Analyzing the Financial Statements: How reliable are the target’s financials?
September 1, 2007
The heart and soul of any business can be found in its financial statements: the balance sheet and the income statement, which is also referred to as the statement of profit and loss (P & L), or the statement of operations. Nobody would be foolish enough to buy a business without examining its financial statements (the books) beforehand. The trick is to understand what you’re looking at. Scan the balance sheet and income statement of Houston Sash & Door, Inc. for a few moments to get a feel for them; we’ll cover most of the entries in depth later.
Seller’s Operations: Plant And Equipment
August 29, 2007
Your seller may have the best of relations with suppliers and customers and the world’s most dedicated workforce, but it’s not going to matter if your plant can’t turn out the products your customers want to buy.
The first and most obvious inquiry relates to the age of the equipment. It may be going along fine now, but if the bulk of the equipment will have to be replaced in a year or two, a cash flow problem may arise. Most sellers who anticipate they’re going to sell the business tend to neglect maintenance and ignore needed capital expenditures; it makes the books look better. As for major pieces of equipment, such as the milling machines at Houston Sash & Door, find out how old the equipment is. Then write down the names of the manufacturers and the model and serial numbers of each piece of equipment and call the manufacturers. They will have a record of when each model was built and sold. (After all, your seller didn’t necessarily buy new equipment.) Ask about the normal life span of each piece of equipment. If you’re calling about machinery engaged in production, ask about the capacity of each item.
Seller’s Operations: Personnel
August 28, 2007
If the business you’re planning on buying doesn’t have any employees or if you plan on firing everyone who now works in the business, you don’t have any immediate personnel considerations. But if you’ll be retaining some or all of your seller’s employees, there are a number of things you should do. If you’re planning on buying a successful business, it’s a good assumption that one of the factors contributing to its success is a stable and motivated workforce. Your goal should be a smooth transition, with the valuable employees staying with you and staying motivated.
Seller’s Operations: Patents And Trademarks
August 23, 2007
I once had a client who bought a business without using an attorney. The business’s trademark was very important to him, since that trademark gave the business’s products a high level of exposure and acceptance in the public mind. This is the purpose of trademarks. Only after buying the business did he learn it had never owned the trademark! The individuals who had owned the business still owned the trademark in their own right and licensed its use to the business. He was stuck, and that’s why he was in my office.
Seller’s Operations: Supplier And Customer Relations
August 20, 2007
Reviewing documents is easy compared with ferreting out all the information you need to know about a business’s suppliers and customers. But when you think of it, there’s nothing more pivotal to a business’s success or failure than its dealings with its suppliers and customers.
Try to get a complete list of the seller’s principal suppliers. You may find some startling things that will never show up in the business’s financial statements. Is a single supplier (or a small group of suppliers) responsible for most of the business’s supplies? Have these providers been suppliers for a long time? How dependable are they? If one supplier drops off, can it be replaced? In our example, Houston Sash & Door may buy its lumber from only one source. It’s very important to establish what Houston’s relations are with that supplier. At some point it may be important to visit the supplier in order to find out if it will be willing to do business with you on the same terms it did with Houston.
Analyzing the Seller’s Operations: Loan Agreements
August 16, 2007
Let’s assume Houston Sash & Door borrowed $200,000 from a bank to purchase the machinery that mills the lumber into doors and windows. Most of the $200,000 hasn’t been paid back. You can be sure that not only did Houston have to personally guarantee the payment of any debt his corporation incurred, but that the assets he bought from the proceeds of the loan were put up as security for the payment of the debt. It’s much the same as when you buy a home: A mortgage is placed on the house, and if you don’t make the payments the bank forecloses. It’s likely, however, that more than the machinery bought with the loan proceeds secures the debt. Banks like to get all sorts of security, to ensure they’ll be paid. They may also have gotten the business’s accounts receivable and any other hard assets that weren’t placed as security for some other debt. Even such items as patents and contract rights can act as security.
How do you find out the extent to which the assets are tied up as security for debts? The first thing to do is have the seller provide you with a list of all the debts and the files of all the loan agreements. You and your attorney should then sift through them, finding out the status of all the loans and the assets that secure the debts. What if the seller “forgets” to tell you about all the assets that are tied up? No problem. Before you buy, you should check with the secretary of state or county clerk in the county in which the seller’s business is located. These resources will have a record of all the UCC-1 filings against the business. Here’s how this works: Whenever anyone loans money to another and takes back a security interest in any assets, the lender files a UCC-1 form with the appropriate agency, either the secretary of state or county clerk. The UCC-1 form describes all the assets the lender has an interest in. The purpose of the UCC-1 is to give notice to anyone who is interested in either buying the assets or lending more money to the borrower. A UCC-1 form says, in effect: “Hey, you! If you’re thinking of lending to or buying from this person, just remember we have a priority interest in the assets! We get paid first!” The UCC-1 filing serves the same function as recording the title to real estate when real estate is sold or mortgaged. It gives notice to everyone else of a prior interest in the property.
