I felt compelled to write this longish article after spending a lot of time with 250+ small businesses (valued at $5M or under) over the last 2.5 years, across multiple industries throughout the US.
I hope this will help those are looking to exit their businesses or looking to buy a business. Even if you are not looking to buy or sell a company, I highly recommend giving this a read as it help you understand the dynamic of the largest segment of the US economy – the Small Business.
So that you understand where I am coming from, my efforts involved helping 50+ companies create and execute exit strategies. I have also looked at over 200+ small businesses with an intent to acquire them.
All this is 1st hand learning!
While all this may not be surprising to many, what I found actually baffled me. Please pardon the occasional satiric tone, but I just could not help myself 🙂
Let’s start with the key players.
It is not surprising that small business owners do not have time or resources to create a completely buttoned-up business. When I say buttoned-up business I mean companies that have clear SOPs for operations, redundancies for processes and resources, proper Marketing & Sales systems, formal HR systems, repeatable processes that can be easily transitioned to anyone, and finally – audited and well-explained financials. Some companies do have some of them and the very “very” few that have tackled all these, are exceptions. Many owners started their companies as a means to a livelihood or as an alternative to full-time employment. Some owners inherited the business from their families. Others started the company with an intent to make a big company, but could not scale. These days eCommerce (Amazon, Shopify etc) and SaaS companies are sprouting up every hour and after 18-24 months years, they are ready to be flipped (look at Empire Flippers, Flippa, Boopos, WebsiteClosers, WebsiteProperties, QuietLight, Acquira, Latonas etc).
Small Business Buyers
The main types of buyers are folks that are (a) looking to get into an established business rather than starting out on their own, (b) sold a company (or two) and looking for their next venture, (c) own a company (or two) and looking to grow through acquisitions, or, (d) investors. Buyers can therefore range from seasoned entrepreneurs and executives to fly-by-knights who are hoping to get on a get-rich-quick scheme by scoring on some absentee business or a flip. Sellers, brokers and lenders have to weed through all such types of buyers to ensure that a transaction can get to a successful close and, more importantly, a successful transition with no legal issues post-sale (which happens more often than not).
Small Business Brokers
Most transactions are facilitated by brokers and advisors. I work as an M&A (Mergers & Acquisitions) advisor and I understand first hand the challenges we face. I can also say for a fact that no two brokers are the same. Every brokerage has their own process, every broker within a brokerage has their own pace and way of running deals and every transaction will generate a new way that the same broker will use. There are no commonalities. If you try to buy a business you will be faced with a myriad of processes, contingencies, constraints and sometimes downright peculiar requests by brokers that merely waste everyone’s time. Having said this, I have worked alongside some excellent advisors that truly understand and care about their clients and their businesses.
A business cannot be (rather should not be) bought and sold without attorneys. Generally attorneys come in towards the latter part of the transaction once due diligence (see below) is complete and the final purchase agreement needs to be drafted. Most attorneys will work on a set rate based on the transaction size and complexity. Once again, each attorney will have their own set of legalese and frameworks. And if you happen to get in the middle of a buyer and seller attorney gunfight, you will not really be amused because all that you gain is a lot of wasted time and in turn wasted dollars. Having said that, I have seen that most small business deals end with attorney fees in the $10K-$20K range.
This is where rubber meets the road, where all deals either come to fruition or go to die. A large number of small business acquisitions are funded through the SBA 7a program. Discussing the 7a program is a novel by itself and I will hopefully write that soon! On the surface it is quite simple – in fact it is the only clear-cut, consistent component of the small business M&A industry. Yet, every transaction will present its own set of colors because no two transactions are the same. In fact the same transaction will look different depending on the stage of the deal. As weeks and months go by, the same transaction will change face and the underwriters will add new risk factors to the original term-sheet. This is SBA 7a. Which as I mentioned, is consistent (somewhat) across transactions. Then there are non-SBA traditional lenders (banks), and finally, alternative funding vehicles – financial brokers, equity partners, small home offices, mini-private-equity partners, rich uncles, boiler-room-Wall-Street-underbelly operators, loan sharks, crowdsourced lenders, revenue-based lenders and almost anyone that can make 2% to 5% of the transaction by connecting a buyer to a money source. Finally there are sellers that will offer seller financing with all kinds of terms and deals – if you ever played Monopoly with a shrewd cousin, you will see some solid similarities.
