Eyeing a small-business deal? Think due diligence.

While the U.S. Census Bureau reports there are approximately 32 million small businesses in the US, only a third of them have employees and must meet a weekly payroll. While all small businesses are vital to the economic health of our country, I am only referencing the one-third of small businesses with payroll for the purposes of this discussion.

Whether your small business is for sale or you are in the market to purchase a small business, a heightened emphasis on compliance is currently slowing down the due diligence process. Buyers and sellers alike are asking for more assurances and information about how a business manages its policies, procedures and processes to remain in compliance.

What has been slowing the process down from the seller’s side of the equation is being able to assemble all the information needed in an organized fashion to share with the potential buyer. This information can include everything from how the seller deals with consumer complaints to how they respond to these complaints, which many times are simply disputes.

Each industry will have its own unique reporting requirements. A restaurant may have to account for food safety and sanitary issues, a food delivery service may have to account for pedestrian injuries and a telemarketing company may have to deal with Telephone Consumer Protection Act issues.

The structure of a transaction, whether an asset or stock sale, will lead to differing implications for assumed liabilities for the buyer post-transaction. This will impact the level of diligence required. The most tax-advantageous structure to the seller of a business will likely be a structure that leads to greater legal exposure for the buyer, requiring more extensive diligence efforts.

Seek experienced legal counsel

Having legal counsel retained who is knowledgeable in this area – internal or outsourced – who can answer questions around any recent lawsuits or legal actions against the company can accelerate the due diligence process.

At our mergers and acquisitions company, we have experienced firsthand how an experienced attorney who understands an industry can help to accelerate the due diligence and legal documentation process.

Prepare compliance materials ahead of time

Any small business thinking of putting itself on the market or is already on the market should take time to prepare compliance materials and have as much available right from the beginning to avoid issues that can come up later.

The more preparation work that can be done on the compliance side will help to shave off valuable time in the due diligence process.

Sellers of small businesses should always disclose, disclose, disclose during a negotiation. There is no point in hoping a prospective buyer will not find out about a troublesome issue – a “skeleton in the closet” – or that the issue is not relevant/applicable to the due diligence process.

In the long run, if you are selling a small business you will be much better off putting everything out on the table, while explaining what, if anything, happened in the past regarding any inquiries. By doing so the seller can anticipate the possibility the buyer could come back later to claim he or she didn’t share information. Even worse, the purchaser could file a lawsuit post-transaction leading to years of legal action.

You should begin by establishing a trusting relationship with an M&A specialist, before either buying or selling a small business. As in all aspects of your business life, it is never too soon to start planning ahead.

Michael Lamm is a managing partner at Corporate Advisory Solutions, a merchant bank headquartered in Philadelphia and serving Lehigh Valley businesses. He can be reached at [email protected] or 202-904-7192.

Before selling the business, bring financial order

Before selling your company, you have to ensure that the financial side of your business will be ready for analysis by prospective buyers. If you are not in a distressed situation or turnaround mode, and have time – ideally one to three years – prior to starting down the path with a buyer, a mergers and acquisitions specialist can help focus on the following key themes to get the financial side of your business ready for sale.

1. There is no requirement to obtain audited financial statements to sell your business. If you do have audited financial statements it will make the financial aspects of the transaction easier. If you are a larger company – $3 million or more of “adjusted” earnings before interest, taxes, depreciation and amortization, or EBITDA – many financial and strategic buyers may require it to complete a transaction. We often see a seller auditing the most recent completed fiscal year to satisfy the buyer. If you are contemplating a sale, it is not necessary to go back to the beginning of time and audit your historical financial statements. That is a time-consuming, unnecessary scenario, unless there was a particular issue with your financial controls that would warrant that.

2. Take a look at who is running finance and accounting in your business. If you have an outside or internal person handling your financials – bookkeeper, CFO or controller – it is very important for the person in that role to understand your numbers and be able to speak to them. When questions come up from a prospective buyer – for example, why is this expense booked in this particular way or why was it categorized in QuickBooks here? – you want someone other than you, the owner/seller, able to answer that question. If you are a small company, you may not have a choice in the matter and you will be answering the questions. If you are a larger company, making sure that person is able to not only speak to the numbers but was involved in preparing them will help to assure that the numbers you are providing to the buyer prospect are real, legitimate and vetted by someone other than yourself. This person is absolutely critical in helping to get a deal done.

3. If there are any financial “skeletons in the closet” – not necessarily compliance-related – for example, there was fraud going on in the business at some point and, as a result, you had a lot of unexpected expenses related to it. The key is to identify what those “skeletons” are and determine how they impacted your financial statements. You want to have plenty of time to clean up those issues and also be able to explain them. It will come up. You won’t be able to hide anything. You want everything out in the open, as much as possible. If you have time, you can start getting the facts, story and numbers right as to what the effects were and how you fixed the problem.

4. Figure out your “personalized adjusted” EBITDA and determine what would be accurate expenses to apply to your earnings. Many owners may run personal expenses through the company – meals, entertainment and travel – some of these expenses may not have anything to do with the business. Assess those expenses to see if they can be viewed as an adjustment to help show higher profitability. Those expenses would go away after a sale. Another example of a potential adjustment would be the extreme weather events we have been having over the years. For example, you may have been impacted by a hurricane leaving water damage. This would be something expensed through the income statement that isn’t happening every year. If those expenses ran through the income statement there could be a potential adjustment. Getting all the data and records to support those adjustments is critical. The buyer isn’t going to take it on face value that you had this expense. The buyer is going to want to see you had and paid the expenses, using AMEX or invoices showing actual expenses that ran through the business.

