Today, I would like to share a couple of stories.
Part 1: The Missed Opportunity
A few years back, I worked with the buyer of a reasonably successful business. It turned out that the buyer was a key employee, and the seller, after 30 years or so in business, had decided it was time to sell. The business was showing a decline in sales, from $1.5 million down to $1.2 million over the prior 3 years. Furthermore, the business was showing a net loss for 2 of the same 3 years.
The Deal
The asking price for the business was $600,000, which included the inventory, equipment (much of which was quite dated), and goodwill. The business did not own the property it was in. It was leasing, and had a good, long-standing relationship with the landlord, which had been pledged to continue with the buyer. For this industry, multiples for valuation purposes range from 25-35% of sales + inventory + fixed assets.
The buyer obtained the company tax returns, all of the proper legal documents, their own tax returns, and every other scrap of documentation the lender needed in order to evaluate the deal. The seller provided inventory estimates, which were roughly $30,000. We received an asset schedule, which was estimated at around $50,000. Meaning that the seller was seeking roughly $520.000 in goodwill for the acquisition of the business.
The initial lender involved in the deal valued the business at the cost of inventory plus equipment at $.40 on the dollar. Roughly $50,000. The second lender involved managed to get the estimated value up to roughly $300,000, with a somewhat more generous valuation of the equipment, and only by doing some pretty impressive forensic accounting and financing gymnastics.
The Inadvertent Devaluation of a Perfectly Good Company
There were several things that coalesced into a perfect storm that gutted the value of the company and left the seller with far less than what they should have realized from the sale of the business. By all accounts, it had the potential to be a good company.
- The seller had no exit plan. When the seller decided to sell the business, there had really been no forethought involved. It was a decision without a path. The mistaken assumption was that it was a healthy company with good sales and a long history. Of course, it was not worth what he thought it was. In reality, the seller needed to work with his advisors for a minimum of 3-5 years to prepare to sell his company. That did not happen.
- The decline in sales sank this company. We’ll get to the financial statements in a moment. Bottom line was that the top line was not communicating a good story. The seller had taken the foot off the gas, the sales had declined, the innovation and creativity had ceased, and the customer counts were down. In my professional opinion, all of the issues the company had from a sales perspective were easily addressable. Because there was no plan in place, the owner was ill-prepared to sell his business at peak value, and the subsequent decline in sales told the wrong story. Had he a plan in place, the business could have sold at peak sales 3-4 years earlier, and at a value premium.
- The financial statements were a mess. Three critical ongoing problems existed here.
- As the seller had no plan, his advisors (financial advisors, accountants and attorneys) were not in the loop to be able to provide him the guidance needed to position the finances properly for the optimal value of the business.
- These same advisors abrogated their responsibilities in not coaching their client well in advance, either as a result of a lack of knowledge about providing such advice, or simple incompetence. To this day, I’m not certain which it was.
- His taxes were structured to bury as many expenses in the business to maximize tax avoidance while simultaneously devaluing the business, hence the losses on the tax returns. Essentially, some business expenses included in the returns, while following the letter of the law, were only hurting the value of the company. While the sales reported by a business are certainly important, what mattered most was the net income, which reflected value of the business.
A Deal Done, but at a Cost
Piecing together the various buried expenses to eek out the valuation finally arrived at by the second lender was a chore, and had the lender not had tremendous faith in the buyer, this deal would have been dead on arrival. As it stood, a business that should have easily been valued at a minimum of $500,000 before inventory and fixed assets was estimated at 60% of that…a potential loss to the seller of $200,000. The “failure to exit” in this case is more about the failure of good planning to arrive at the favorable terms that the seller so desperately wanted.
Part 2: Realtors are Great at Selling Property
Full disclosure…I have nothing against realtors. When it comes to helping to sell a property, either commercial or residential, they absolutely should be in the mix. But I have yet to meet a realtor who knows much about selling a business. I’m not saying they don’t exist…I’m simply saying I haven’t met one yet.
In this case, I was once again working with a buyer who had the means, credit and situation that could have made them a success after the acquisition of a struggling business. Once again, the seller had no strategy to sell. They believed they would simply wake up one day, roll out of bed, decide to sell and get their asking price.
The particulars:
- Property valued at roughly $350,000
- Over 30 years of successful operations in a small community
- Good reputation, despite some operational issues
- Hospitality industry business (pre-COVID)
- Business was dated, and owner was on autopilot, but anxious to sell and go retire in Florida
- Family member was the representative for the seller, and a licensed real-estate agent
- Sales for the business had been close to flat for the prior three years
- Original asking price was roughly $600,000
Doomed from the Start
To say that this sales process was doomed from the outset is putting it mildly. First, the realtor demanded that the buyers provide “proof of funds” prior to acquiring the needed financial statements to perform due diligence. This was the first major red flag.
