Due Diligence: Know as Much About the Buyer as They Know About You
As many readers already know, I have been watching consolidation carefully for the past several years. As this trend continues to make itself felt, I continue to field calls from plumbing and heating contractors who have been approached about selling their businesses. In most cases, they want to know how they can determine if it is a good deal for them, and whether or not they should do it.
The first thing I would advise you to consider is whether you are really at a point in your life where you want to sell your business. If you are in your 50s or 60s and wanted to be able to retire in 5 years or so, then selling to a consolidator could be the best thing you can do. Generally they are able to pay top dollar, they are able to pay cash and they are usually willing to keep you on board for a few years until your company has been completely assimilated into their still-evolving corporate culture.
However, if you are not at a point in your life where you are ready to retire, you have to ask yourself a couple of soul-searching questions. How do you feel about being an employee of a big company after having been the owner of your small business for all these years? Are you prepared to answer to someone else about your sales growth, expense budget and profitability? No matter how well intentioned both parties may be when going into the relationship, things can sour, if the sales and profits are not what was expected. I don't have any first hand knowledge of anyone being fired for poor performance, but that is something that needs to be expected. If the consolidator is a publicly traded company, they have enormous pressure to meet Wall Street's expectations or the stock price will fall dramatically.
Most small contractors I know tend to see large variations in their profits from year to year. They also tend to enjoy the advantages of being able to run some personal expenses through the business. Once you have other owners to answer to, this has to stop. No more gasoline credit cards for your family, no more business meals with the Board of Directors, which consists of the husband and wife. No more business trips to exotic locations for key employees.
On the positive side, you will probably be able to cut some expenses like financial reporting, and you may see the cost of your materials go down. This will have a positive impact on your profits. You will also probably be able to get rid of any personal guarantees you've made to your banker and your vendors.
Assuming that you have made the decision to sell your business, there are still several things you need to do before you agree to sign a contract with a consolidator. At this point I should also point out that these are lessons that I have first- hand experience with. In addition to being a financial planner, I also have an interest in a franchise called Unishippers. Unishippers is an authorized reseller of Airborne Express and other overnight and freight transportation companies. My franchise is the second largest in the country, so we have some clout with the franchiser in Salt Lake City, Utah.
In 1998, we considered rolling up our franchise along with the other 10 largest franchises in the nation and the franchiser. This would have created a company with 100 million dollars in sales and over 20 million dollars in profits. We would then have had the critical mass to go public. During due diligence, we interviewed investment bankers, and I learned a lot more than I expected about the process.
Key issues that were brought up included the offering, the industry classification, the number of analysts assigned to cover the stock, the reputation of the analysts, institutional ownership of our stock and the sales and earnings growth expectations we would have to meet.
I mention this because there are basically two types of consolidators. Those that are already public and those that expect to go public at some time in the future. I realize there are some privately owned consolidators, but I think that has more to do with the weak demand Wall Street is showing, rather than a long-term business strategy. I suspect that if they could do it over again, many of the companies that joined in the roll-up would choose to remain independent.
If the consolidator is offering you all cash, it doesn't much matter if they are public or private. All you need to do is sell to the one that offers the terms that best suit your situation. That may just be the highest sales price, or it may include other factors like an employment contract, performance incentives and earn outs.
However, if the consolidator is offering you its stock as part of the sales price, you need to analyze that stock very carefully. You need to know what their sales and profit growth have been for the past five years, if available. If they are a public company you also need to know how well the stock is being covered. How many analysts are covering it? Are they experiencing positive earnings surprises (a good thing) or are they experiencing negative earnings surprises (a very bad thing).
If the consolidator is privately held, you need to know who the other shareholders are. What multiple (of earnings) were they paid for their companies? Will the purchase of your company dilute the overall earnings of the company? Getting top dollar for your company might seem like a good thing to you, but if the purchaser is willing to over pay for your company, are they willing to do the same for others? If a consolidator is so intent on growing that it is willing to pay too much to acquire a company, it may have a hard time ever taking the company public at a price that allows people to realize the full value of their shares.
Similarly, if the consolidator is offering you a note or a debenture, it is important to know what their balance sheet looks like. While your position should be secure, it is a good idea to see a high coverage ratio. This means that there is significant cash flow to service the interest and the debt. Ideally you'd see a coverage ratio better than 10 times. If the coverage were less than 3 times, a recession could cause a default in the payments.
In summary, once you've made the decision to sell, your work is not over. While the consolidator is pouring over you books and learning everything they can about you, you should be pouring over their books and learning everything you can about them.