These days you are more likely to buy into a service-oriented business rather than one in which inventory is involved. The following are a pair of such cases with quite different end results.
Business Case 1
Jerome and Bob had been partners in a sales agency that represented a number of foreign manufacturers of household appliances. Over some twelve years their list of clients and earnings had grown steadily. They carried no inventory and their fixed overhead consisted of a lease on a small office plus the usual utilities. There were no accounts receivable (the manufacturers invoiced the merchants directly), they had no bank loan and no liabilities. The agency's annual earnings were in the seven-figure range.
Wishing to go their separate ways the partners agreed that it was time to cash-out. What they offered for sale was an established and profitable sales agency. The asking price was three times annual earnings (before taxes)—not an unreasonable price for a company showing steady growth. The purchaser however, would be paying cash for a firm with zero assets.
I asked Jerome if his accounting records would verify the claim of the seven-figure profit and he affirmed that they would. Personally, I was skeptical that anyone would lay out this kind of money for a firm with no tangible assets except for the track record and connections of the two partners. Jerome and Bob were prepared to stay on for a year or two in order to provide continuity. Incredibly, via a broker friend, I found someone who showed a keen interest in the deal—a corporate lawyer. The man sat on the board of a bank and several public companies and apparently felt that it would be “cool” to have a profitable company all to himself.
Preliminary negotiations over price done, the due diligence process kicked in. The purchaser engaged a senior partner in one of the “Big Four” accounting firms who promptly sent a team of two to go through the company's records. The procedure, which took nearly three months, included contacting major customers. Jerome and Bob were pressed to disclose their personal tax returns in order to verify the firm's bottom line.
Jerome complained to me that the investigation was taking far too long. By then he and Bob had produced all the confidential data, both personal and company, but there was still no definite closing date. "Enough is enough," he bellowed at one point, "I have opened my kimono wide, everything is exposed."
At long last, the accounting team brought in a report. The sales and profit figures matched up 100 percent to the listing statement. There was a further delay of sixty days before the money changed hands as the parties got tax advice.
Business Case 2
Ned and his brother Walter had been anxious to get into some sort of business. In their youth they had been waiters, car salesmen and recently operated a cleaning service. I suggested they talk with Nick, a man with a twenty-five year old business managing residential and commercial properties that been foreclosed on by lenders. Nick's clients were banks and insurance companies. At sixty-nine years of age, he wished to retire.
The brothers looked into the business and found it to be to their liking. The assets consisted of two pick-up trucks and a small warehouse/office. Nick collected rent for his clients, dealt with painters, plumbers, put properties in shape for either rental or sale, and occasionally performed the unpleasant task of evicting a recalcitrant tenant.
The asking price for the business was one and a half years of gross earnings, the appraised value for the vehicles and garage and one hundred cents on the dollar for receivables. As the latter comprised of billings to “AAA”-rated companies, there was no problem. In the next few days Ned and Walter met with some of the clients and quickly decided the business was a potential gold mine.
Nick, they figured, had not taken full advantage of his contacts. The men and women whose job it was to maximize the return on foreclosures or powers of sale (for their institutions), had no personal stake in the properties. Walter felt that by being in closer contact with these people, he could improve the company's overall margin. The price for the business was agreed upon by a handshake and the deal closed within thirty days. The brothers' due diligence consisted of verifying Nick's accounts receivable and tax returns.
In the first case, the high-priced expert team had failed to take into account that times were changing. Direct computer link-ups between manufacturer and retailer have made agents superfluous. The mass merchandisers demanded that the manufacturers eliminate the agency's commission. The commission had become an additional discount. The agency would still function to service smaller accounts but, insofar as the big boys were concerned, the agency's commission was a thing of the past.
Whenever new products were introduced, the manufacturers would fly major buyers to their factories. The buyer would establish an approximate minimum and maximum range of inventory for each outlet and let the computer link-up do the rest. Daily sales figures went directly to the manufacturer who would supply the warehouse with replacement stock based on the parameters set by the buyer. In the 21st century, nearly every large operation has such systems in place.
Inside of a year, it became clear that the new owner was unlikely to ever recover his investment. The due diligence team was out of date on business trends, as was the lawyer.
In the second case, the firm is flourishing. Helped by the ups and downs of the real estate market, defaults on mortgages are not uncommon. The brother's business has grown eight-fold. By offering (gifts) of tickets to high profile sporting events, the boys had their clients' sold on their company and more business was sent their way. The occasional lavish lunch solidified relationships further and also made the clients examine billings less closely. Maintaining cozy relations with clients, Walter and Ned are doing very well indeed.
In the aforementioned cases, in one instance an expensive due diligence team failed to uncover the most important element. In the second case, where the investigation had been minimal, the purchasers had come away smelling like roses.
Manny Drukier has been in business, from manufacturing to publishing, retail to real estate, stocks to stockpots for the past 60 years. He is the author of two books and resides in Toronto, Canada.