Valuation Companies & Services
Some brokers and sellers use valuation companies and services to find out the valuation of their companies before they list it for sale. Read on below to see how valuations are normally done in the small business M&A industry. These services and companies do minimal diligence and spread tax returns and financials to come up with a cookie-cutter valuation and report. They have standard templates based on industries and use business-school frameworks to justify their reports. If you lift the covers these valuations really will not mean much, especially if the buyer comes with a lender that will end up doing their own valuation to underwrite the loan.
Accountants & Auditors
Buyers and Sellers have accountants and auditors that they use to do financial diligence, modeling and forecasts. Not all buyers have accountants and not all sellers have good accountants. Some businesses require audited financials and these companies generally have clean books, matching tax returns and proper explanations for all add-backs (see Valuations sections if you want to know more about “add-backs”). Some sellers have their spouses or cousins managing their books and some buyers read up on Financial terms and try to go about it hoping to save transaction fees by not hiring a proper accountant or accounting firm. Lenders have their own accountants and some attorneys give financial advice which is not their sweet-spot skillset.
And there were none!
Well not really 🙂
Transactions also involve key employees of a seller, or those of a buyer (if a company is buying the business). There are key suppliers and vendors that will be consulted during the sale. Some buyers and/or lenders will force a Quality of Earnings audit by a neutral audit firm where key customers (or random sampled customers) will be contacted to review sample orders, invoices and payments. Industry consultants may be brought in to add their 2c. Some brokers use consulting firms or consultants to create their Marketing packages (CIM, OM, CBR – there are many abbreviations for these packages). Some brokers hand out Marketing of the business to an agency. By the end of the transitions of a successful transaction from a seller to a buyer, one can lose count of the number of parties that were involved from start to end.
Before I get into specific challenges of buying and selling a small business, I want to phase-gate the process that is generally followed in the M&A industry of this sector.
Process of Buying & Selling a Small Business
On average a small business transaction takes 9 months to complete, from start to close. Transition and separation takes 3 months more. But it is RARELY the case.
Generally the industry follows a somewhat standard process to buy and sell companies. A reader’s digest version is as follows. I have also written a very detailed article on how to sell a company which I believe can be a good resource for anyone looking to be part of a business sale.
- A seller works with a broker / M&A advisor (also called a sell-side advisor) to create a Business Valuations and Marketing package. The business is listed in classifieds (BizBuySell is the largest), the brokerage’s own website (if there is one) and sometimes on social media using a “teaser” which is usually a vague summary of the business with some numbers (price, revenue, EBITDA, cashflow to a new owner, inventory, FF&E etc).
- Buyers read the teaser, sign an NDA and review a business summary of the business. Some brokers ask for proof of funds before the NDA & summary can be released. The business summary is created by the broker (and sometimes the seller) and is called a CIM (confidential information memorandum) or OM (offering memorandum) or CBR (confidential business review) or just “package” or whatever term a broker likes to call it. Some CIMs are 2 pages, others are 10. The average is about 5 pages. Some contain details, others contain garbage. Some contain good financial data, others contain tables created by someone that does not like Business Math. Here is an article I have written on how to write a good CIM. If you need a good template CIM do reach out to me.
- Based on just this, a buyer has to decided if he/she wants to pursue the deal. A seller interview is organized which is typically 30 mins. At this point, a buyer will have to send in an LOI (letter of intent) which is a “rough” offer. An LOI can be 2 pages to 5, with an average of 3 pages. It typically lists transaction type (asset sale, stock sale etc.), due diligence process and time and other legalese which no one reads. Most LOIs are non-binding which basically means it is a feel-good document that can be trashed the moment it is signed. Binding LOIs require buyers to create an escrow. Escrow is usually 10% of the total downpayment or $25K to $50K. But there are no norms here. I have experienced brokers wanting 100% of the final downpayment as escrow (yes 100%) at this early stage. Think about that – you are buying a house and at a very early stage you are being asked to pay 100% of your final downpayment as escrow! Anyway, if you need a good LOI template please feel free to reach out to me.