Commercial transactions involving business acquisitions do not allow for lenders to be able to issue such documents on behalf of buyers in normal circumstances. What buyers must demonstrate to lenders is that the cash flow of the business can support the debt service, not whether the buyer has a “pre-approval” from the bank. It does not work like a residential mortgage. So the first task was convincing our seller’s representative that this “proof of funds” request was ludicrous.
Once that hurdle was passed, we then got our hands on the financial statements. This included some poorly prepared tax returns and a box of receipts…yes, you read that correctly…a box of receipts. Which, of course, no lender is going to go through. Apparently, the seller was keeping two sets of books…I know, I know, we’re all shocked by this. But there was zero chance of evaluating the true value of the business based on doctored tax returns and a box of receipts.
And then the coup de grâce. After weeks of finally getting a valuation figured out (the lender and I ended up around $450,000 — which was somewhat generous), the realtor announces that there is no way the business, fixed assets and the property were worth less than $1,000,000. That sound you hear was the flushing of this deal down the toilet.
A Deal not Done, and at a Terrible Price
Three years later, the business and property remain unsold. And as a result of COVID, valuations on hospitality-related businesses have been negatively impacted. In this case, the involvement of the realtor as a “business broker” was a disaster for the seller. The business and the real estate should have been valued separately, with the realtor solely focused on the property sale, and the business owner working with advisors on the sale of the business. Had there been a plan in place and the team of experts involved, it is likely this business and the property could have sold pre-COVID and the seller could be sipping a refreshing beverage in Key West.
The Moral of the Stories
I’ll be honest…I really hesitated putting the proverbial pen to paper on these stories. And I do not mean to roast the sellers or even the realtor in these circumstances. The problem is more systemic, and not just a reflection on these business owners. There was essentially a common thread to both of these examples:
Business owners and their advisors appear to be largely unprepared and improperly educated about the process and realistic expectations of the exit planning experience.
This “failure to exit” is a direct result of a failure to plan and a lack of understanding about the inherent value of their business. It is also the inability of business owners to surround themselves with advisors who understand what needs to be done over a period of time to guide the seller through a successful transition to the third act of their lives.
It takes a minimum of 3-4 years to plan an exit. Unless you have the kind of business to sell that is likely to attract someone with deep pockets and cash to burn, buyers will more than likely need financing from lenders or economic development agencies (or a combination of financing sources.) There are dozens of documents to have compiled, updated each year in order to be ready to hand a package to a potential buyer in order for them to do their due diligence. To position a business for sale, I believe the seller should think the banker that is backing the buyer. Doing so dramatically increases the likelihood of a successful transaction.
Perhaps a more mundane example will help. Let’s say you are in the market for a used car. You find a model you like at what you believe to be a fair price. You call the dealer, give him your bank account number and ask him to deliver it to your house tomorrow. You do not take it on a test drive or even inquire about the condition of the car.
When you buy a car, especially a used car, you will likely do your homework. How old is the car? How many miles are on it? What is the maintenance history? Has it been involved in any accidents? Can you imagine a buyer of a business who may be investing hundreds of thousands of dollars not wanting to get all the information they can in order to do their due diligence?
Asking someone to “take it on faith” that you as a business owner are fully representing the history and current condition of a business is essentially no different. And to maximize value, it is the seller’s responsibility to provide every possible bit of information about that business so the buyer can make an informed decision. Seller’s must be transparent partners with the buyer to help ensure a smooth transaction and to maximize business value.
A brief word about business brokers. In some cases, a broker may be a helpful resource. But not in every case. For smaller businesses, involving a broker may be more costly than the benefits of getting them involved. And it is important to understand the motivation of a business broker. Most are commission-based, meaning that they will be interested in driving the value up (perhaps unrealistically) to increase their commission. Carefully weigh the pros and cons, and perform a thorough analysis of the numbers before signing a contract with a broker.
So Now What?
I expect to publish additional content to help sellers of businesses develop sound strategies to avoid the “failure to exit” syndrome. If you are planning to pass from this Earth while running your business, then perhaps you need not do much of anything. When you die, there will likely be an asset sale, your business will probably close, and your employees will have to find other jobs.
But if your goal is to maximize value and exit at a time of your choosing, then it’s time to wake up, especially if you plan to exit your business in the next 3-5 years. The clock is ticking. The goal of today’s piece was about one thing…to get you thinking now.
Pick a date on the calendar for when you would like to see a successful transition of your business and you can be sipping Mint Juleps at a resort in a warmer part of the country. If it is more than 3 years now, there may still be time to get you prepared. Less than that? Best to be ready to accept that you may not get as much value from the sale of your business as you would like.
Get your advisors on board. Reach out to folks with the SBDC or other business support organizations to discuss your options and your plans. The plan is the most critical step. And hopefully, you will avoid the “failure to exit” dilemma.
Details of the specific businesses have been altered to protect the confidentiality of the buyers and sellers involved.
Pragmatic 