Buying a Business?

What it Takes to Get to the Finish Line

Buying a business is one of the most complex transactions you will ever experience. The many and often varied steps leading up to the closing agreement are critical in determining which party walks away with the better end of the deal. From the time you decide on the business you want to buy, the process is a series of negotiations with both parties seeking the upper hand. You meet with the seller, make your opening bid and negotiate the key purchase terms. But that is all preliminary – simply the prelude to the real work of due diligence, submitting a formal offer, final negotiations, signing the purchase agreement and closing the deal. Not to diminish the effort that goes into the preliminary stage, because it can be very extensive, but nothing is real until a letter of intent is signed.

It Starts with the Letter of Intent

Once you and the seller agree to the broad terms of the deal, the next step is to have your attorney put it to writing in a letter of intent (LOI). A properly drafted LOI offers the buyer certain protections, such as restricting the seller’s ability to entertain other offers for a period of time. It should provide you with the time you need to thoroughly evaluate the company’s operations, financial statements, contracts, employee agreements, suppliers, pending litigation among other issues that could impact the purchase price. Although the purchase price is included in the LOI, it does allow for the buyer to question the assumptions and propose price adjustments and negotiate provisions based on changing assumptions or circumstances.

Getting to the Final Price

In most cases, the purchase price agreed to in the LOI is based on an EBITDA calculation of its earnings before interest, taxes, depreciation, and amortization. However, EBITDA is not a thorough measure of the business; rather, it is an acceptable starting point from which you can more thoroughly evaluate profitability and future returns. You can then apply various adjustments (add-backs and deducts) to arrive at “normalized earnings”. These adjustments are typically based on income or expense items currently included in the income statement that will not continue after the acquisition. Identifying these adjustments is vital to determining what you are likely to pay for the business. Typical adjustments include:

Owner salary and compensation: If the owner’s salary and benefits are deemed to be excessive when compared to market levels, an add-back for the excess would be appropriate. This could also include any family members receiving benefits who are not active in the business.
Owner-related expenses: Any non-essential items which the owner expensed through the business and are deemed excessive could be added back. These could include personal vehicles, travel, entertainment and memberships.
Unusual or non-recurring incentive compensation: The company’s income statement may be laced with large bonuses or other forms of incentive compensation that won’t be continued under the new owner. This could also include severance payments.
Management needs: Should the departure of the owner leave any gaps in the management team, requiring the new owner to fill the gaps, an adjustment should be made for the cost of hiring and compensating the new executives.
Rent expenses: If the seller owns the property housing the business as a separate entity, it may be charging above market rent. An adjustment should be made reflecting the true market rent. Conversely, if the company leases a building and pays under-market rent, and the lease is not assumable by the new owner, a similar adjustment can be made.

There are dozens of potential adjustments that could be made to EBITDA. It is vitally important not to miss items that could positively or negatively impact the purchase price. The normalized earnings calculation becomes the new starting point entering the final acquisition stage.

Your CPA Gets You to the Finish Line

Critical to the process of calculating normalized earnings is the buyer’s CPA firm. To conduct its part of due diligence, your CPA should have a minimum of three years of financial statements and tax returns, a copy of all material leases you expect to assume, a list of open receivables and payables, a list of all fixed assets you will be acquiring, payroll records and employee agreements.

Your CPA can evaluate all of these records in detail to evaluate their integrity and identify inconsistencies, improper record-keeping and mispriced assets. It is critically important to have any assets you expect to acquire to be confirmed. Are the company’s biggest assets actually owned by the company? Any significant assets that have been sold off in recent years could drop the purchase price. Some companies may try to misrepresent its asset register, listing assets that don’t actually exist or overstating their value. Your CPA will be able to challenge inventory value if it is outdated, damaged or otherwise unsalable.

In essence, your CPA puts you on the final glide path to successfully negotiating a fair price based on a clear and supportable evaluation while protecting your interests in the deal.

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