How Seller Diligence Maximizes Business Value

Jane Johnson Business Transition Academy | October 4, 2018

Late last year, our advisory firm worked with the owners of a family-owned retail chain with more than 20 locations. Our business analysis pinpointed several company strengths — but also multiple areas for improvement that were sure to be issues for potential buyers including inconsistent store and product profitability; lack of non-family member key personnel in such areas as business development, IT, finance, and marketing; and an oversized inventory.

The owners were fearful of missing their opportunity to sell while the market was good, so they went to market despite these red flags. After 6 months, they still hadn’t found a buyer – which we knew was a real possibility.

They were so consumed by the deal process that they were not able to make improvements and lost valuable time. The buyer feedback was quite clear, and the owners have now refocused their efforts to improve the business and its marketability in hopes of securing a deal at some point in the future. But there are no guarantees – the universe of potential buyers in their industry is quite small and these buyers may not be willing to take a second look.

We see this scenario play out all too frequently, and it should serve as a lesson for other owners. There are thousands of baby boomer owners who will have to transition the ownership of their businesses to either internal or external buyers in the next several years. If owners are proactive, they can do their own pre-sale diligence, maximize business value, and improve their chances of consummating a sale.

Here are a few things to consider.

Understanding Business Value Drivers

Two obvious and essential drivers of business value are business profits and growth potential, but eliminating risk and increasing the quality of your business can also make a dramatic difference in the value. Owners should review all facets of their businesses for improvement. There are three common and critical areas that deserve very close scrutiny regardless of industry. Here is a partial list of best practices in each of these areas:

Human Capital:

• Recruit and hire a talented management team (COO and CFO at minimum)
• Cross-train to secure backup for key employees and their duties
• Implement incentive plans so key employees will stay before, during, and after the sale
• Benchmark your compensation and benefits to be sure they are competitive, but not too much above market
• Take HR compliance seriously
• Upgrade your advisors as you grow

Financials:

• Consider a Quality of Earnings engagement to ensure that your numbers are accurate and your reporting is beyond reproach
• Limit owner personal expenses and document them for add-back purposes
• Resist the temptation to depress earnings and minimize income taxes
• Set up proper internal controls
• Be sure you understand your financials andtax returns

Information Technology:

• Use state-of-the-art software to handle operations and reporting
• Set up proper access controls for ALL employees
• Establish multi-level backup and protection from malware and invaders
• Ensure compliance with privacy and other regulations/requirements
• Develop a disaster recovery plan

You Never Know When the Right Offer Will Come Along

These pre-diligence activities are important for businesses at all stages – not just those that are explicitly preparing to go to market. We recently worked with the owner of a $20 million construction company who had received a pre-emptive indication of interest from a private equity group. The company immediately provided the PE group with high-level financial information before contacting us for assistance. The company had no internal accountant or CFO.

Our quick pass of the CPA-reviewed financials they sent over revealed unexpected and significant issues with the gross margin calculation. We discovered that there was no proper cutoff completed for work-in-process at year-end. All of the data for hundreds of projects was kept in Excel. It took weeks to go through each project to confirm the financial data and calculate the percent complete at the end of the year, and several additional weeks to have the financials restated. We also discovered that sales taxes had not been remitted to 6 states for more than 3 years.

The misinformation, lack of project tracking software, overlooked sales tax compliance, and overall delay was ultimately too much for the prospective buyer to handle, and they walked away.

Owners cannot predict when they will receive pre-emptive offers, but they should be ready at all times. The company had never hired an internal financial professional who was familiar with sales tax rules and had never made the move to a larger, more capable CPA firm in order to keep their costs down. The company also never bit the bullet and purchased automated project tracking software to handle their increased volume of projects.

It is difficult enough to find a buyer and consummate a transaction. Owners who don’t conduct pre-sale diligence are leaving money on the table and making their odds that much worse. Well-run and high quality companies stand out from the crowd and generate more profits.