More Lessons from Buying A Small Business

The following is for informational purposes only and not meant to be investment, legal, or tax advice. Please consult a CPA or an investment professional.

I am hopefully close to a deal for a small business. Through the process I have learned a few additional lessons on top of the takeaways I wrote about in the first article in the series, Lessons Learned from Searching for a Small Business to Buy.

Small business owners don’t know how to diligence companies

The vast majority of the small business owners I have met with did not really conduct any substantive diligence on their acquisition. They may verify that a company generates somewhere near the amount of cash that is claimed, but the diligence stops there. If you do extensive, formulaic diligence you have a significant advantage versus other acquirers.

AI revolutionizes diligence

The amount of time it takes to complete diligence has shrunk due to AI. You can ask AI complicated questions and get its opinion on matters that would normally be extremely time consuming and costly. Using AI has also helped me avoid costly errors and potential risks that I would otherwise not have identified using my own research. AI can also help you review complex documents and recommend best practices.

Not all flags are red

Due to the largely unsophisticated nature of small businesses, there will always be minor problems. You will almost never find a well-run business that fully complies with all regulations, has a sterling reputation with its customers, good margins, solid growth, and great employees. You cannot let the perfect be the enemy of the good. Some hair is always to be expected and it is why multiples are low and the possibility of improvement is real.

Recurring revenue’s value is not fully appreciated

A dollar of recurring revenue is worth significantly more than one that is episodic. Every financial analyst in the world understands this, but small businesspeople may not. If you have a part of your business that generates recurring, high-margin revenue almost all of your advertising/marketing dollars should go towards growing this segment. Instead, small businesspeople will chase large, one-time chunky revenue that temporarily fills their coffers at the expense of recurring revenue that pays out significantly over time and increases the multiple of the business.

How and when a seller is paid matters

The most important single number in a deal is the total amount being paid, followed closely by how and when it is being paid. Cash upfront directly from a buyer’s savings has the highest chance of closing and minimizes the seller’s risk. A cash deal with required financing from the Small Business Administration (SBA) or another lender gives the seller the same sale value, but with a higher risk the financing won’t come through or will take longer than expected. Deferred compensation or seller’s notes may result in the seller getting more money over time and on a more tax advantaged basis, but carries considerably more risk that the buyer won’t pay out.

Consider all elements of a deal

Although price is the most important element in a deal it is by no means the only one.

Taxes are critical. Your true acquisition is the amount you pay for the acquisition after tax benefits are considered. Conversely, a seller’s after-tax proceeds can be reduced significantly by the tax attributes of the deal. The buyer will always try to allocate the maximum amount to tangible assets especially those that are eligible for bonus depreciation while the seller will try to allocate to goodwill or intangible assets that get capital gains treatment.

Working capital is another critical element. If a business has large swings in working capital you need to establish a working capital “peg” wherein working capital needs to be at a certain level and either side is trued up based on the difference from the peg. If the working capital is higher than normal the seller gets a credit, if it is lower the buyer gets a discount on the purchase price. The peg prevents the seller from taking cash out of the business by liquidating working capital.

Fees are an underestimated part of the whole equation. It is customary for the buyer to pay for the drafting of the purchase agreement and for closing and escrow costs to be split. These costs can be considerable for a small deal as a percentage of the total deal cost. Just because the aforementioned cost allocations are customary doesn’t mean they cannot be changed, everything is negotiable.

You want to keep the seller happy

Nickel and diming the seller into giving you the cheapest all in price possible might seem like a good idea, but its usually not. This doesn’t mean that you shouldn’t try to get a good deal, but if the seller feels like you put one over on them, they may take value from you in less obvious ways. The post-acquisition transition is critical. The buyer wants to maintain employees, customers, and suppliers. Seller’s will also provide training and give you insights that could make a huge difference in your profitability. If the seller feels like got screwed over they may “forget” to tell you a critical detail for example about a customer that could cost you more than you ever saved by getting a slightly better deal.  

Conclusion

Small business acquisitions carry a lot of risk, but also significant rewards. The advent of AI has dramatically improved the speed and quality of diligence that a buyer can undertake themselves.  Every small business has issues, it is important to focus on the bigger picture and not see a red flag in every minor problem. To maximize your potential earnings from an acquisition consider all elements of the deal not just price, focus on after tax returns, and make sure that the seller is happy.