“Let our advance worrying become advanced planning and thinking” – Winston Churchill

Every June 6th, our nation pays tribute to the heroic actions of the 156,000 American, British, and Canadian soldiers who stormed the beaches of Normandy, France, on that date in 1944. Operation Overlord, the invasion’s code name, was the beginning of the end to Hitler’s rein of European terror and the end of World War II. Although the efforts to occupy the initial beachheads are often the celebrated stories of D-Day, the success of the entire operation was only possible because of the extensive planning that began two years prior, in the summer of 1942.

Similar to planning the D-Day invasion, planning an exit strategy from your privately held business will be the difference between the success and failure of your lifelong mission (your company).

Know Your Enemy: The Risks of Failure

General Douglas MacArthur once said, “It is fatal to enter any war without the will to win it.” So when you’re making plans for the successful sale of your business, you must understand the ramifications of a failed attempt to sell. These include:

• Loss of key personnel. Buyers at some point will expect to meet your key employees. This expectation is fair enough, as the buyer will rely on your key employees to ensure that the business stays on course post-transaction. Should the attempt to sell your business fail, you may be faced with disenchanted and demoralized employees who no longer trust you as a business leader. These employees will often seek employment elsewhere or, worse, linger in your business.

• Loss of momentum and profits. Your business has momentum whether it’s growing or not. Momentum is required every day to service your existing customers. Negotiating with a buyer and participating in due diligence is distracting, and it will temporarily sidetrack that momentum. A dip in profits within the short term is often the result. If efforts to sell your business fail midway, the loss of momentum and reduced profits might remain as ongoing problems.

• Emotions. Emotions become involved when a buyer and seller negotiate. When an attempt to sell falls through, emotions on either side of the table are often too great to overcome, thereby making a second attempt difficult. Sometimes the timing for a sale is just not right. Understanding that the timing is not right and not engaging in the sale of your business is the professional decision, as it will preserve a relationship with the buyer for when you are ready.

• Seller’s personal momentum. General Dwight Eisenhower is heralded as an American hero for his role in the D-Day invasion. But how would history view him if the Allied landings had failed and the war had continued for another three years? How would Eisenhower have viewed himself? Failed missions have a horrific effect on the consciousness of leaders.  Going most of the way with the sale of your business is risky; many owners are mentally finished and looking forward to finally lifting the weight of the world off their shoulders. Do you want to face the day-to-day challenges of your business after you have mentally checked out?

• Lawsuits and legal ramifications. Engaging a buyer opens up your business for potential legal ramifications should a disagreement between you and the buyer develop. This risk of potential legal ramifications should never prevent a business owner from entering into negotiations with a buyer. However, the threat of what could occur further justifies that the seller prepares an exit strategy and executes it in such a manner that the transaction reaches a successful conclusion.

• Expensive consulting time. A sit-down meeting with a prospective buyer has little cost, and they might even pick up the lunch! As the process continues, the likelihood of committing to consulting expertise becomes greater. Attorney fees, accounting fees, and consulting fees are all necessary expenses when completing a business transaction. A transaction that dies at the eleventh hour will leave you with a handful of invoices to be paid. In the end, these invoices would be so much easier to justify having completed the transaction.

• Leakage of confidential information. In order to negotiate with a buyer, a seller will be expected to present volumes of company information. Although the seller and the buyer will enter into a confidentiality agreement, the reality is that the seller will be sharing company information with the outside world. Similar to the potential for lawsuits, the fear of leaking confidential information is no reason to not engage with a buyer, but the risk of potential leakages must be considered. The more buyers engaged, the greater chance of your business’s information hitting the street.

• A “shopped” reputation. No one wants to be the business owner who has been “trying to sell for a while.” The image is not favorable to receiving fair market value for your business. In addition, buyers will not appreciate nor want to spend their resources on analyzing and considering a business that has or is in the middle of conversations with multiple buyers.