- Buyers arrange funding and perform due diligence which is roughly planned for 30-60 days, but almost always goes far beyond the days mentioned in the LOI.
- If a lender is involved, the deal is underwritten while the official and final Purchase Agreement is drafted by the Buyer’s attorney.
- Once the Purchase Agreement is agreed upon by “all” parties, a closing date is set. The funds are escrowed at one of the attorneys (generally Seller’s attorney) and at closing the wet signatures are sent to the Buyer and funds are remitted to the Seller’s bank.
- Transition is planned. Normally there is a free period of 1-2 months where the seller transitions the business to the buyer. Training may be involved.
- Seller officially “separates” from the business, although this is not formally done in most cases.
Except…the above process is an ideal scenario which does not happen in majority of transactions.
If there is real estate involved, that could be a separate transaction depending on the structure of the deal. There could be regulatory and compliance complexities which will create additional tasks and add to the timelines. If there are patents or IPs to the transferred then IP transfer agreements come into the picture. A lot of discussions happen regarding goodwill (a topic by itself). Some transactions bring transfer of large amounts of physical assets (machinery for example) which also add to the complexity.
There are many companies that are poised for stable, as well as the cliched “hockey-stick” growth under a seasoned entrepreneur or Executive. Many of them make more than 7 figures a year in profit before they are sold. Yet, when it comes to the actual buying and selling of such companies, there are significant challenges. I will outline the most important ones here.
Challenges in the different stages of sale
Valuation of small businesses are mostly in multiples of SDE (Seller’s discretionary earnings). Basic math is simple – take EBITDA, add owner compensation, owner expenses, one-time expenses that a new owner will not have and certain other “addbacks” like depreciation (depending on useful life of assets left), interest etc. This gets to SDE. Then multiply this with a “multiple” or multiplier to get the valuation. And this is where things get ugly.
Many businesses are listed with high SDE (and hence higher valuation), but when the covers are lifted the net income is actually a lot lesser.
This causes heart-ache for buyers, and lenders. Some companies, & brokers add-back a lot more than traditional lenders (especially SBA) would allow. For example, adding back rent is quite common but generally not accepted by lenders, Or, compensation of all the owners (normally 1 is allowed), Or, certain expenses that are being claimed as expenses that a new owner will not have (specialized Marketing, legal etc). Next comes the multiple – most businesses are valued based on comps and historicals. But how do you compare small businesses? No 2 small businesses are alike, even if they do exactly the same thing – because small businesses do not follow standard processes and they are completely unregulated. And to regulate small businesses will break the backbone of the American economy – barrier to entry, costs and compliance hassles will deter most to start a business in the first place. Historicals are also difficult because the economy has seen such wild swings in the last 2 decades. Bottomline, brokers put in a multiple between 3 and 4 for SDE under $1M and higher (5, 6 or even 7) for more than $1M. Some businesses area valued at 1x or 2x because of high fixed cost or other extenuating circumstances (motivated seller, high dependencies etc.). I have even seen transactions where the multiple was just 1.5x to increase marketability but as I went further into the transaction I realized that the net income was actually a lot lesser and the real multiple was over 4! And then, if there is real estate involved with the transaction that is a whole different dynamic, a completely different type of transaction. It will take a separate volume to discuss that, a topic for another day.
This is where things get messy and complicated. There is no set process for due diligence (DD) in the industry. Experienced buyers come with a set of document requests. Non-experienced buyers read up the internet or ask their cousin lawyer and create a list. Some buyers just go with the flow. Some brokers pre-empt the document requests and create a decent data room / deal room. Next, buyer’s lenders will have a whole slew of documents they require. For SBA it is a fairly standard set of documents (the one consistency!) – at least at first. But the document requests and barrage of questions can pile up pretty quick depending on the business (e.g. special licensing, mandatory regulatory & compliance processes, overseas manufacturing etc.).
