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The Privately Held Company Is Provided To You By Gary Papay, CBI, M&AMI CK Business Consultants, Inc.
Due diligence is generally considered an activity that takes place as part of the selling process. It might be wise to take a look at the business from a buyer’s perspective in performing due diligence as part of an annual review of the business. Performing due diligence does two things: (1) It provides a valuable assessment of the business by company management, and (2) It offers the company an accurate profile of itself, just in case the decision is made to sell, or an acquirer suddenly appears at the door. This process, when performed by a serious acquirer, is generally broken down into five basic areas: • Marketing due diligence • Financial due diligence • Legal due diligence • Environmental due diligence • Management/Employee due diligence Marketing Issues It has been said that many company officers/ CEOs have never taken a look at the broad picture of their industry; in other words, they know their customers, but not their industry. For example, here are just a few questions concerning the market that due diligence will help answer: • What is the size of the market? Financial Issues Two important questions have to be answered before getting down to the basics of the financials: (1) Do the numbers really work? and (2) Are the seller’s claims supported by the figures? If the answer to both is yes, the following should be carefully reviewed: The accounts receivable Legal Issues Are contracts and agreements current? Are products patented, if necessary? How about copyrights and trademarks? What is the current status of any litigation? Are there any possible law suits on the horizon? What would an astute attorney representing a buyer want to see and would it be acceptable? Environmental Issues Not too long ago this area would have been a non-issue. Not any more! Current governmental guidelines can levy responsibility regarding environmental issues that existed prior to the current occupancy or ownership of the real estate. Possible acquirers – and lenders – are really “gun-shy” about these types of problems. Management/Employee Issues What employment agreements are in force? What family members are on the payroll? Who are the key people? In other words, who does what, why, and how much are they paid? Operational Issues The company should have a clear program covering how their products are handled from raw material to “out the door.” Service companies should also have a program covering how services are delivered from initial customer contact through delivery of the services. The question is, do you give your company a “physical” now or do you wait until someone else does it for you – with a lot riding on the line? A recent article in INC magazine titled “Street Smarts,” by Norm Brodsky (his column is worth the price of the magazine) addressed the subject of the title above. However, in the very first paragraph of the article, Mr. Brodsky stated, “Unfortunately, most of them [business owners] have grossly inflated notions of what their companies are worth.” Mr. Brodsky is not one to mince words. Some of his examples were: “One company had lost money on sales of about $60 million, and yet its owners thought it was worth between $50 million and $100 million ... Another company had a net profit of less than $335,000 on sales of about $6.5 million – and still the owners somehow came to believe it was worth between $100 million and $200 million.” Mr. Brodsky feels that the reason for this is “... our egos can get us in trouble when it comes to putting a dollar value on something we’ve created. We generally take the highest valuation we’ve heard for a company somewhat like ours – and multiply it.” He goes on to point out that prospective acquirers are more concerned about profits, especially Free Cash Flow, than sales. Too many company owners use some rule of thumb based on sales. He also points out that company owners tend to use a comparison of a similar business across town that sold for some multiple of sales and then apply it to their company. There are so many variables of how sales (and subsequently earnings) are generated that no two companies are ever alike. Business owners tend to forget the negatives of their business; e.g., sales from just a few customers, lack of contracts with customers and suppliers, lack of product diversity, out-dated equipment, etc. Also, as Mr. Brodsky points out, “Before you try to sell, make sure you know what buyers want.” Turning to another expert voice, here is some good advice from Allen Hahn, Senior Vice President of Valuation Research Corporation: “The level of EBIT or EBITDA used for negotiating a purchase price is the ‘normalized’ level that will be available to the new owners from the assets acquired. Often times this requires elimination of unusual, inappropriate or non-recurring expenses. Buyers will typically consider a company’s last twelve months of financial performance. However, projected results may be more relevant if a structural change has recently occurred in the business (loss of a key customer, acquisition, etc.) that renders historical results less meaningful.” What does all of this mean? It means that owners should disregard rules of thumb based on what the company across town sold for; it means that owners should not use a multiple based on what the business did four or five years ago, or what they think the business will do next year. Business owners should first put their egos aside, then look long and hard at the company’s cash flow, realistically assess the negatives – and positives – of their business and “make sure you know what buyers want.”
• It may not be a good fit for the parent company, thus diffusing efforts that could be placed into the core business. • Because it is an orphan, it is a distraction. • It may be a break-even side business that with a full-time effort could be profitable, but resources are better devoted to the core business or service. • The money received could be used to expand the core business or fund some improvements thatare not currently budgeted. Certainly, there can be some disadvantages in allowing the adoption of an orphan – on both sides. There is the all-important people issue. Some valuable employees may be attached to the product line – and may go with the sale or decide to leave and move on. This can negatively impact both sides of the transaction. It can also have a negative impact on the selling company’s employees when the selling or purchasing company releases employees. There are cultural issues to consider. The product may be a more important part of the selling company than management thought. It may have played a role in selling other products or services. The distribution channels may play a role in other product lines. It is important for management to consider whether the orphan is really an orphan before selling it off. On the plus-side for the acquiring company, the addition of the product line may be a perfect fit for their existing distribution chain. The brand name acquired may provide name recognition to some existing products. The new product line may be able to be manufactured with only a minimum increase in employees and plant capacity. The purchasing company may have a difficult time establishing a price. It may seem easy to look at the sales and the cost of sales, but the cost of sales may not include an allocation for rent, and for support services such as legal, accounting, corporate oversight, etc. Some part of the product may be manufactured on equipment used for other products, warehousing may be shared, and parts used in other products. Many acquisitions are sold with a form of licensing agreement so the selling company receives a royalty or license fee representing a small portion of the sales of the acquired product line. Company management is prone to think of only selling the entire business, a division or subsidiary of the company, when a sale of a product line may be an excellent solution. The decision to sell a product line or service may solve a host of problems and perhaps even eliminate the need for sale of the entire business. As Fortune magazine has written, “Companies once obsessed with cutting costs are now urgently trying to boost sales – with new products, new services and new markets. The surest – and ultimately cheapest – way to increase your total sales is to persuade your existing customers to buy more products.” |
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