It’s important to note that the severity of all of these risks escalates as discussions with a buyer proceed. If you were to sit down with a buyer over a cup of coffee and discuss the merits of selling your business, the risk of disastrous repercussions are significantly reduced as opposed to entering into negations or going as far as signing a letter of intent.

The Elements of a Successful Exit Strategy

With a full understanding of the risks of being unprepared, what is an exit strategy and how do you execute one? An exit strategy is a plan to sell your business in the future and goes beyond a quick valuation and pulling together financial statements when a buyer is at your door. An exit strategy is the process of refining the features and highlighting the positive attributes of your business. It is finding capable and willing buyers and preparing for the actual sale. Much like planning to storm the beaches of Normandy, an exit strategy will take some time and effort by the owner. Steps included in a successful exit strategy include:

• Set expectations. Determining what it is you have to sell, setting your expectations, and coming to terms with your intentions are the first steps of an exit strategy. Without an understanding of your expectations, there is no way to determine how long your exit strategy will last and what your ultimate goals may be. There are no defined lengths of time, and some plans are shorter than others. Other exit strategies begin the very first day that the business starts.

Setting expectations includes understanding what the value of your business is today. An unbiased and accurate valuation is done through a valuation professional. A good valuation professional familiar with exit strategies and business transactions will also help you understand the strengths and weaknesses of your business.

• Identify your company’s strengths and weaknesses. A full evaluation of your business is required here, but the initial valuation should provide some key information. The strengths of your business should be capitalized upon, and your weaknesses immediately addressed. Some weaknesses will take longer than others to resolve, and both strengths and weaknesses will vary business to business. Some common weaknesses include; low to no profitability, excessive debt, runaway receivables, inconsistent service agreement programs, unattractive work mixes, declining revenue, lack of secondary management and poor procedures in place. While maintaining the strengths of your company, a successful exit strategy includes the business owner addressing all the weaknesses.

• Enhance profitability. An integral part of any business valuation is the company’s ability to generate profits. Little to no profits will result in a lower valuation and fewer interested buyers. Those buyers who are interested will appropriately apply a low value to your business. Improving the gross profit margin and bottom line of your business is a crucial piece to any exit strategy. In this situation, a business owner should first understand why his business is not capable of demonstrating adequate profits then focus his attention on making improvements. This challenge may be accomplished by relying on industry consultants, group alliances, and success groups as well as your existing network of contractors and professionals. The ability to demonstrate adequate gross profits and net income cannot be stressed enough.

• Perform due diligence. Due diligence is a term used for a number of concepts, involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care.

Due diligence is disruptive whether a seller is prepared for the process or not and entering into due diligence unprepared multiplies the disruptions. Once you have signed a letter of intent with a buyer, the proverbial invasion has begun, and it is too late to plan for due diligence then. Business owners should be prepared to deliver to the buyer 100% of the requested due diligence information on a timely basis. Due diligence requests are extensive. Many transactions are delayed or, worse, die when the seller is unable to deliver requested information to the buyer on a timely basis. A complete outline of the steps involved in performing due diligence can be found at the end of this article.

Put together a good team. Eisenhower did not plan the D-Day Invasion alone. Something of this magnitude required the input of military leaders and experts from multiple nations. Does it make any sense to attempt to sell your business all by yourself? Selling your business without seeking expert advice is short-sighted and more than likely impossible in today’s business environment. You should already have a portion of your team, including a CPA and an attorney. In addition to these professionals, consider adding to your team of experts the following support: a business valuation professional, specialized attorney with transaction experience, an exit strategy consultant, a profitability coach, a tax expert, and a business broker.

Your Fate Is In Your Hands

Unlike the D-Day Invasion of 1944, the fate of the free world does not depend on the success or failure of your exit strategy. What is at stake, however, is a strong return on the investment of your time, blood, sweat, and tears, not to mention your retirement nest egg. Launching into your operation to sell your business unprepared will guarantee a shortfall in meeting these expectations. Plan your maneuvers carefully, and when the right time comes to engage with a would-be buyer, your chances of a successful mission will soar.

