Thursday Thoughts for SMEs – When buying a business, beware of the contracts.

Conventional wisdom states that businesses with long term contracts command more value. I have seen this wisdom result in many searchers or business buyers overlooking good businesses or de-valuing the business because long term contracts were not in place.  

Ultimately this has resulted in deals not being done which in my view is insane.  

I want to suggest that in SME transactions the weight that should be placed on long term contracts should be significantly reduced. I further suggest that the risk related to client retention can be mitigated in other far more practical ways.  

Care less about long term contracts. 

I think buyers should care less about long term contracts when buying a business for 3 key reasons:  

We have seen recently that long term contracts can cause havoc if there are material price rises that impact the ability to perform the contract. Just look at Scott's Transportation and ProBuild. Both of these companies possessed long term contracts which bound them into delivering services for agreed upon prices. These contracts which were seen as ‘valuable’ items became the very same instrument which tore them down.  

An inability to renegotiate the instruments in light of external price rises resulted in these companies going into liquidation.  

The inability to re-negotiate or increase prices binds the business into a position with little to no leverage. In both ProBuild and Scott’s circumstances they had leverage which couldn’t be used. Scott’s had major supermarkets supply chains in its hands. For a couple of weeks both Woolies and Coles had to scramble to get refrigerated transport back online. If the contracts were a little more flexible, I suspect that Scott’s could have thrown their weight around a little more.  

Unless the margin in the long term contract is so generous that any fluctuation is insignificant, the long term contract inhibits the ability for the business to increase prices when they need to or when they want to.  

SME land is not like Tier 1, institutionally funded land. SMEs break contracts frequently. They are privately held and in many cases, we have seen material changes to contracts impact the desire for the other party to contract with the new owner.  

Furthermore, any contract worth its weight will have a material change of contract clause. This often results in clients of the business being able to terminate the contract in circumstances where they are not satisfied in the new owners or if there has been a change in control.  

So even when you have long term contracts, these contracts are still at risk and need the cooperation of the seller and the customer.  

Contracts are binding on both parties. This means that when its good we celebrate but when its bad we are stuck. If you acquire a business that has long term contracts, this means that you need to fulfil them whether you like it or not.  

Similar to point 1, this results in inflexibility around decision making. It might be the case that a key person within the business leaves which inhibits your ability to deliver, or you may decide to change the direction of the company or reduce your service offering. In each case, if you have a long term contract then you are bound to deliver the service irrespective of your decisions internally. This can hamper your strategic vision and the pace at which change is made.  

Whilst I thin contracts are valuable; I suggest that long term contracts may not be as valuable as people think and I believe there are 3 ways short term contracts or relationships can be beneficial to a new buyer.  

Fundamentally relationships are greater than paper contracts. If we understand this then it forces the new buyer and the seller to think carefully and plan how these relationships get handed over. It forces the people factor to be considered rather than simply the paperwork.  

Focusing on relationships often delivers a much better outcome for all involved.  

The lack of contracts forces the parties to understand that there is risk in the ongoing performance of the company. This should bring both the seller and buyer together to think about how to structure the deal and how to mitigate any risks.  

If the seller is not interested in helping the buyer then the buyer should run for the hills. It could be the first sign that the deal will go south. Sellers who genuinely want buyers to do well and who care about their clients/customers will invest in and devise strategies to transfer relationships and will recognise the risk.  

It is the canary in the coal mine. If the seller doesn’t recognise the risk, buyers should get out of there.  

If the service or good is as good as the seller represents, and the seller works hard to transition, the buyer can look at price as a mechanism for profit growth. It is critical to never reduce the tools in the toolbox if you can help it.  

Price in SME land is often overlooked as a point of change however if your service or good is in demand and the relationships are strong, an incremental price increase will likely result in money straight to the bottom line rather than a loss of businesses.  

I have often seen cases when new owners make changes a year into ownership after relationships have been handed over and established and the customers have made comments that the price rise should have happened years ago. If the product or service is quality then the customers will see the value in it and not quibble over a few dollars.  

Summary  

Contracts are good, in fact they are great but I think we need to place less emphasis on long term contracts and more emphasis on the unwritten contract, the repetitive nature of the client base, the demand for the good or service and the quality of the people selling it.  

Too often I have seen good businesses with short term contracts or no contracts be passed over without even a discussion with the owner as to how this risk could be mitigated. It’s folly in my eyes. Every business operates on relationships whether those relationships are documented or not.  

Don’t pass over good businesses because of a lack of written long term contracts. Look past the paper and see the relationships.