So You Want to Buy (or Sell) the Business? Rules of Engagement
There are six rules of engagement when negotiating as a buyer or pre-planning as a seller
In part one we’ll cover the first three of six rules in depth
There are some basic rules that any prospective buyer of a business must remember during the negotiations. Similarly, there is some pre-planning that a seller must do to ready his business and herself for the best price. This article will attempt to cover the major rules of engagement, from each sides perspective .
Rule 1: Take Emotion Out of the Equation
Over 40 years of seeing deals done, we have observed that a seller’s estimation of value of her company often increases disproportionately and illogically based upon the seller’s proximity to retirement, or when the seller has excessive debts to pay. Neither of these motivational factors are related to the true value of the small business enterprise ( SBE).
Therefore, sellers need an advisor on their side to help the seller understand the real value of the business, and to encourage a seller to deal with realities. However, even if the seller does not have an advisor, the lack of interest in the deal from qualified buyers will ultimately tell the seller she is over-pricing the deal, and that economics will prevent a deal from being made. This occurs many times because funding sources like banks, economic development agencies and the Small Business Administration will send clear signals that a deal is not bankable .
Similarly, buyers sometimes ”fall in love with the deal”. We have seen situations where a buyer felt so determined to buy a company, that he would “do it at any cost”.
If an SBE has signs of distress (overly burdened with debt, decreasing pattern of sales over time, shrinking profit margins) or does not have sufficient cash-flow to cover all operating expenses, pay the new owner fair and reasonable compensation, and pay the new monthly bank loans, based on the deal you would make, it may be a bad deal. In order to force the deal, sometimes buyers will stretch their personal economic assets by cashing in their retirement plans, tapping out high interest credit cards or borrowing “grandma’s last nickel”.
A deal needs to fund itself through reasonable market-rate bank financing. Just like the seller, a buyer needs an advisor. While most buyers go to see their attorney (and attorneys are an important part of the entrepreneur’s advisory team) the buyer should either seek out a certified public accountant experienced in business acquisitions and business valuations, or the buyer can make contact with your state’s Small Business Development Center (SBDC) . To contact the local SBDC, simply do an internet search , and your closest SBDC should be found easily .
So, let the buyer beware, and remember Rule #1: No Deal is Better Than a Bad Deal.
Rule 2: Be Honest With All
A buyer needs to first be honest with himself.
Take inventory of what your skills and talents are, what ability you have to obtain sufficient financing, and evaluating where you are in life. If you have never owned a business before, that does not disqualify the buyer. But if you expect “learning on the job” is your plan, that is a dangerous first step. Instead, take appropriate business classes (primers) at your local community college or high school, or check with the local SBDC for available training. Make sure you understand the product or service your proposed SBE offers, if you plan to be the company’s primary sales person. Determine what are your economic resources .
If you are nearing retirement age (59 or more) and must cash out your pension to make the deal happen, you may be making a serious mistake because you won’t have enough time to recover if the deal flops. Finally evaluate the state of your physical and mental health. Small business owners do not work an 8-hour day, and often face tremendous stress associated with owning an SBE. Know yourself.
The seller has to demonstrate integrity. While the seller may “hype” (exaggerate) the positives of the business he is selling, any buyer should be leery of a seller who shows you his tax returns and financial statements, and then tells you something like “ Well, there is actually more money that does not hit the books”. When a seller suggests something like that, it is evidence that he either lied on his tax returns when he filed them, or that he is lying now to you. Either way, this means the owner lacks integrity. Such verbiage does not mean a buyer should immediately walk from the deal.
Our approach is typically to value the income streams of what the business actually shows or can prove, and make an offer based on what can be proven. Some small business owners will at least attempt to record all of their sales a year or two before the owner wants to sell off, as a means of showing what the company actually generates in profit. While this is good news for both the buyer and seller, it may produce an untrue appearance of company growth, because the most recent years are inflated compared to earlier years when the owner was “skimming” cash.
Either way, Rule 2 is simple. As the buyer or the seller, be honest with yourself, so that a good transaction occurs with all the facts known.
Rule 3: Due Diligence Is Required for All Deals, Big and Small
Due diligence is a fancy term for “checking underneath the hood” of the business.
A buyer needs to learn everything about the company from internal sources, and then cross-check the information against external sources. For instance, a buyer will obtain company tax returns and financial statements. Part of the cross-checking would involve comparing the SBE’s numbers to published industry data. While you may not have immediate access to such information, you may be able to obtain that data through trade associations for that industry, data published in a guide called the RMA Statement Studies, data available through your local library or through the SBDC.
Your CPA or business advisor will also suggest you do a spreadsheet comparing a series of years of income statements. Look at the comparable historical data and make inquiry of the owner about any trends or unusual fluctuations in revenue or expenses. Determine if those fluctuations make sense, or whether there is something requiring further inquiry. For instance, if you see a sudden increase in legal expenses, does it mean the company is being sued?
If the receivables ( uncollected sales) seem to be growing at a faster rate than sales, does it mean that some customers are not paying their bills? If so, why? Initial analysis of the data for an SBE usually is a 4 to 10 hour process by a skilled CPA or advisor, but this is only a “quick read” or analysis of the numbers. Pre-purchase inquiry and investigation into the company’s history and likely future is a time-consuming process that must be done to prevent the buyer from purchasing a bad business. A skilled CPA or advisor will usually have a list of documents and information to request early in the process.
There is no such thing as a “simple deal” in today’s world. A buyer should be willing to hire qualified help to evaluate the deal, and should make sure they have some money aside to cover the cost of expert help. Some buyers like to rely on friends and acquaintances for advice on an acquisition. But, the buyer should always remember an old adage: “ Advice is generally worth what you pay for it”.
A seller who wants to maximize profits from the sale of the business will actually want to cooperate in the due diligence process by making documents and information available to the buyer’s advisors. Most sellers will anticipate the problem areas in the acquisition and transition, and may want to be reasonably open about issues.
His motive for being open is that he wants the deal to go through, and not get held up at the tail end for “newly discovered” negative information. Such bad news can either cause a buyer to walk from the deal, ask for extra indemnifications ( promises by the seller to make good on previously undiscovered bad news, like an environmental hazard) or ask the seller to take a reduced purchase price. If a seller is holding back information or reluctant to make disclosures, a buyer will usually feel that he is not getting the whole story.
Related articles:
Acquisition? What’s Your Company’s Valuation?
Eli Mendoza on Equity and Financing