 

Outline for Due Diligence for Privately Held Contracting Businesses

By Brandon Jacob, CPA

Here is a complete outline to be used when performing due diligence on a privately held contracting business. Developed by Brandon Jacob, CPA, over a period of 10 years, the outline has been used by buyers to successfully complete due diligence on numerous acquisition candidates. Used by owners preparing to sell their business, the outline provides a great understanding as to what to expect during due diligence. Success is not in the sale of the business, rather in the preparation. A successful business is a sellable business. 

The outline is divided into six specific segments that are integral to a successful service contracting business:  income statement,  balance sheet, other financial, operations, personnel/employees, and other. These segments are consistently the focus areas for anyone interested in purchasing a business. Without an understanding of these segments, your business will not be as profitable as desired and it may not be suitable for a would-be buyer. The outline is extensive and each segment contains multiple subsets.

 

Income Statement

Financial Statement Review

• Last three years year-end financials and/or tax returns

• Stub period — current and prior year to create trailing 12 months

• Revenue growth test — revenue growth over the last three years

• Cost of goods sold test — analyze the adjusted COGS

• Adjusted EBITDA — understand and review

• Owner’s actual adjusted earnings — taking addbacks into consideration, what is the owner taking home, based on income statement adjustments, salary, bonuses and distributions.

• Report any expense items that are “out of order” — analyze the financials.

Revenue/Invoice Review

• Analyze invoices from the last two years

• Categorize revenues by:

  1. Type — service/new construction/HVAC/plumbing/drains
  2. Amount — amount per invoice
  3. Average ticket — calculate.

Revenue Mix

Obtain an understanding of work mix through review of invoices and interview with owner. Through the interview and review of the revenue/invoice review, the business mix will be determined.

Chart of Accounts

• Review and make suggestions on improving chart of accounts

• Discuss bookkeeping accuracy.

Adjustments — Extraordinary and nonrecurring expenses

• Discuss extraordinary and nonrecurring expenses and with the owner

• Verify proposed adjustments.

Balance Sheet

Bank Statements Review

• Review last two years — get an idea of consistent cash flows.

Accounts Receivable Review

• Aging review

• Calculate days sales outstanding (DSO)

• Document accounts receivable procedures.

Significant Operating Fixed Assets

• Vehicles

• Computers and communications equipment

• Office furniture

• Other significant equipment

• Intellectual property — document all patents, patent applications, trademarks, trade names, service marks, licenses and franchises that relate to or are used in the conduct of the business of the company.

• Make inventory worksheet that lists significant operating fixed assets

• Document any fixed assets that are contained within the business that are not business assets

• Document the branding that is represented on vehicles

• Document fixed assets capitalized on balance sheet that are disposed of (eliminate).

Inventory Review

• Discuss how often inventory is taken

• Inventory balance — determine if it represents the true fair market value of what is on hand

• Determine levels of old and unusable inventory.

Accounts Payable Review

• Payables review — review the payables aging, if any

• Document accounts payable procedures.

Debt Review

• List debt — obtain copies of any agreements or other instruments relating to any borrowings or available borrowings by the Company, including loan and credit agreements, promissory notes, indentures, mortgages and any other evidence of indebtedness.

• Interest rate — what interest rate is being paid on debt?

• Debt-to-equity ratio calculation

• Explain the debt-to-equity philosophy.

Other Financial

Corporate Structure

• S Corporation

• C Corporation

• LLC.

Stockholders

• Number of Shareholders — list all stockholders with outstanding shares of the company’s capital stock, including each holder’s name and relationship to the company and the number of shares held by each of the company’s officers and directors

• Stockholder agreements — determine if there are stock purchase agreements or other agreements affecting the control of the company or the transferability or issuance of its securities

• Secure copies of stock certificates and list of stockholders including number of shares and date of issuance

• Secure articles of incorporation and all amendments.

• Secure corporate by-laws and all amendments

• Secure minutes of all board of directors, committee, and stockholder meetings.

