Business Sale Report Blog - News and views on buying and selling businesses

Buying a business is not like buying a car. Get it wrong with a business and it is likely to seriously hurt your wallet. So how can you tell if you are looking at one where the wheels might fall off? Nick Pritchard from Transaxman ltd has helped us put together a few examples of what to look out for and how to assess the true profitability of a businesses. Remember that the seller knows a lot more about the business than the buyer.

There are a number of indications that a business is in difficulties. Such as reduced recruitment and training activity, delay of planned maintenance, missing a major trade show, closure of product or quality development teams and reduced investment in tooling or software. When companies are prepared for sale, if the business is in some difficulty, they may simply cease any forward expenditure or investment. Continued investment in a business is essential in ensuring growing profits. This is often the reason that the best businesses to buy are the ones that are not actually being marketed for sale.

So you have seen a great business and you are doing due diligence. Don’t let the vendor pull the wool over your eyes! There was one well documented fraud where everything seemed hunky dory, but the vendors had hired in a number of temporary staff to make the factory look busier while the potential buyers were looking around.

Arriving at the adjusted net profit

There are essentially two main types of adjustments that need to be made:

* Allowances for non-recurring items, such as a grant or a big debt
* Items shown as costs that are really a distribution to the current owners.

For example, distributions to owners might be special pension contributions, or expenses that are a consequence of the life style of the shareholders, as well as the usual salaries and benefits in kind. In one instance a US business was in the process of buying a company in South Wales, unfortunately the vendor had forgotten that he had put his Cardiff Arms Park debenture through the company - Once the purchaser understood the importance of being able to take customers to the match, the vendor had to buy his own tickets.

Where a company occupies its own freehold property it may also be necessary to adjust the trading results for a notional rent charge, if the property is worth substantially more than its book value.

Standardising earnings
The purpose of restating results is to show what the earnings of the business would have been on a standardised basis, as a guide to the future earnings. The valuation exercise is done therefore to establish how much a theoretical buyer would be prepared to pay as a capital sum in exchange for the right to receive those future earnings.

Earnings for this purpose would be trading profits before interest but after a notional taxation charge. This recognises that the value of the business may be different from the value of the equity, as the latter value will depend on how the business has been financed. Where businesses have accumulated cash reserves it should be remembered that these funds represent past earnings which have not been distributed.

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The importance of due diligence to the success of a transaction is often underestimated. I thought it might be useful to put together a few pointers to keep in mind while running a due diligence exercise on a business you are intending to buy. It is not a checklist – there are a few good due diligence checklists around – there is a good booklet available to subscribers of the Business Sale Report entitled ‘Due Diligence - over 1000 Key Questions to Evaluate Any Business For Sale’. You can download an extract here.

Plan it, scope it
Define the scope of the due diligence exercise and clearly mark out who is doing what, when. Work to a timeline. Don’t waste time on areas that are not likely to cause any real issues or have any effect on the final sale agreement.

Employee issues
Thorough due diligence should pick up any issues, risks and potential liabilities relating to the seller’s employees. For instance, check if there are any past or present employees litigating against the business. Do any of the employment contracts have unusual clauses i.e. over-the-top redundancy packages? What are the specifics of the pension plans?

Move fast, top down
It is important to spot any issues early on so that the appropriate warranties and indemnities can be quickly put in place. Focus on major issues first. As with any aspect of due diligence, the late uncovering of issues which lead to changed warranties and indemnities at an advanced stage can reduce strength of the negotiating hand and, (i.e. in the case of pensions) in some cases, even scupper the deal.

Communication is vital
The flow of communication between the buyer and his/her solicitors is of paramount importance, for if they do not work closely together, the process can quite simply fail.
Buyers must communicate the key issues of concern to the solicitors; they should not just assume that all areas are of equal importance, and that everything will be dealt with in good time. The solicitor must be told what the key commercial reasons are for the purchase, which areas are high-risk and which areas should be prioritised.
Continually monitor the activity of the solicitors and accountants carrying out your diligence and make sure they are giving you regular feedback.

Don’t forget the culture
Funny how the lack of understanding of the target’s company culture is one of the main reasons for failed acquisitions, yet has been notoriously ignored in the due diligence process. Don’t make the same mistake. This is usually one for the purchaser’s management to consider, rather than delegating to legal or financial advisers. Map out the management styles of your business and the target business. Look at the core values of each and analyse the differences. How do the communication structures and styles differ? Look at the dispute policies.

Collect information, then analyse
Don’t let any of your advisers analyse whilst collecting the information. These are two distinct activities within the due diligence process. First find out where the required information is, then collect the information, recording its source and noting whether it is fact or hearsay. Then start an objective analysis.

Don’t panic, take your time
A focused but comprehensive approach is better than taking shortcuts in order to reduce costs. Often the buyer discovers that ‘thin areas’ of diligence need to be covered again in more detail. It will end up taking more time overall and costing more money.

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