October 29, 2019 | Steve Wain
Diseases of Due Diligence
Pitfalls and tips to avoid when buying a business
This individual thought that with the money he had and the time off from work, he could handle almost any issue and get a deal closed. When asked what he would do to finalize on the sale, he thought for a minute and said, “I’ll put a plan together shortly.” The reason this individual was so cavalier about the next steps was that he did not understand the game.
The game is a very detailed and, at times, extremely nerve-racking process that can lead to failure almost as often as it leads to success. Buyers who take on this task without adequate professional help eventually come down with an illness I call Buyers Attention Deficit Disorder, or BADD.
BADD occurs when the sum of the moving parts exceeds the buyer’s ability to control them and then process the information to come up with a valid decision when needed; when a buyer tries to “squeeze” out dollars when hundreds of thousands are on the line; and when short-term desire for success outweighs long-established practices of successful concerns.
We all know that a business’s primary objective is to make a profit. Yet, could you be happy if you had a loss? The answer is yes if your other concern is cash flow. Ask yourself this: As a buyer, can you dissect a company’s financial operations to make a distinction between profitability and cash flow trends? What does it mean to lose money on one hand, and then take home a lot of cash on the other?
I am sure many people will say they understand the difference but do they really have the time to evaluate the nuances of cash flow, including effects of monetary policy on prospective debt service, capital expansion needs and use of funds, or short-term “tax-planning” vs. longer term inventory carrying costs?
These questions, and about 10,000 more, usually either pop-up during or just before the period called “due diligence.” (get a taste for what you have to review here in this interesting Forbes article) Good business owners will work with others to create a memorandum that helps paint a picture of the business they want to sell. As a buyer, you will rely on those “facts” to help in determining whether the business is a good investment. If you are one of the lucky buyers who happens to get comfortable with these facts and makes an offer for a business, then the next stage is where the fun starts.
Due diligence is a period of time between an accepted letter of intent, or more formally after definitive documents have been signed, and the exchange of money between the parties. During this period, you as the buyer need to get ready for battle. The battle is to convince yourself that both the facts presented and your belief in the future potential of the business are what you believe them to be before you take control.
The fact is you WILL find discrepancies, whether it be a reasonable or large amount. What you can be relatively certain of is that you will not find a “clean business,” because all businesses have issues — issues that are either not presented, not understood originally, not aware of by the owner, or classified as derived. A derived issue is one that “crops up” during the due diligence period. In any case, these should be expected.
So does this mean the deal is off? Absolutely not! As a buyer, you must go into the process knowing this will occur. The question is a matter of severity and resolution. Case in point: During due diligence, you find out the seller carried a line of insurance you feel is necessary upon further review of the company. Does that mean the seller was withholding the lack of insurance? No. It could be innocent on their part for not knowing, or more likely, they knew but decided to take the risk without the coverage to abate the loss if it occurred.
Now, think of trying to handle figuring out what this issue is, its impact to operations if a loss occurs and if coverage is obtained, how much it will cost, what it will cover and what impact it may have on your ability to financially run the business. These questions are reasonable, but when you are under pressure to investigate their answers, you must consider the analysis of that “inventory planning” you determined earlier. Is this the correct amount of warehouse space, and what about the eight years left on the lease that is $3 per square foot more than the current market?
Here is a fact: Even the best professionals in this business, those people who I respect, need to spread the analysis and investigation to make a purposeful and educated evaluation of a business to many people. The objective of the closing day is to feel confident about your decision to acquire a company. Buyers who do not recruit the best professionals will invariably make a decision that puts them at risk for poor pricing, poor financing and, worst of all, possible business failure.
As a buyer, put together a team of professionals who understand the game. Who should be on it? Here is a list of your team and the positions they play:
Business Broker or Intermediary
As a person who plays the game every day, this is your quarterback. Business brokers/intermediaries have a 12-month season, usually with no bye weeks. A certified and/or very experienced and competent business broker or intermediary will understand all the aspects of due diligence, what information needs to be collected, how to evaluate it, and how to work with the other team members to achieve a goal. A big benefit to the buyer is also this person’s ability to value a business and help negotiate a fair and equitable price that allows the buyer to acquire AND run the business from day one! That last point is important because many buyers tend to stretch themselves to acquire a business and then find themselves short of working capital to keep it running after the acquisition. Qualified business brokers and intermediaries will help ensure you do not misstep here.
When due diligence starts, and your intermediary tells you to start analyzing the information — including financial reviews, operational reviews, technology reviews, quality of earnings, regulatory issues, union issues, contracts, competition, etc. — you will see why taking on the task of buying a business yourself is a “BADD” idea. The number of balls being thrown into the air is not the only issue; it is the fact that they are not all going straight up and straight down. When one goes off course, it makes grabbing the rest a challenge even for the best juggler.
Due diligence is the world’s biggest juggling act, partially because of the number of balls, and because some of them are invisible and require experience to know they are in the air and when to grab them. Typical due diligence periods last from 4 weeks (for a very small business) to 3-6 months (for a larger mid-sized business). It is a full-time job for the buyer, not a part-time exercise.
You are probably thinking, “Wow, that is a lot of work and a lot of people involved. How much is this going to cost me?” Although you think it will cost you a lot of money, you need to think of this as an insurance policy that is part of the acquisition cost. This cost can get bundled into the sale and amortized over a period of time. All of the professionals will charge a combination of retainers, hourly fees or a percentage of the deal. You will likely see a combined deal cost up to 10 percent or more just for the professional assistance you need. It is expensive, but these costs are typically factored into EVERY GOOD DEAL. Does planning to spend less mean you will fail? No, but your odds of jeopardizing the capital and acquired debt you put into the deal will increase significantly. On a $1 million deal, the $100,000 paid could be the difference between losing the $1 million because of poor analysis and decision or, just as likely, helping you from paying $1.2 million!
So as a buyer, go about the identification, offer and due diligence carefully. Buying a business should not be seen as an easy exercise. Because most buyers invest significant personal capital in their investments, make sure you do not take on what others can help you do better. Do not make a “BADD” decision.
As one attorney recently said to me, “In the grand scheme of things, 10 to 20 years from now the amount in a transaction will seem to blur, and the only memory will be one that shows you either succeeded or failed.”
About the broker blog
The Blogger- Steve Wain
Steve is the President and CEO of Calder Associates worldwide operations, and also the past Chairman of the International Business Brokers Association, and President and Founder of the Mid-Atlantic Business Brokers Association. A professional whose owned and sold a number of businesses in the past, Steve has provided expertise to thousands of business owners and buyers. Steve’s background in technology and finance has served many business owners and buyers over the years. Steve is a Certified Business Intermediary (CBI), and one of a select few worldwide to be awarded the certification of Mergers and Acquisition Master Intermediary (M&AMI). Steve is also a frequesnt speaker at industry conferences, as well as mentor and educator to many professionals in the industry. Steve sits on the Boards of Directors of multiple companies and associations.