5. Look at “profitability by client” to assess who is driving your margins month over month, and quarter over quarter. Develop a way to track profitability by client or stream of business. This is no easy task. There is no packaged financial model you can use to pull it together. Every company has different cost structures and ways of managing how they deal with clients, specifically contingency or fee-for-services clients. Being able to have that model in place prior to sale will help to figure out any issues you may have. You may have significant concentration with one or two clients who make up a bulk of revenue and profit. You may have significant concentration with one or two clients who make up a bulk of revenue and profit. You can begin to make a plan to diversify to help lower your concentration risk for that buyer, which means the buyer may pay you a higher multiple or valuation if the concentration isn’t as significant. Working with companies to assess profitability by client not only helps determine deal structure but can help sellers determine if they want to keep, terminate or change staffing levels with a client.

How long does it take?

Some companies have all their financial controls in place. They don’t need to wait three years to go to market. But some companies have a QuickBooks file with many issues as to how they managed the numbers. As a result, being able to quickly pull together all the information needed to have a conversation with the buyer can take a long time for some companies.

You don’t want to share numbers that aren’t accurate. If you start rushing you could make errors in sending out information to the buyer. The numbers are critical to figuring out whether you can value or structure a deal that works for you and the buyer. You don’t want to have many mistakes out of the gate. The more time you have, the better off you will be.

Do you need help?

Most companies are able to assemble key information. Assembling it is one thing, but figuring out how to analyze it and go through what is there to identify issues is more complicated. This is why having an M&A adviser or anyone else who really knows the financial or accounting side of the process is important.

The preparation you take when it comes to your financials in advance of a sale will help lead to a positive outcome to you as an owner. It will also lead to a more efficient sales process.

Michael Lamm is a managing partner at Corporate Advisory Solutions, a boutique merchant bank headquartered in Philadelphia and serving Lehigh Valley businesses. He can be reached at [email protected] or 202-904-7192.

Corporate distress calls for clear M&A process

Even during favorable economic conditions, certain companies will falter. While some of these companies may prove beyond repair, others can be turned around under proper leadership. But there is a process that needs to be followed for companies interested in purchasing these distressed companies, as outlined below.

What can drive a company into distress?

1. The company lost a very profitable big client. This could have been a first-party project or a traditional contingency client relationship that was a significant portion of the distressed company’s revenue, and the loss threw the business into a tailspin.

2. Legal or compliance issues. These issues can push a company into a tough position where it needs to do a deal quickly.

3. The company’s balance sheet could be upside down. A company can have been overleveraged for a variety of reasons. For example, the owners assumed significant debt when purchasing the business or when financing a capital improvement. As a result, an unexpected hiccup could have thrown the distressed company into a tough cash flow position.

How can you structure a deal to protect yourself when pursuing a distressed asset?

1. If the distressed company is having issues, it is likely there are other problems going on with the company from a compliance perspective. Companies buying a distressed situation should consider looking at an asset rather than a stock deal. This helps to avoid any “skeletons in the closet” the purchaser may be walking into or inheriting. While there may be a strategic reason for a stock purchase, all else being equal it is advisable to buy assets in distressed situations.

2. Make sure the distressed company is operating in trust and isn’t using client money to fund the business. This liability is an issue that will follow the purchaser after the business is sold. Make sure to assess at the front end whether the distressed asset is in trust or out of trust with any of its clients. If the answer is “yes,” hit the brakes. Avoid doing a deal because transferring the clients could pose a significant legal exposure to you as a buyer.

3. Figure out who “owns” the client relationships. That person or persons will be critical in transitioning the client base to the buyer. Make sure you are either locking into or assuming an employment agreement as part of the deal to make sure clients will move over to you as part of the transaction.

4. Look at the balance sheet, specifically the liabilities. Instead of paying cash up front as part of the deal, there may be a facility-lease assumption; some form of long-term debt that could be assumed by the buyer instead of paying cash up front.

5. Structure the deal in a favorable manner. Many distressed scenarios are deals where it will be “pay for performance” and making sure the client operation can stay in place, so the buyer can help to turn around the situation and make a good return.

In a distressed situation, a number of things could be at play – a client loss, a legal issue, key people have left, the balance sheet is upside down. The key is to determine as quickly as you can if you can solve the problems that led to the company’s distress in a timeline that will work for everybody.

Distressed situations come up quickly. When they do, the selling shareholders are looking to move as quickly as possible. As a result, the due diligence timeline and process is condensed. This is where things can get missed.

The more you can evaluate a distressed situation up front, the better off you are. Does the company have good financial controls in place? Are clients who continue to place business salvageable?

The more the purchaser can determine what the pain points are upfront and whether you can solve them, the better off the combined business will be after closing the deal.

Final thoughts

Begin by establishing a trusting relationship with an M&A specialist, whatever your plans for purchasing a distressed company. Don’t let the fact you have to do something quickly prevent you from doing your due diligence on the situation and examining all the issues at hand. By remaining disciplined, distressed situations can be a win-win for both sides of the sale.

Michael Lamm is a managing partner at Corporate Advisory Solutions, a boutique merchant bank headquartered in Philadelphia and serving Lehigh Valley businesses. He can be reached at [email protected] or 202-904-7192.