You and your attorney must use the same care in examining the loan documents that you would in examining the premises lease-and for the same reasons. The terms of a loan may effectively prevent a transfer of the assets. If this is so and the bank refuses to waive its rights, a sale may be impossible. Why would a lender try to prevent anyone from buying the asset and assuming the debt? Because the lender parted with its money only after
it checked and was satisfied with the seller’s credit rating. It may not want to deal with you. Checking with the lenders that have a security interest in the assets is one of the first things you should do. Even if the seller tells you getting the banker or the finance company to consent to the purchase is “no problem,” don’t take the seller’s word for it; check it out.
Here’s one thing you should never do: If the seller knows the lender won’t consent to the transfer of the assets, the seller may suggest that the two of you simply don’t let on that a transfer will take place. The seller will suggest that you pay the monthly, quarterly, or annual payments to him or her, with the seller then rerouting the payments to the lender. You’re playing with fire with a setup like this. If the lender ever learns you’ve attempted to circumvent the rights granted to the seller in the loan agreement, you may find the lender has the right to accelerate the loan, that is, call in the whole loan. In this case you’re stuck with an enormous debt due right now. It could kill your business.
We’ll see in Chapter 6 that there are two ways to structure the purchase of a business conducted in corporate form: Either buy the stock or buy the assets. If you buy the assets, you’ve no choice but to check to see that the assets are transferable. Even if you plan to buy the stock, the loan agreements still may prevent the sale. The lender may have obtained the stock of the corporation that owns the business as collateral for the debt. The seller may be prevented from selling the stock because the seller doesn’t have it; the stock certificates may be lying in some banker’s vault. Even if the seller still has physical possession of the stock, the seller may have agreed not to sell the stock until the debt is paid. Once again, make sure you read the loan documents to see whether the business can be sold.
Analyzing the Seller’s Operations:Leases
August 9, 2007
A thorough examination of the seller’s lease should be high on your list of priorities. The lease may contain some news (including news the seller isn’t even aware of) that may be so bad as to prevent the business from being sold on any terms.
Let’s assume Houston Sash & Door leases its plant and office space from a local real estate company. Houston tells you what the monthly rent is and it sounds favorable. The plant is located close to a major highway; consequently you’d like to stay in this location after you buy the business. You ask Houston how long the lease has to run, and he tells you it expires in three years. With three years left on the lease, you could buy the business and take your chances on what’s going to happen when the lease expires. Either you’ll be able to negotiate a new lease on favorable terms or you’ll have to move. But what if the lease has only eight months (or eight weeks) to go? Whatever you do, don’t take the seller’s word that the landlord will agree to a new lease or to extend the existing lease. Before you commit to buy, make sure the landlord will sign a new lease. If you can, get the landlord to sign a new lease with you, which should take effect only if and when you close the sale.
Your First Inquiry: “What Does This Business Do?”
August 6, 2007
Sounds simple enough, doesn’t it? After all, we said Houston Sash & Door, Inc., buys lumber and manufactures doors and windows, which it sells to general contractors. Many businesses, however, are engaged in two or more different, but similar, lines of work; they have more than one profit center. For example, Houston Sash & Door may also sell a small number of windows at retail.
Analyzing the Seller’s Operations: Learning All The Facts
July 28, 2007
Most of us are brought up not to be too nosy. We develop an instinct to mind our own business and stay out of other people’s affairs. This attitude can be deadly when you’re thinking of buying a business. Everything concerning the target business’s operations is your affair, because you’ll have to live with it all should you buy the business. You should take the position that absolutely nothing about this business is going to surprise you after you buy.
You must drive yourself to learn everything you possibly can before you buy it. This means being very nosy. It means asking embarrassing questions and pressing for details if the answers don’t satisfy you. Only after you’ve convinced yourself that there’s nothing more you can learn should you even consider closing the sale.
How To Find The Right Business
July 9, 2007
Let’s assume you’ve got a pretty good fix on the type of business you’re best suited for. How do you find this business? Unfortu¬nately, most people select a business in the worst way: by hearing about one available business and buying it. Just as you probably wouldn’t buy a house after looking at only one, you shouldn’t buy the first business offered to you, no matter how attractive it looks. Scrutinize the real estate section of your local newspaper. You’ll find listings for a number of businesses being offered for sale. Check out all those that look promising.
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