15 Things Every Business Buyer Should Know
By David Grossman
We’ve finally come to the end of this series on business acquisitions after previously exploring an overview of the buying process, drafting a letter of intent, and questions to ask during the due diligence process. You can find the previous articles online at cleanfax.com/acquisition. While there is no magic-bullet approach to completely smooth out the overall process, I’ve attempted to provide guidance to make buying a business easier based on my own experiences.
I wish I had been given a list of tips before I made my first investment because it would have saved me a significant amount of time, energy, and money. What follows is by no means an exhaustive list, nor is each item pertinent to every situation; it is merely an attempt to shed light on a few issues—and maybe help you in at least a small way as you look to buy a business, whether it is your first company or your fifth.
Ask the key question, “Why are you selling?” Then ask it again and again until you feel certain the explanation is consistent and the motivations are clear and real. The two most cited reasons are retirement and inability of management to scale with the business. Make sure the owner’s story checks out and she isn’t hiding another reason that could negatively affect your ability to succeed with the company.
For example, while a 60-year-old owner looking to retire may feel credible, that reason might warrant further explanation if she has working-age children who traditionally might take over the company. I cannot tell you how many times I have been told by a seller, “I lack the energy and knowhow to roll up my sleeves and do what needs to be done, but a young guy like you with piss and vinegar can really take this business to the next level.”
There may be truth to that statement, but it also might be masking something troubling like an adverse change in the marketplace. The point is not that any single rationale for wanting to sell is better than another, per se, but some might require further probing.
The seller is almost always less financially sophisticated than the buyer. Having spent most of her time focused on sales, marketing, and operations, there was likely little focus on financial issues. Compiling financial statements and understanding the intricacies of structuring a sale of a business may involve treading into unchartered water. After all, a common reason for an exit is that the company has outgrown the managerial capabilities of the current owner.
It is helpful to speak on the same level as the seller to effectively communicate and not come off as intimidating. The sale process may progress slower than desired because of a seller’s lack of sophistication, and she might have less information available on her business than desired since the need for detailed financial statements as a management tool may be a low priority.
Emotion frequently is a major factor in the seller’s behavior, so honesty and objectivity are critical. As the cliché goes, often the best deal is the non-deal, and you should be just as prepared to walk away from a sale as to close the transaction. It is important not to fall in love with the business until after the deal is consummated.
Putting emotion aside will lead to clearer decisionmaking. Objectivity is important for both deciding whether to continue going forward—as you learn more about the business throughout the due diligence process—and negotiating purchase terms. Don’t be too accommodating in an effort to close the deal at any cost.
Play the political angle with any intermediary, also known as a “business broker,” representing the owner of the target company. While this individual is compensated almost entirely only if the deal closes, he is often more aligned with the seller since she is the one who both hired him and pays him.
The broker will have known the seller for a longer period than you and likely had several conversations with her regarding the value of her business. He also typically serves as an adviser to the seller. By gaining the respect and attention of the broker, you may be able to obtain an understanding of the seller’s expectations and concerns.
Don’t take the seller’s financial statements at face value. Very infrequently will you encounter a target company that has undergone annual audits by a top-tier CPA firm. More commonly, the numbers are compiled by a small, local accountant or possibly only reviewed by one. Thus, you may want to consider performing your own forensic audit in which you track random invoices and bills and reconcile revenues to monthly bank statements.
It may be helpful to hire a financial consultant or an accountant. (Note that you may be able to cut a low rate for this work in exchange for hiring the firm as your company’s CPA should the deal go forward.) If you discover that the business is less attractive than the seller boasted, then a renegotiation of price is warranted.
Do not assume costs can be cut. Unless you are a strategic buyer and will combine the business with a pre-existing, similar one, there is typically little room for expense reduction. In fact, more frequently than not, I find that expenses will need to be increased, especially for marketing.
Conversely, the apple may be tastier than it appears. Be sure to back out from cash flow the owner “benefits.” Without claiming any unacceptable activity, it is likely a portion of the seller’s business expenses would more accurately be classified as personal items. Areas to examine include auto expenses, travel and entertainment, professional fees, rent, and salary. Changes should be made to:
- Adjust the salary to a market-based compensation package for an active owner/president—$100,000 to $150,000 for a small business.
- Include a realistic rent. If the seller also owns the real estate, the rent paid may not be the fair market value.
- Take out personal expenditures such as non-business auto and travel costs.
Strongly consider spending money to hire a lawyer to review documents such as supplier and customer agreements, a financial expert to perform an audit on the company’s financials, an industry veteran to recommend certain questions to ask, and an experienced buyer to help guide you through the process. A significant amount of the investigation into the company and its industry, employees, customers, and competitors can be done firsthand. Also, depending on how knowledgeable you are of the industry, attending an industry conference can provide a wealth of information in a short period of time. These expenses should be considered as the first part of your investment in the business regardless of whether the deal transpires.
Be creative in your due diligence. A lot can be learned about a business through some unorthodox investigative methods. I have two favorites:
- The first involves asking a friend to approach the company, posing as a customer. Pay for her to receive their services, and you can see every step of the customer interaction process. Then ask her to do the same with key competitors and compare the experiences.
