Recently Jessica and I attended a webinar put on by investor Tony Cappaert and his guest Sam Rosati, owner of two light manufacturing businesses. That day I put on LinkedIn how it seemed Sam was channeling my thoughts on things to look out for in a deal. Here’s a short summary of what we got from the session.
Operating experience – Sam said be careful if you don’t have operating experience. If interested in a manufacturing or distribution business make sure you are comfortable with the setting and with blue collar workers. At one point he said if a buyer is uncomfortable taking inventory in a hot, dirty warehouse they should forget the deal and go back to their spreadsheets. Experience is important and it’s why we say a good buyer should be able to lead and manage, to some degree, people, processes, money, and enthusiasm.
EBITDA ‡ FCF – Sam’s comments about how you can’t calculate ROI based on EBITDA when it’s a capital expenditure type business sounds like one of my Myths of Business Valuation: Using EBITDA in a capital-intensive business will burn the buyer. You must use free cash flow to truly calculate ROI.
Financial diligence – we agree a Quality of Earnings report is not usually necessary for small business deals (those that fit in the SBA loan range) but you must get a “proof of cash” from a CPA firm. We used to call this a mini-audit (not as sexy as QofE or proof of cash) and it means tying the money on the bank statements to sales reports and financial statements. “Trust but verify” as President Reagan said.
Customers and employees – we also agree they are the key to most companies and you have to make them part of the diligence. My rule is, if a buyer is not allowed to talk to the customers (blindly, as a reference check as someone wanting to use the services) the deal is on hold or off.
Working Capital – it was an interesting discussion and Q&A on this. Working capital is always a bit confusing, especially where there’s work-in-process, which never seems to be recorded correctly in small businesses. For one deal Sam said they looked at the trailing 24 months to get the average but most of the time they use 12 months (which is pretty standard).
Due diligence – Sam commented you need to get the whole story and have trust in each other as they are key factors in the due diligence process. You don’t want to push too hard about things that don’t matter too much. We say, “don’t get analysis paralysis,” get what you need so you can make your leap of faith off a chair not the roof.
Owner Dependency – What makes a great business is having reliable management. A passive seller gives you the opportunity to work on the business, not in the business. Sam gave an example of a trick he uses. He calls the owner at 9 pm from an unknown number and if the owner answers, there is a good chance the owner is the go-to contact at all times. This means it’s a very involved seller with little to no support, which could be a red flag. It’s why we list owner dependency as one of the top four things an owner should fix before selling.
Passive owners – to me, there are very few reasons for a truly passive owner to sell. It could be health, not wanting the risk of a lawsuit or similar, or just the ongoing worry. Sam made it clear the best situation is an owner who works “On” not “In” the business (an old and very true refrain).
People are key – One of our four things an owner should do when planning to exit is to be able to attract and retain great employees. Sam said basically the same thing, “Managing people is hard, but finding quality talent at a fair price is VERY hard (today)”
Broker relationships -Sam said if it wasn’t for keeping in touch with brokers, this deal would not have closed. This is what happened to them: they stayed in touch with the broker, they built a good relationship, and the broker came back to them when the first deal fell apart.
Seller’s market – first, it’s always a seller’s market for good businesses. It’s even more so now with so many hurt by Covid, which Sam emphasized. Buyers need to be proactive (not lazy) and not fall into the trap of overpaying. The only thing worse than no deal is a bad deal.
As I said in the first paragraph, the comments in the webinar are the same as our thoughts and what’s in our books, podcasts, and newsletters. There really isn’t anything new in this area but there are a lot of exaggerations, or should I say “Putting lipstick on the pig.”
It’s often because the owner woke up one day and said, “Let’s flip the switch and sell.” They should have got up one day three years prior and said, “Let’s start dimming the switch by getting the business ready for a buyer in a few years.” When the business and the owner are ready to sell the owner will exit with style, grace, and more money.
