Who Else Would Prefer To Avoid The Challenges Resulting From Being Prepared By Accident?
Another interview with a former business owner on the topic of “If I Had Known Then”. The seller had owned a service business largely based on longer term contracts. The service augmented or substituted for the internal information technology capability of a variety of companies.
During a particularly hype driven hot market for this kind of service, the owner was approached by an investment banker to determine whether he was interested in selling the business. At first he thought it was a joke, but she assured him it wasn’t, and that there were buyers seeking just such a company as his.
As the seller’s story unfolded I came to believe that she was just cold calling seeking listings that she could then show to companies that she thought would be prospects. My reason for this belief is that events revealed that she really hadn’t understood how the business operated, and how it created value. That is not a criticism of this kind of approach, as it is the way a lot of things begin. Someone began ‘dialing for dollars’.
However, with the passage of time she was able to introduce a public company that seemed to operate much like a holding company. It was represented to be seeking an opportunity in just this kind of business and in the particular geographical area that it served. The seller worked hard to understand the buyer, its management, its motivation, and its future plans for the acquired business, assuming a transaction could be concluded. The buyer’s team made all the right noises and the seller became reasonably comfortable.
It was in this context that the seller made his first observation about ‘If I Had Known Then’. He observed that it is important as a seller to set realistic expectations. About what the transaction will look like. About how the buyer will behave and perform, including after the transaction closes. This is particularly important if as part of the transaction the seller is required to remain with the business, or if there is money owed post closing.
His observation was that a seller should examine all the facts carefully, and then develop his own worst case scenario based on these facts. Particularly when dealing with the way events will unfold after closing. Then he should set his expectations based on this worst-case scenario, and determine whether that outcome is acceptable to him. His reasons for this observation will become clearer later.
However, let’s pick up the story as it unfolded. The buyer knew that the seller had a price in mind, and what it was. However he advised that his financial people disagreed with the price. In fact they were unable to arrive at a value that was even close. The investment banker must have had little or no understanding of valuation methods beyond a simple cash flow multiple, so she was no help. And strangely the CPA advising the seller didn’t appear to understand either.
What they were all missing was something quite simple. None of them had done a restatement of the financial statements to adjust for the fact that there were two shareholders in the business both extracting large salaries and even larger costly benefits. Neither excessive salaries nor unlimited expenses would continue after the buyer took over. This is something that a skilled valuation expert would have realized immediately, and acted on. That is why it is important to have valuations done by skilled valuation specialists, and not by your usual outside accountant.
The seller knew that the business was worth much more than the valuation used by the buyer. He knew by the bulge in his wallet. So even though he was not sophisticated in financial matters, he decided that he would find the information necessary to support a higher valuation. Amazingly he quickly determined that restating the financial statements to reflect more normal management compensation and benefits got him there. Or at least close enough.
The buyer and seller were close enough for a transaction to be possible. And indeed the business sold to the public company. The transaction provided that the buyer would be paid out over the time that he was required to remain as part of management during the transition period. Payment was to be made in cash, with a floor and subsequent performance payments tied to the ongoing performance of the business.
This is a type of earn out agreement that is frequently used to bridge gaps between asking price and the price offered by the buyer. All very practical when there are proper safeguards for both sides resulting from proper wording. It is an even more common practice when the buyer is a public company, and the seller is willing to take the public company’s shares in part or full payment.
Although the buyer was a public company, the seller resisted the buyer’s offer of payment in shares of the company. He had many good reasons for doing this. And he was proven to be right. Subsequent events also showed that he had reason for the concerns that earlier prompted extensive discussion with the buyer’s management about future operations etc. The discussion where they made all the right noises and gave him the assurances he asked for.
But not in writing. He hadn’t asked for them in writing. And they certainly didn’t offer them in writing. His advice is that sellers should get as much in writing as they can from buyers, particularly in areas that are of great concern. Noting that a verbal agreement isn’t worth the paper it is written on.
Hopefully this has proven to be interesting as well as useful. To learn more, you may return from
Prepared By Accident
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