from people wanting to get into business (often starting one) and it’s usually to create a job using their skills versus growing a business (I refer these people to the local SBA/SCORE office so they can get a mentor and counseling). 

Advice: 

  • Know why you want to do what you’re going to do.
  • Get the right help to succeed.
  • Realize getting into business (or exiting) isn’t easy. 
  • Plan.
  • Make a decision; analysis paralysis doesn’t help anybody.

Things always look better and easier from the outside. Just like, “the grass is always greener on the other side.” It’s only looks easy, better, or greener when you don’t do the things you’re supposed to do and do them correctly. Doing it the right way takes more time and effort, and it’s worth it.

If You Don’t Have Time to Do It Right, When Will You Have Time to Do It Over” John Wooden

Coasting – Downhill

A business owner told me his sales were X dollars – put in whatever figure you want, $100,000, $1,000,000 or $10,000,000. His actual sales were:

  • 2017 – 90% of X
  • 2018 – 75% of X
  • 2019 – 65% of X
  • 2020 – on track for 50% of X 

The abovementioned owner is coasting and the business is going downhill. And once on the slope it’s tough to recover. I’m sure there’s not a lot of calling to customers, much less prospective customers. I can’t imagine there’s much marketing at all.

What’s compounding this is he has no idea of what’s really going on. Yet all it takes is paying attention to the financial statements. He doesn’t need to have management reports, although they would add a lot of value and clarity.

Business buyers want one of two things:

  • A well-oiled machine with room to grow.
  • An underperforming business in a solid industry (coasting).

What they rarely want is a damaged beyond-repair business. Whether you’re an owner or advise owners, keep these points in mind. Coasting (downhill) doesn’t let you exit with style, grace, and more money.

“If liberty means anything at all it means the right to tell people what they do not what to hear.” George Orwell

Ask the Right Questions; Get the Right Answers

For some interesting early summer reading here are a few things from my buy-sell world. Issues that, for the most part, can be avoided by asking the right questions. However, I can tell you from experience even if you ask the right questions you don’t always get the right answer (meaning what the client really thinks).

Question: (for all owners thinking of selling) “Have you worked with a financial professional to see if the proceeds from the sale are enough for your next great adventure in life?” A deal collapsed when the seller said because of other financial matters in his life he just can’t sell his business now. Believe me, this is not the first time I’ve experienced this, with both my clients and those on the other side of the deal. Plan before you jump.

Question: “What will you do when you sell your business?” I was working on a project involving selling the company to the management team. The owner, a client of at least three other projects, insisted he was prepared to sell. In reality, he wasn’t. He didn’t know what he would do, especially since the answer to the question was not, “Retirement.” He can’t see himself retired. Now, if the answer is retirement, my next question is, “Does your spouse want you around 24/7?”

Question: “Regarding your offer, can you show me your financing package?” A business buyer lost a deal to two other offers that were substantially higher than his offer. Then both other offers couldn’t get the financing together. My constant advise to buyers is, get financing alternatives lined up before making an offer. Another buyer got bank indications of interest before making the offer and it was powerful.

Question: “Have you hit past projections?” There’s a deal lingering because the company (actually the very optimistic seller) can’t seem to ever hit their projections. Another deal was lost recently because the seller insisted on a price based partially on earnings projections for 2019. When those projections turned out to be 25% above the actual earnings the buyer wondered if growth was possible. 

Question: “What are your anticipated capital expenditures?” A business owner is touting the firm’s EBITDA as actual earnings. Yet 25-30% of annual EBITDA is new equipment with an immediate write-off. That’s cash out the door or bank payments over time. It’s a real expense. This is a lot different than when capital expenditures are for a handful of computers and are only 3% of EBITDA. 

To summarize, ask the right questions (usually you’ll get an honest answer), realize how little projections are worth in today’s fast-moving world, get financing lined up before making an offer (on anything, business, home, commercial real estate, etc.), and realize while depreciation used to be a “non-cash” expense, these days it’s probably a real expense in the year assets were purchased.

“The solution to the mystery is always inferior to the mystery itself.” Jorge Luis Borges

All You Need to Know About COVID Era Banking

From June 4-10 Jessica and I interviewed bankers representing eight Puget Sound area banks.* This memo is a synopsis of those conversations about what’s going on in banking during the COVID crisis, with a focus on business acquisition loans.

If you want the full report, click here to get it. It’s in table format so you can easily see what each banker said on the various topics.

