Last month I published the first article in our Demystifying the Sales Process series. The Series unpacks the key steps that a business owner needs to take in order to take their business to market.
The first article focused on how important it is to know your buyer when going to market. If you have not read the article, you can find it here.
This month we continue the series by looking at Step 2: Assessing Your Weakness.
We have all heard the saying, “the best defence is a good offence” and when it comes to selling your business this could not be more true!
We need to first understand that a sell-buy transaction is a contested event. We have a seller who is focused on the highest price with the lowest risk and we have a buyer who is focused on the lowest price with the lowest risk. This automatically creates a tension between the parties. Now in most cases this tension is eased by the parties’ approach to the transaction, however, many transactions end up in context litigation because of a fall out between the parties and the enforcement of transaction terms.
In a sales transaction the seller needs to understand the strength of their position so that they can know what to press back on and know what to accept. The way this occurs is by assessing the weakness of your business. Once we know the weakest aspects, we can address them or understand their impact on any transaction.
We focus on 4 key areas being:
- Structure & Governance
- Financial
- People
- Clients & Suppliers
These 4 areas are critical to the strength of any business and are universal in their application from a due diligence perspective.
Structure & Governance
The structure of your operation can have a major impact on the value of an enterprise or the exit options available to the owners.
For example, it is not uncommon for pre-settlement restructures to be required by a buyer when the structure is not right. This occurs when the corporate structure is a ‘mess’ or is not suitable for the purchaser.
An example might be where there is a trading trust which has a government license attached to it such as an NDIS registration. The registration is extremely valuable and underpins the business for the purchaser. They cannot simply acquire the assets of the business because they need the license.
In this case the purchaser may require the seller to restructure into a more appropriate structure such as a company structure to then be able to acquire the shares in that entity, therefore enabling the transfer of license and clients.
Any pre-settlement restructure will almost always be at the cost of the seller and increases dramatically the risk of a transaction. The greater the risk the greater the downward impact in price for a seller.
Governance links very closely to structure. More often that not we see SMEs and family owned enterprises with little to no governance in place. Decisions are made on the fly and there is no record of those decisions at a board or executive level. The core issue with a lack of clear decision making rigor or record is that you cannot prove to a purchaser the why and how these decisions were made.
For example, the business may have a stock buying habit of increasing stock in September for a Christmas rush. Whilst there is a pattern of stock buying each year, if there is no record of why and how the management team arrived at that decision it can be very difficult to justify an ‘over stock’ position to a purchaser who is not necessarily familiar with the stock movements of the seller.
A rigorous system of good record keeping is critical to a well functioning governance regime.
An appropriate governance regime and corporate structure can have significant impacts in increasing buyer confidence therefore lowering transaction risk. This in turn can have massive impacts on the purchase price and terms.
Financial
It goes without saying that the finances of an entity are critical to its value. This goes both ways.
A profitable entity which is run with clean books and records is a very attractive proposition. An entity that continually pushes the limits of tax rules can on the other hand be an unattractive proposition.
For example, if a company has a balance sheet whereby the owner has a major division 7a shareholders loan, the purchaser will require the seller to clean up that loan prior to settlement or will look at an asset purchase. As outlined above certain situations require a share purchase which are problematic when there is a major shareholder loan.
Another example is where business owners use the business as their personal piggy bank. Cars, boats, livestock, lunches, hobbies, race cars…the list goes on. We have seen it all when it comes to how business resources are used personally. The core issue with pushing the boundaries of the use of company funds for personal use is that it creates uncertainty for the buyer. The more add-backs that are disclosed and that need to be justified the more uncertainty there is for a buyer. The financial statements are the single source of truth and if these are ‘questioned’ by the excessive use of add-backs then a buyer is eroding the seller’s faith in these reports.
The profit of a business is one thing, however, the more sophisticated a buyer, the more they will look beyond the headline numbers and drill down into the issues which might create risk for them.
It is critical to remember that the more risky a transaction for the buyer, the more they will reduce their offer or increase the seller’s risk via earnouts etc.
Clean books and records create confidence. Confidence creates trust. Trust facilitates transactions.
People
People are a business’ best asset and biggest liability. People generally are the key to a business’ ongoing success. Even in low human capital industries such as tech, the role of key employees is even more amplified due to their critical role in the business.
Ensuring that the people in your business are engaged, paid and stable is critical to the value of any business.
We commonly see examples of where there is little to no employment system in place and no policies or procedures. Therefore there is no way for a buyer to determine with any confidence the terms of each individual’s employment or the liabilities that have been accrued.
In each case the seller has ‘worn’ those liabilities because they cannot rebut the argument. In some cases this can be hundreds of thousands of dollars.
An example we have seen recently is where a business had a group of key employees but those employees had no agreements or policies. They had an email advising them of their start date and pay at the time of engagement. The issue that arose was with regards to underpayment in relation to employees covered by the award. In this case the seller had to reduce the purchase price by a sum equivalent to a possible underpayment claim whilst the purchase went through the process of securing employees and increasing their pay accordingly.
People are critical to any business. Ensuring that a purchaser can have trust in the way a seller has engaged and retained staff is central to ensuring that the purchase price is not adversely impacted.
Clients & Suppliers
A business without clients or customers is a dream.
We all know that clients and customers are critical to a business and its success. However, the way a business engages with a client and the type of client it has can have a major impact on the value of that relationship to a purchaser.
For example, if a business has the majority of its revenue linked to a few clients, this presents a major risk to the purchaser especially if there is a change of control mechanism within the agreements. If on the other hand there are many clients but those clients do not necessarily have recurring revenue attached to them this can also impact the value of those clients.
There are two key aspects we look at with clients and suppliers: firstly, how they are engaged and secondly what their pattern of behaviour is.
Engagement is critical for any purchaser. If a business has written agreements with its clients which outline terms etc this can have a significant impact on the value of the business. If on the other hand there are no agreements then this can have a massive impact on the risk of a transaction.
Further to this we need to go one step further and look at the pattern of behaviour of these clients and suppliers. If the client is on 28 day trading terms but pays on 60 days, this could have a major impact on the cash flow needs of the business especially when the business pays on 28 days.
How clients are engaged and how they behave is critical to the value of any enterprise and will have a major impact on the risk of any transaction. The greater the risk for the buyer, the greater the reduction in price or the greater the risk that will be borne by the seller.
Conclusion
Understanding the weakest parts of your business is critical to understanding how you can address them at the time of sale.
The best defence is a good offence. The same applies in the business world. If you can demonstrate or explain that weaknesses are being addressed and that those weaknesses should not pose a material transaction risk, you will go a long way to reducing the risk and evening the bargaining position between the buyer and seller.
Small incremental changes can have a major impact when it comes to the valuation of a business. Given that most business sales are a multiple of EBITDA, every dollar of profit is multiplied by the multiple. It could be worth $3 or $5 or $7 depending on the multiple.
Every risk will impact the multiple and will impact the purchase price.
At Frank Law + Advisory we have developed an Exit Ready report which helps clients understand their risks and helps develop a plan to address these so that they can go to market in the best shape possible as a match fit business.
If you would like to discuss the above please reach out to James Frank jfrank@franklaw.com.au