Other Financing Arrangements

• Other financing — obtain information on all other financing arrangements involving the company, including sale and lease-back arrangements, revenue bonds, installment purchases, off-balance sheet liabilities, etc.

• Other commitments — any commitments for capital expenditures exceeding $10,000

• Credit agreements, debt instruments, security agreements, mortgages, financial/performance guarantees, liens, leases and/or promises to pay evidencing outstanding loans to which the company is or has been party to within the last three years

• Leases for real and/or personal property

• Any arrangements with suppliers

• Contracts including yellow pages, uniforms, telecommunications, etc.

• Secure a list of the five largest suppliers to the company.

Pricing

• Hourly labor rate (if T&M)

• Material upcharge (if T&M)

• After hours surcharge — is there a fee charged to come out after hours?

• Diagnostic fee — is there a fee charged to “come out”?

• Market — how does our business compare with that of others?

• Flat rate book (if flat rate)

• The built-in labor rate (if flat rate).

Operations

Hours of Operation

• Office hours

• Regular service hours

• On-call procedures (after-hours procedures).

Operating Procedures

• Scheduling and dispatch

• Work orders

• Invoicing

Advertising

• Yellow Page advertising

• Direct mail campaigns

• Internet advertising

• Other advertising

• Advertising documents — obtain an example of any documents used during the last two years relating to advertising, publicity or marketing

• Press releases and news articles — obtain copies of all press releases and news articles relating to the company

• Website.

Licenses

• List all licenses that are required for business (business, plumbing, electrical and/or waste removal).

Service Agreements

• Number

• Pricing

• Expiration date

• Services performed

• Secure a sample of the service agreement

• Secure a listing of the service agreement

• Secure a sample contract provided to customers for installation work.

Warranty Policy:

• Policy

• Rework figures

Personnel/Employees

Personnel

• Ownership — exact percentage and names

• Key manager

• Revenue generator.

Employee Perks

• Medical

• Insurance

• Dental

• Bonus

• Spiffs

• 401K

• Annual expectations.

Employee Files

• Employment agreement

• Background check

• MVR (motor vehicle record)

• Employee education

• Other files.

Employment Agreements

• Employment Agreements – list all that exist.

Collective Bargaining Agreements

• Union Contractor?

Drug Testing

• Discuss the importance of having drug tests.

• Can proof of drug tests be supplied?

Employee Handbook

• Does one exist?

Uniform Policy/Dress Code:

• Should be part of the employee manual — does one exists? Is the dress code enforced?

Other

Litigation

• Litigation — schedules of currently pending or threatened litigation, arbitration proceedings and investigations to which the company is a party or its properties are subject

• Employee claims and labor disputes — schedule of all employee claims (including worker’s compensation, employment discrimination, informal labor practices, etc.).

Accounting System

• Document computer system.

Real Property

• Lease information

• Mortgage information

• Maintenance

• Condition — tour facility and make recommendations.

Other

Assumed names – list all assumed or fictitious names used by the company or any of its subsidiaries in the last three years

• Undocumented agreements — list any that exist

• Marketing/distributing agreements — list any that exist

• Association memberships — obtain a schedule of all memberships held by or on behalf of the company in any trade merchants, marketing or professional or industry related organization or association

• Outside experts — list of attorneys, bankers, auditors and any other experts used by the company, including the years used and a description of the relationship

• Appraisals — obtain a copy of all business appraisals in the last five years

• Environmental – advice or opinions previously received from counsel regarding potential environmental liability

• Major markets

• Minor markets

• Professional team — CPA/tax specialist

• Professional team — transactional attorney

Brandon Jacob is recognized industry-wide for his experience and knowledge in valuations, mergers, acquisitions, and the ability to assist contractors in successful exit strategies. He has had numerous industry speaking engagements and multiple articles published, and recently published For What It’s Worth (www.Forwhatitsworthbook.com) a contracting-industry-specific book that explains in detail how to value air conditioning and plumbing businesses. He can be reached at 713/43-8311 or by email at Brandon@contractorscfo.com.