First, all the banks are, “Open for business” meaning they are considering making loans. What’s changed is underwriting is going to take longer and will be more thorough (my comment – underwriting wasn’t sloppy before COVID, especially compared to the years leading up to the Great Recession). COVID will be a focus of all analysis and underwriting, where the business was pre-COVID, how it was affected, what the future looks like.

Year-to-date monthly statements are extremely important. The banks recognize there are a lot of unknowns and realize we all fear the unknown to varying degrees. Projections will be scrutinized more than ever and owners and buyers who can present thoughtful projections, answer questions realistically, and not gloss over the current situation will be in a more favorable position. 

My accounting and CFO friends will like the following: the quality of the financial statements has never been more important. Some banks will look at the accounting department, ask if there’s a CFO or controller, and use that in their decision-making process. Having the owner’s sister-in-law who’s really a data-entry person but called the controller won’t cut it.

And, no surprise, there will be more sensitivity analyses and stress tests. Mentioned a few times was the figure “30%,” as in, what will the business, its cash flow, and debt coverage look like if revenue goes down 30%. As part of this, banks that previously did more conventional loans will now be looking to use the SBA 7A program (for its guarantees to the bank).

Consistently mentioned was how important relationship is (the PPP showed this) as well as how borrowers with known and quality advisors will be looked upon more favorably. It was said the source of the referral matters and if advisors are involved it’s a big plus. A few people encouraged borrowers to talk to multiple banks, find the right fit, talk holistically about how banking works, and have thoughtful questions and answers. Especially in regard to how the business is handling the COVID stress.

* Bankers who helped us

  • Banner Bank – Lynell Smith & Jacque Coyan
  • Columbia Bank – Jeff Wilcox
  • Heritage Bank – Addie Roberge
  • Key Bank – Jane Pekasky & Jennifer Ringenbach 
  • Live Oak Bank – Lisa Forrest
  • NW Bank – Gary Strand
  • Sound Credit Union – Donna Himpler
  • WA Trust Bank – Kit Gerwels

The gang that couldn’t fly straight

A few months ago, the Wall Street Journal had an article on Boeing’s recent problems titled, “The Gang That Couldn’t Fly Straight. It covered how Boeing got so off track. I’m not qualified to analyze Boeing’s issues and the article made it seem they made some decisions based on numbers versus the planes or the people. It reminded me of when in “The Reckoning,” David Halberstam wrote about Lee Iacocca’s outrage because the financial people, who had such power at Ford, had “so little feel for cars.”

For many years there was an incredible demand of planes. Did Boeing lose their “feel for planes?” (and for people?). It was boom times for sure as it was for many other businesses. It caught up with Boeing and it’s catching up with other businesses. As I heard on a recent webinar, “Any company can do well in a boom.”

When things are easy there’s less attention paid to the details, especially the details about what a business buyer will want. Here are some examples of businesses I’ve seen in the last month or so.

  • A proprietary product manufacturing company with an 82-year-old owner who is (still) the product designer, especially for the little tweaks each customer wants. 
  • A booming manufacturer with 90% of sales to one customer. The customer is no longer local and supposedly uses this firm because they can’t find a supplier near their current location. What happens when they do find a nearby supplier?
  • A firm reduced to a skeleton staff due to COVID, their best month over the last three showed sales at about 30% of last year, and they want to sell for a large, guaranteed price.
  • A very solid consumer business wanting to capitalize on a COVID spike in business, assuming (hoping) it’s a trend. Deeper analysis of sales shows it most likely is a spike.

Once again, it’s easy when things are booming. But business buyers want to know what happens when it’s not booming, when dependencies like the above owner and dominant customer manifest themselves, or what COVID and other risk factors do to the business. 

And speaking of COVID and how it’s affecting buy-sell deals, here’s what my friend Gregory Kovsky with IBA wrote me, “…until a business shows three months in a row substantially similar to 2019 prior to believing it has returned to its prior strength and where historical valuation models are appropriate.  Until that occurs, I believe some adjustment mechanism is warranted related to the ultimate value of a business in a transaction paid by the buyer to a seller.” For those of you not in the buy-sell industry, it means the buyer probably won’t guarantee the full price upfront, will pay a lower price, or a combination (or some other adjustment technique).

The value of a business is really what a buyer will pay for it. Too many risk factors and the price goes down. And the bottom line is, many of the risk factors present in small and mid-sized businesses can be mitigated over time. It takes awareness and effort. With COVID, we just don’t know.

“There seems to be some perverse human characteristic that likes to make easy things difficult.” Warren Buffett