- The other is to make phone calls to the large trade magazines covering the company’s industry. You would be surprised how much the typical ad salesperson and editor can disclose about the industry and the key players.
Frequently remind the seller she is selling the business. By this, I mean talk about what will happen after the sale. This will serve two purposes:
- By observing the seller’s reactions, you will gain a sense of her comfort and desire to sell. It is helpful to know early on if the seller could, at some point, decide not to go forward.
- By reinforcing the vision in her mind that she will soon have a great life lying on a faraway beach, you may be able to gain leverage in the final negotiation process.
It is never too early to plan for the transition. While you may be pre-occupied with—or overwhelmed by—closing, the due diligence process can be used to help plan for when you are in the driver’s seat. If done correctly, prior to the purchase you should have strong ideas on such topics as how to effectively grow the business, which employees are underperformers, the size of the investment needed in the following twelve months, and what areas you personally need to focus on. Furthermore, thinking hard about these issues will enable you to see yourself running the company and allow you to know if taking the plunge is right for you.
Remember the deal is not done until the final paperwork is signed and the check has cleared. Know second-guessing your thinking every step of the process is expected and even healthy. While you may end up having nothing to show from months of hard work except large legal and due diligence bills, there is no shame in walking away even at the very end. You should use every last moment to research and every interaction with the seller to learn more about her business. As the great Kenny Rogers says, “Know when to walk away, and know when to run.”
From my experience, whenever momentum is lost, even for legitimate reasons, the deal falls apart. While it is important to perform a thorough due diligence process, milestones need to be set and the process should move along. If a deadline will not be met, frequent and frank communication between the buyer and the seller will help mitigate the risk of the transaction tanking.
Push for the seller to have skin in the game. Tying part of the seller’s proceeds to actively working with you as you learn the business—and helping you succeed—post-close is critical. Including a large percentage of the sales price in the form of a multi-year note (as opposed to a 100% upfront cash payment) helps accomplish this.
While there is no set-in-stone formula, a buyer should strive for paying no more than 50-75% of the total purchase price in cash upon closing. The balance, referred to as a “seller’s note,” should be paid over the next two or more years. This note typically calls for a fixed, quarterly payment and a reasonable interest rate.
However, the post-closing payment can be variable and tied to several different metrics such as the future revenue of the business. If for some reason the seller is unable to remain with you, then the price should be lowered. For example, an individual purchases a company and is counting on the seller to stay around for several months to introduce him to the customers. Two weeks after the sale closes, the seller suffers a fatal heart attack—a tragic event, indeed, but one that leaves the business arguably less valuable. Unfortunately, the buyer has no recourse against the seller’s estate if this issue is not addressed in the contract.
Consider letting the seller pocket more money. While this may sound counterintuitive, you may want to incorporate a provision wherein the seller can reap additional money if the business grows over the next several years by a pre-determined amount. This is known as an “earn-out” and is intended to further align your interests with the seller’s. It is worth considering if the seller’s involvement could be particularly helpful in generating additional sales or profits.
In the past, I have proposed that the seller could make more money than she was looking to if the business had higher revenue than either of us anticipated. Of course, the trade-off is she would make less if it underperformed. In one situation, I was willing to pay to the seller 10% of all revenue above a set benchmark for the year following the sale. Given that gross margins were well in excess of 10%, both the seller and I benefited from the growth.
If the seller does not agree to this type of arrangement, then either she does not have faith in the business or she does not have faith in you. Either way, that is a serious red flag.
There are a few issues that, if addressed upfront, can save a significant amount in taxes. For example, in most circumstances the purchase agreement will require allocating the price to various components of the business, namely the assets. The asset base consists of fixed assets, a contract prohibiting the seller from going into competition with you over the next several years, and the seller’s agreement to work as a consultant with you during the transition, among others. The balance will go toward an accounting item known as “goodwill.”
As the buyer, you naturally strive to value the assets as high as possible and the goodwill as low as possible since the assets can be depreciated over a significantly shorter timeframe than goodwill. Greater upfront depreciation will lead to lower taxable profits. Lower income taxes
will be due, and, therefore, higher after-tax cash flow is generated. This cash can then be used for other purposes, such as investment in the business or bonuses/dividends to employees and the owner.
Granted, when it comes to taxes, generally what is good for the buyer is bad for the seller, but some creativity potentially can enlarge the after-tax pie for both parties. Given the importance of this and other accounting issues often not properly tended to, I recommend further investigation into the relevant topics for your transaction. Spending some money to on guidance from an accountant may be prudent.
Buying a business requires a mix of patience, persistence, a sense of humor, a little bit of luck, intellectual honesty, an understanding that outside help is available if needed, and upfront commitment to not fall in love with any business until you own it. Pay attention to the details, trust your instincts, and the process will go much more smoothly. Good luck with your future buying.
David Grossman is president of Renue Systems Inc., a global franchisor and operator of specialized deep-cleaning services businesses to the hospitality industry. He can be reached at [email protected] with more information available at renuesystems.com.
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February 21, 2023