In addition to the future expected cash flows, prospective buyers will also take a careful look at the target’s balance sheet to gauge the financial condition of the business, proper ownership of assets, and other matters affecting the operations of the business. In this Part IV of our series of “55 Questions to Ask Yourself Before You Sell Your Business,” we will dive deeper into questions about financial condition and capital structure.
The goal of our series is to encourage owners to work to make their businesses more attractive to prospective buyers, thereby earning the right to command a strong valuation in an eventual transaction.
Financial Condition and Capital Structure Questions to Ask Yourself Before You Sell Your Business
- Does my balance sheet properly reflect the assets actually owned by each legal entity?
We encourage owners to review their asset titles, deeds and leasing agreements to ensure the related assets and liabilities are properly reflected on the correct legal entity’s balance sheet.
Privately-held businesses often have multiple legal entities, which are designed to isolate liability risks and to achieve certain tax advantages. Over time, however, recordkeeping and contracting may become sloppy, resulting in a mismatch between actual ownership of buildings, machinery, equipment, and rolling stock, and placement within the balance sheet(s) of the proper corresponding legal entity(ies) those assets.
In a transaction, the buyer may prefer not to purchase land and buildings from the existing owners and elect instead to pay rent i. However, the buyer will likely want ownership and title to IT assets, production equipment, and the vehicle fleet in order to operate the business. If the legal and accounting records are not in sync, transactions can be delayed and desired tax treatments can be lost.
- Is there significant deferred maintenance on my facilities or key equipment?
Developing a strong culture of maintenance of both facilities and equipment can create a powerfully positive image of the company to a prospective buyer. Buyers who tour the facility will to try to gauge the level of attention paid to maintenance and care of the company’s operating assets. For transactions that progress into due diligence, buyers will inspect maintenance records on all key equipment and will look for proof that the facilities’ key systems such as HVAC have been consistently maintained.
If buyers notice that facilities are cluttered, machines are dirty and/or rusty, and maintenance records are weak, a potential offer may be affected by the assumption that valuable time and money will be needed to remediate the facility and the processes to a higher standard.
- Will significant investments in additional facilities, equipment, and/or people be needed in order to expand my business organically?
Ideally, you will want to position your company with prospective buyers as a growing, thriving business that will sustain strong cash flows into the future. Depending upon the economic cycle of the industry and the overall economic environment in your markets, additional investments in facilities, equipment and/or people may be required to accelerate the growth of the company. This is yet another great example of why we believe it is vitally important to consider these issues at least 2 to 3 years ahead of a proposed transaction. By making those investments well ahead of a transaction, the returns on those investments will already be apparent in the financial statements and will add confidence to the future prospects of the company.
In some industries, the next level of investment required to maintain market share is significant rather than incremental. For example, if the industry is in the early stages of digital disruption, the transformation of equipment, people and processes may require a level of investment that cannot be reasonably recouped in the current owner’s time horizon for operating the business. In such cases, it may be appropriate to accelerate a potential sale of the business before customer bases and their related cash flows are eroded. Again, timing and planning are critical to this evaluation. We have seen instances where sellers are so locked into their personal timetables for exiting their business that they fail to appreciate the impact that an eroding market share and falling further behind their competitors will have on their transaction value.
- Do I have strong controls and accurate records over my inventory?
We believe that maintaining an accurate and well-controlled inventory is one of the most difficult tasks of running a business. Very few companies do this well. In most cases, the value of a well-run perpetual inventory system is greatly under-appreciated. Consequently, owners underinvest in people, processes. Often the result is a strategy we label as “managing inventory by having plenty”. Since no company wants to run out of an inventory item and because the systems have proven unreliable, the organization, usually unconsciously, maintains too much inventory.
Poor inventory controls is also a major source of fraud in companies of all sizes. Employees with knowledge of the inventory and the market can take advantage of the lack of oversight to monetize the inventory for personal gain.
In addition to the ongoing advantages of lower investment in working capital and reduced risk of fraud, a well-run inventory can position your company to earn a premium valuation from a prospective buyer. Conversely, if the buyer discovers major issues in the valuation of inventory on hand and in the processing of inventory transactions, confidence can quickly erode in the overall operations, and valuation will go down.
- Are there significant amounts of obsolete inventory on my balance sheet?
As discussed above, many companies maintain too much inventory. Eventually, this results in obsolete, excess, and unsalable inventory sitting on both on the warehouse shelves and on the balance sheet. This issue is so prevalent that we have come to expect it.
Recently, we assisted a client with buy-side pre-Letter of Intent due diligence on a proposed transaction. We believed it was probable the inventory on the balance sheet was overstated due to obsolete inventory, and we urged our client to walk through the warehouse and make his own observations and inquiries. He took our advice, and while the buyer was walking through the warehouse and asking some probing questions, the seller agreed that approximately 75% of the inventory on the balance sheet was essentially worthless. This issue, coupled with other items, led our client to move on to look at other targets.
In the example above, as well as others that we have seen, this issue could have been completely avoided by dealing with excess and obsolete inventory before prospective buyers have reviewed overstated balance sheets and before they tour the warehouse.
- Are my fixed asset records accurate?
Many companies maintain very poor fixed asset records. Assets which have been replaced but remain on the books, inflate the gross value (i.e., value before accumulated depreciation) of the assets. For capital intensive businesses, prospective buyers will want to cross-reference some of the key operating assets from the accounting records to their physical presence in the manufacturing or warehouse facility. If the fixed asset listings are cluttered with assets no longer owned by the seller, this process could become tedious and confusing.
