The Offer, Part Four
What would you think about having a team of outside accountants, lawyers, and operations people descend on your business to go through your records, question your employees, dissect everything you do, and judge how good your company really is and how truthful you really are? That's what happens in due diligence, and I'm sure most people would feel at least a twinge of anxiety about it. I know I did. But then "Greg"--the venture capitalist whose firm wants to acquire my three main businesses--sent in his crew to check us out late last year, and due diligence turned out to be one of the easiest parts of this whole process.
The truth is, we were ready. For the past eight years, we have had an outside accounting firm do annual audits of our financial statements and certify their accuracy. We began the practice in 1998, when we were doing only about $4 million in sales. Back then, the cost of an audit was $30,000 or $40,000--today it's well into six figures--and I questioned whether it was really necessary for a company our size to spend money on that, but my partner Sam convinced me that we would need audited financials to get the bank financing we'd be looking for in the future, and it was much cheaper to do the audits annually than to have an accounting firm do them retrospectively. The audited statements made the financial part of the due diligence process a walk in the park.
The accountants also wanted to review all of our customer contracts. "You can see whatever you want," I said, "but we have thousands. You'll be here a month." They insisted, and we gave them everything. Overwhelmed, they quickly decided it would be enough to review the 20 percent of the contracts that account for more than 80 percent of our business. The rest they would spot-check. We'd made a point of keeping them up-to-date and well organized, so this went smoothly as well.
All along, we followed Sam's warts-and-all disclosure policy. People selling a business often make the mistake of trying to hide anything they think might discourage the buyer. Of course, most owners are salespeople, who by nature tend to paint the rosiest picture of whatever they're selling--not because they're trying to fool anybody but because they believe it. You have to believe it, or you can't sell. I have the same inclination. But Sam has shown me that, in this kind of transaction, you should take the opposite approach, telling the people on the other side everything that is bad, that might be bad, or that has a one-in-a-million chance of going bad. Not only should you tell them, you should put it in writing.
Why? First, because candor builds trust. The people you're dealing with will feel a lot more comfortable if they see that you're not trying to hide anything. In the sale of a business, moreover, a significant chunk of the money--5 to 10 percent--is put into escrow to protect the buyer in case problems come to light after the sale. If you're the seller, you want to make sure that you get all of that money. The best way to do that is to anticipate everything that could go wrong--every customer the company might lose, every additional expense it might have to pay. Then, if something does go wrong, you can say to the buyer, "Look at our statement of October 29th, page 3, line 14. We warned you about that possibility, and you chose to buy the business anyway."
The accountants finished their work in a week or so--faster than they had expected. And the operations people took just a few days. There were four of them, all managers at the records storage company we will merge with if the deal goes through, and their job was to review our systems and our staffing. But it quickly became apparent that our senior managers weren't happy with the process. I had briefed them about the possible sale. I'd told them that I hadn't made up my mind but that if I did sell they would receive the amount of money I had promised them when we were considering a previous bid (see "The Offer, Part One," November 2006). In the meantime, I wanted them to cooperate fully with the people who'd be reviewing our operations. Now they seemed depressed, and it dawned on me that they thought the people they were talking to might soon be their bosses. I immediately called a meeting. "You have nothing to fear from these people," I said. "It's highly unlikely that you'll ever report to them. They may wind up reporting to you. Our company is bigger than theirs. They're here to observe and to find out what we're doing." Thereafter, the mood of our managers seemed to improve, and the buyer's operations people seemed to like what they saw.
The next step was to settle on a final number for EBITDA (earnings before interest, taxes, depreciation, and amortization). During due diligence, both the buyer and the seller examine the sale company with an eye toward figuring out how the financials will look if the business is sold. Accordingly, you and the buyer go through your income statement, trying to determine whether items are recurring or nonrecurring--that is, whether the buyer will continue to get the revenue or pay the expense after the sale. The buyer's accountants are looking for any items that could have been deducted as expenses or taken as revenue but instead were depreciated or amortized over a period of years. You're doing the opposite--looking for items that were deducted from EBITDA but could have been depreciated or amortized. Remember, the price of the business is a multiple of EBITDA. If you and the buyer have agreed on a multiple of, say, eight, then every $100,000 that's added into EBITDA could be an additional $800,000 in your pocket.
Inevitably, there's give-and-take, and trust plays a role. For example, we spend about $600,000 a year on bonuses and on company contributions to our employees' 401(k) accounts. I wanted to know whether Greg and his people intended to continue these practices. They wanted to know why I was asking. "Because if you weren't going to keep doing them," I said, "I'd add the $600,000 back into EBITDA and then distribute that portion of the purchase price to our employees." They said that they fully intended to keep all of our benefits and bonuses; in fact, they wanted the rest of their company to have a culture like ours. I trust them and thus didn't insist that the $600,000 be treated as a nonrecurring item in calculating EBITDA. Nevertheless, if I sell, I'll insist that the programs be written into the final contract. You know: Trust but verify.
In the end, they came up with an EBITDA figure that was about $600,000 less than ours. Although the gap wasn't huge for a business of our size, it looked a lot bigger when you took into account the multiple we'd settled on. In any case, we had to resolve our differences. One of the conditions I had set early on was that all disputes would be handled one-on-one by Greg and me. I realized that he had partners and would have to clear with them whatever we agreed to, but I wanted to make sure there would be no negotiating between anyone else on either side. That way, if the deal fell through, it would not be because of fights between accountants, lawyers, or others. It would happen only because Greg and I couldn't come to terms.
When we got together to discuss our different EBITDA numbers, I told Greg that he should just accept mine. He pointed out some items that his accountants thought should be handled differently. I mentioned several other items that, if handled differently, would make our reconstructed EBITDA even higher. "For every dollar your accountants find," I said, "I'm going to find a dollar fifty the other way. You might as well just go with our number." We eventually came up with a number we could both live with.
Meanwhile, I went to bat for Greg. He had already started to raise the money his firm would need to complete the purchase. I agreed to meet with three or four groups of potential investors, answer any questions they might have, and explain how the deal would change the competitive landscape to the buyer's advantage. That wasn't just a sales pitch. I believe it so strongly that I've told Greg I would be willing to accept a portion of my proceeds in the form of stock. He can use that fact to reassure anyone who thinks he might be paying too much. In addition, I met with the board of the records storage company that we'd be merging with. Most of the board members represent earlier investors in the business. They came with a lot of questions, but they left solidly behind the deal.
Now, as I write, we are working on a draft of the ultimate contract. We're close enough to a decision that I've begun talking about the possible sale with more employees. I held off at first because I didn't want to make people anxious about something that might never happen. I probably waited a little too long. There were rumors floating around by the time I filled in the supervisors and front-line managers. I told them that they would all participate in the sale: "I can't say how much you'll get, but I think you'll find it a very nice surprise."
When we started this process, I could imagine a hundred ways that the sale could fall apart. We're down to four. First, we might have a disagreement we can't resolve about some clause in the contract. Given how far we've come, I doubt that will happen. Second, Greg might not be able to get the financing he needs. He tells me that he already has commitments and just has to work out the details. Third, Greg and his partners might change their minds and pull out. That would be very surprising considering how much time and money they've already invested. Last, but not least, I might get cold feet. One way or another, I'll probably have to make a decision in the next three or four weeks. I hope to tell you what it is in my March column.
Norm Brodsky (firstname.lastname@example.org) is a veteran entrepreneur whose six businesses include a three-time Inc. 500 company. His co-author is editor-at-large Bo Burlingham.
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