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 email@example.com. Additional information on IBA, the Pacific Northwest’s oldest business brokerage firm, can be found at www.ibainc.com.