Musings on business value, sale preparation, sale negotiations, sale structure.

Archive for the ‘Due diligence’ Category

Romans, romance and exhaustive examination

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Legend has it that in Ancient Rome when the supports used for building an archway were removed, the builder was required to stand under the arch as an assurance that the thing would stand. Those that still stand today, had builders who lived long fruitful lives.

When a business is placed on the market, the eventual buyer needs some sort of assurance that he isn’t buying a bag full of lemons. This assurance is generally gained through the due diligence process. The due diligence (DD) can take many forms and be of varying degrees. I am always very wary of an open ended DD. There is just too much risk for the seller. Instead I prefer to work on the promise – prove or lose – format. The DD should be defined around the purchaser expectations, so the seller knows in advance whether or not the deal is on.

It works like this:

  1. Give enough information to all prospective buyers to enable them to make a decision about whether or not this business might be a proposition for them within their own scope of expertise, ability, interest, expectation etc.
  2. Provide them with enough high level financial information for them to arrive at a preliminary opinion of value to them. Discuss that value expectation with the buyer.
  3. In order provide a value proposition, the seller will have to make some bold statements around the way things are done. It is important that these be kept to within reasonable limits, and be 100% verifiable.
  4. Let me say that again… For this process to work, everything must be 100% true and verifiable.
  5. If, subject to the seller proving all the promises he has made, the purchaser’s value paradigm settles the seller’s expectations, we have a deal.
  6. Back briefly to the 100% promise. If the seller has been honest in his promises, there is no reason why the deal should fail, other than through a failure to perform by the buyer.
  7. Before the DD progresses, the seller should satisfy himself that the buyer makes promises about his ability to perform – to pay. If that promise is broken, then the seller should have meaningful and material recourse by way of break fees, deposits and the like.

With that all in place as a departure point, the buyer is then able to constitute his offer to purchase. With the help of a skilled intermediary, this should be put together as agreement of sale, with input from both sides, rather than the somewhat ham handed bully approach of “this offer expires at the close of business on Friday”. The ultimatum tactic has its place sometimes, but should be avoided if possible.

In formulating the agreement of sale, both buyer and seller can be kept happy with the use of suspensive conditions of sale (or conditions precedent). That particular process works like this:

  1. The seller’s promises are put to the test in the agreement of sale.
  2. If any of the promises fail, the buyer gets to walk away without having lost anything except his time.
  3. If the seller goes into the agreement knowing that he is going to be able to prove all his promises, he can also know that he his business is going to stay sold.
  4. The intellectual property remains safe within the realm of the seller until he has a signed agreement of sale, which he knows will be consummated because his promises are all provable.

In a series of articles following this one, I am going to unpack some elements of typical due diligence exercises. Just go to the “due diligence” tag on the right hand side of this blog to get the updates as they are published, or to read past articles.

The growth of small things

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Which element of your business is growing the fastest?

One measure of risk in a business, is the speed with which a business can adapt to a rapid drop in sales, and the possibility of such a drop.

Central to the problem is that operating or fixed expenses are just that – fixed. In good times when the money is flowing, the tendency is to allow anything fixed to rise, because we can. Those new mobile phone contracts are not easily turned off, and nor are employees which become surplus to requirements.

Gross profit is made up of two constituents – the ability to negotiate input costs of purchases, and the number of sales made. An often unrealised input cost is the early payment discount offered to customers.

We look at the income statements of hundreds of clients in our valuation exercises. Very few of them operate on a net margin above 10% of sales (the net profit divided by the sales). Most of them are around 5%. Some are at 2% or even 1%.

On very tight margins, there is a propensity to give in to cash flow pressures and offer early settlement discounts to customers. Those discounts are usually around 2% of the outstanding (sales value, plus VAT). You see what happens here?

Tight margin businesses give away ALL their profits just so they can continue to exist.