While this issue is unlikely to derail a transaction, it is yet another opportunity to demonstrate that your company is clean and pristine and worthy of the value you are expecting.
- Do I bill my customers promptly and accurately?
In most transactions, buyers require the seller to leave a “targeted working capital balance” in the company as of the day the transaction closes. Targeted working capital is intended to represent the normal level of working capital necessary to operate the target’s specific business. It is a negotiated amount, and the seller will want the target to be as low as possible because typically any working capital in excess of the target is paid to the seller as additional purchase price.
A key ingredient to negotiating a lower working capital target is to be able to demonstrate best practices in billing customers promptly and accurately. These practices, coupled with a good approach to collections of past due balances which are discussed below, will lead to a lower overall investment in working capital and lower borrowing costs over time.
Many companies fall into the habit of billing all of their activities at the end of the month. This puts tremendous pressure on the organization to focus on billing for several days or even up to a week, instead of taking care of customers. Just as critical, this habit is delaying cash receipts on those revenues by 5 to 30 days.
We often observe these habits in project- based or ticket-based business models. It is a natural organizational tendency to stay focused on the demands of project schedules and reducing ticket queues until the last possible moment and only focus on paperwork and invoicing when there is a looming deadline, usually the month-end accounting close. The result is a compressed time schedule, an increased likelihood of errors, and a stretching of the cash flow cycle.
The best companies bill every day or every week. Doing so requires excellent management and diligence. In addition to the positive impact on targeted working capital discussed above, additional benefits are accelerated cash flows, more time to ensure invoicing accuracy, and reduced strain on personnel. Read more about improving your ability to collect invoice promptly.
- Do I have a formal collections process to prevent aging of account receivables?
Used in conjunction with best practices in billing discussed above, good processes for collecting past due invoices will nearly eliminate losses from bad debts. Furthermore, a pristine aging of accounts receivable with but a few, well- understood past due accounts will greatly increase a potential buyer’s confidence.
Most customers intend to pay their invoices, and most actually intend to pay on time. In our experience, the issues that delay prompt payment are related to our own internal processes or to poor execution of the order. Beyond those issues are those customers who habitually pay vendors late or customers who are experiencing financial strain and are struggling to pay all of their vendors..
Regardless of the causes of delayed payment, the key is to discover the cause as early as possible. The only way to discover the cause is to consistently reach out to customers just prior to or just after the due date of their payment. Too many companies wait until invoices are already 60 or 90 days past due before they attempt to find out what issues are delaying payment. As a result, actions that could have been taken earlier are delayed, and sometimes the opportunity to correct the issue is altogether lost.
Because of the importance of this process on the organization’s cash flows, we recommend executive leadership be involved. In the most effective processes we have observed, an executive of the company is present on a weekly call or at a weekly meeting to go over past due accounts and to ensure that issues are being advanced. With involvement of executive engagement, process owners will not let collections obligations get squeezed out by more urgent, but less impactful, issues. We are aware of one CEO of a billion dollar organization who is actively engaged in weekly collection update meetings. If he believes collections activities are that important to his business, it’s probably that important in yours as well.
- Do I have an effective purchase order and accounts payable system to ensure good controls over the procurement and disbursement process?
One of the most effective systems to combat fraud in any business, but particularly in smaller businesses, is a sound purchase order and accounts payable system. By requiring documentation and approval of purchases made on the company’s behalf, followed by a segregated system of vendor invoice matching, approval, and disbursement processing, even smaller companies with limited staffs can achieve proper segregation of duties.
Having these systems in place and operating effectively can greatly assist the due diligence process and increase the prospective buyer’s confidence in the effectiveness of internal controls. In our practice, we frequently see our privately-held clients purchased by larger publicly-held companies. Because of Sarbanes-Oxley requirements, these buyers will certainly inspect the internal control systems. Having these controls in place is both good business and good planning for a potential acquisition.
- Does my revolving line of credit actually revolve?
Most businesses should have a revolving line of credit set up with their bank to assist with the ebbs and flows of working capital requirements during the year. In a healthy company, the balance of the line of credit should actually revolve, meaning it should rise and fall based on the seasonality or natural rhythm of the business.
Prospective buyers may chart the monthly balance of the revolver over the course of several years to help understand working capital requirements and determine whether the line of credit reflects actual working capital fluctuations. A revolver balance that never decreases could indicate a rapid growth rate. But it could also indicate poor management of inventory or accounts receivables, or profitability issues in certain segments of the business.
- Is the amount of debt I carry reasonable for my business model and current growth rates?
In addition to reviewing the activity in the revolving line of credit, we recommend owners think through their overall debt levels well in advance of any potential transaction. Debt is a useful and relatively inexpensive tool to finance growth. Used wisely in a well-managed business, debt can help accelerate growth rates and expansion to new markets and new product lines.
However, because debt must be repaid, it can also put stress on a business by reducing the margin for error. In businesses carrying a high level of debt in relation to their shareholder equity and ability to generate profits, a severe dip in sales of just one quarter can create a significant strain on the business and jeopardize banking relationships.
Prospective buyers will assess the level of debt being carried by the targeted business, and if it’s relatively high, additional due diligence will be required to understand the underlying causes. In short, profitable businesses with lower debt levels will always be more attractive than businesses operating under the pressures of heavy debt loads.
We recently discussed our “55 Questions” with Gordon Deal on the “Your Money Now” podcast. You may listen to the podcast here.