Top 3 Tips for Small Business Buyers

Buying a business can be a complicated process, especially for a first-time business owner. Entrepreneurship through acquisition has become increasingly popular. Here are some insights to assist buyers in negotiating a fair price.

1. Add-backs

Seller add-backs for personal or discretionary spending is a murky area. Some add backs make sense and others do not.  We’ve seen a lease for a Porsche and a leadership meeting in Hawaii. We’ve seen a Rolex watch purchased using business funds.

It is important to scrutinize and verify all of these add-backs. Sellers may try to add back marketing expenses which we would argue likely contributed to sales for the period. Also, ensure that the add-backs line up with the financial statements.

There is a school of thought that a seller shouldn’t get the benefit of reporting lower taxable income for years only to recoup the benefit through add-backs at the time of sale. As the proverb goes, it is “having your cake and eating it too.” This idea is unpopular amongst sellers and brokers, but buyers need to be aware. Verify add-backs and if you get push back, consider it a red flag.

1. Financial Reporting

Financial statements for small businesses are notoriously suspect. Before digging into the numbers, ask about the financial reporting process. Who sends out invoices and who receives payment? How frequently are invoices sent out? How are business expenses handled? What controls, if any, are in place? Who does the bookkeeping and with what frequency? Does a CPA clean up the financials or simply record the data on a tax form?

We’ve seen some broker memos that simply list “Seller represented financials” with no further financial statements upon request. This is a red flag.

When analyzing the financial statements, look for customer concentrations and consider the transferability of those relationships. Is the chart of accounts consistent year after year or does it change frequently? Are there expense items that seem inconsistent with historical periods or industry benchmarks?

Part of the risk in the quality of earnings is in the process of recording the transactions. It is important to understand how the numbers come together. Through this process, you may even identify opportunities to boost cash flow under new leadership through more efficient collection and disbursement procedures.

3. Working Capital

Working capital is defined as Current Assets – Current Liabilities from an accounting perspective. In the M&A world, we’re really talking about Accounts Receivable, Inventory, and Accounts Payable.

A business broker will tell you that working capital is not typically included in small business transactions. An appraiser will tell you that working capital is an integral part of the value of a business.

There seems to be a magical threshold in which working capital becomes part of the transaction, usually around $750,000 or $1,000,000 in enterprise value.

Most small businesses are listed for 2 or 3 times Seller’s Discretionary Earnings (SDE). We push back on the suggestion that inventory is separate and distinct from the value of the business. For businesses to be marketed and traded using a multiple of cash flow (SDE) without the underlying source of that cash flow (inventory) is illogical. Buyers would be double paying for the asset. Do not do this.

Working capital also includes accounts receivables (an agreement that the customer will pay you (typically 30 or 60 days) later. Accounts receivable can strain cash flow in a business if not monitored and collected properly. A business is incurring expenses up front and waiting 30-60 days to receive payment. Payroll is every two weeks or twice a month, and your employees must be paid. Suppliers must be paid.

Often, sellers will try to negotiate all rights to accounts receivable, leaving the buyer with a cash crunch right from the start. Again, this is illogical. A buyer and seller should agree upon a “peg balance” of working capital based on current working capital levels and seasonality. SBA lenders will often try to step in and fill this void with additional working capital financing. However, it shouldn’t be necessary. The value of the business is incumbent upon cash flow and working capital and access to cash flows are vital. If working capital is not included, the purchase price of the business should be reduced accordingly.

Small business buyers often miss this point but rest assured private equity firms do not. Require working capital in the deal, if applicable.

Conclusion:

There are infinite risks to buying and managing a small business. Until the transaction is closed, however, that risk belongs to the seller. We encourage buyers to be thorough in their research, be confident in their requests for information, and don’t overpay for inventory or working capital.

Multiples of SDE or EBITDA can be helpful to gain a rough understanding of value, but, in the end they are just arbitrary numbers based on previous transactions that may be unrelated to your target acquisition. We recommend creating projections of your own based on how the business would operate under your ownership after factoring in the risks.