Normally DD is supposed to last 45 days (30-60 is the norm), but almost always spills over.
The main reason is that the initial period mentioned in the LOI is based on very little information shared by the seller (a 5 page CIM and a 30-min interview). Once the layers are peeled new information comes to light and that creates the need for deeper inspection and review. Lenders and attorneys will almost always add to the diligence requirements and timeline. I have written about due diligence in the past and if you need a pretty well-oiled DD checklist, do hit me up.
The final agreement is where things are official for the 1st time in a transaction. Lawyers (generally buyer’s lawyer) draft up the purchase agreement. This can be anywhere from 15 to 50 pages and can go up depending on the complexity of the transaction. I have seen average agreements in the 30 page range. I have seen agreements crossing 100 pages, with consulting agreements for sellers post-close, IP transfer documents, complicated non-competes, seller notes and earn-out agreements. Every lawyer has their own legalese and there will always be a period where the buyer’s lawyer and the seller’s lawyer will rebound the same document for reasons that are beyond any value-add to any party other than the lawyers themselves.
Many transactions die at this late stage because the original deal structure gets thrown out when the final legal purchase agreement is drafted.
The due diligence almost always reveals information which would eventually change the deal structure. The final agreement which is drafted by the buyer ends up having significant surprises for the seller. The transaction gets renegotiated. Lenders add a completely different level of due diligence and their original term sheet gets updated. Emotions run high and buyers and sellers are only talking through their lawyers and the lawyers with the brokers. All this, while the seller has to keep operating the business with full throttle.
Transition & Separation
The closing of a business sale does not mark the end of a transaction. It is customary to pop open the champagne when cash hits the bank account. But the transaction really begins at the closing table. Up until then it is all courtship and romancing with future possibilities.
Once the close happens, and new ownership comes in, there is almost always going to be some turmoil. That is when the proverbial keys are exchanged and buyers get to drive the car first hand for the very first time.
Prospective sellers do not realize how easy it is for a business sale to end up legal dispute post-sale. I saw a transaction getting reverted after 9 months (yes 9 months). Every purchase agreement has stringent clauses about misrepresentation. Some buyers will take advantage of this when they are in a tight corner and if they have deep pockets. Some sellers ignore this and try to overdress their businesses. Brokerage firms are long gone after the close and in the end only the lawyers win in such cases. In majority of transactions, transition is almost never planned properly before the close. After the sale, differences of opinion on how transition needs to happen or planned open up ego battles. Some buyers are smart enough to let sellers hold their hand through transitions. Others demand things to be run their way right from day one. Some sellers walk away before proper transition can happen. Others have a hard time letting go. I can go out on a limb and say that transitions for majority of small business sale are never smooth. M&A in the large and mid-sized sectors have some statistics about synergies. These deals are planned and measured due to the size of the deals. In small business M&A it is almost impossible to find such statistic. And the studies that are there only come from a small sample and all based on assumptions.
And then there were none!
Well you got my drift by now. The number of challenges in any type of transaction (not just small business M&A) is endless. But in most other types of transactions there are finite categories of challenges. This helps in planning and risk management. I have learned first hand that in small business M&A, there are new types of challenges that can crop up any moment. As such, it is near impossible to plan too far ahead. One can plan for risks but cannot plan for the unknown.
As you see there are significant challenges in trying to buy and sell a small business. But transactions do close. And the last few years have seen some record number of deals finish in the small business sector. Navigating one transaction first hand is definitely an experience every business owner should experience!
The small business M&A industry is riddled with inefficiencies and incompetent actors at every stage of any transaction. And then there are some excellent M&A Advisors (ahem!) that can make this process a lot less painful. Some platforms like Flippa and Acquira are trying to make the process more seamless for eComm and SaaS companies, but there are gaps. Regardless, the industry as a whole is plagued with the problems I discussed in this article – it is kinda like the Wild Wild West. But maybe all this not all bad. Because, it is actually the imperfection that creates opportunities for those that can weed out the winners.