We have seen a significant increase in merger and acquisition (M&A) activity in the closely held manufacturing segment over the past two years. Most of the activity has been on the sell-side, with the increased activity attributed to COVID fatigue and/or fear of tax increases. This has led closely held business owners to decide that the time is right to sell even as they weathered (and in many cases thrived in) the storm and the post-COVID economy.
The M&A activity is expected to continue since investors largely held onto their liquid assets during the pandemic in order to be more conservative as the market fluctuated. As business gets back to normal, investors have capital to spend which makes for a promising 2022 outlook. Companies that continue to struggle in the wake of the pandemic will drive further deals, especially as the government continues to phase out support in the coming months. Finally, President Biden’s infrastructure bill could also provide $1 trillion in spending over five years which will make manufacturing more appealing to investors looking to acquire companies involved in infrastructure projects.
Most M&A deals go through a number of steps (quality of earnings, value negotiation, due diligence, etc.) involving a team of accountants, lawyers, and potential buyers analyzing the business through careful assessment of everything from financial records to contracts to intellectual property. Therefore, even if “you are not for sale”, it is critical to understand the process and plan now to avoid the common mistakes that we see in M&A transactions.
Common transaction mistakes and solutions for avoiding them:
Mistake #1 – Failure to manage the business like you are for sale (even if you are not)
The price paid for the business in most transactions is based on historical and projected earnings. What is often misunderstood by business owners is that, upon sale, an adequate amount of working capital (think accounts receivable, inventory, and related payables) needs to be left in the business. Adequate can be subjective but is often determined to be the average amount of working capital you had on hand for the past twelve months. Think about that for a moment, have you had excess inventory on hand over the last twelve months? Have you carried some receivables past due? Have you paid payables before they were do? All these things increase the average, and thereby the amount of assets that need to be left in the business at closing. Getting your balance sheet right warrants the same level of attention as your earnings. The process needs to begin well before the transaction is contemplated.
Solution – Critical analysis
Make sure you do an annual “quality” review of your earnings and balance sheet to identify unusual or normalizing circumstances that would impact the price of your business. The analysis should include an assessment of how you manage your working capital and whether the current level is needed to achieve those earnings, and if not, ways to manage to a more appropriate level. The discussion should include how your business price is determined and how deals are structured.
Mistake #2 – Failing to get multiple inputs on value
We consistently see owners who fail to follow a process which would allow them to conclude that they got optimal value for the entity.
Solution – Identify the players and get input
The players could include a valuation expert, investment bankers with relevant industry knowledge, or competitors who have gone through recent transactions. We recommend input from a variety of sources to ensure confidence in the price assigned.
Mistake #3 – Failing to assemble the right team
Your existing CPA and/or attorney may not be the right selection of advisors to get you through a transaction. You need advisors that have significant transaction experience in order to anticipate opportunities as well as issues, so you are guided through the process with limited “surprises”.
Solution – Interview and/or hire experts
The interview process should include multiple investment bankers (even if you decide not to hire one for the transaction), CPAs and law firms/attorneys (M&A, employment, retirement, environmental) that do M&A work.
Mistake #4 – Failing to appreciate the impact of the sale process on the business
The due diligence process is an all-consuming full-time job, and you still need to run your business. Many business owners fail to grasp the magnitude of the effort required, and therefore fail to hire the required resources to accomplish the task.
Solution – Consider a qualified investment banker
The role of a “qualified” investment banker is not limited to assignment of value and finding a buyer. A significant portion of the value they deliver is “managing the due diligence process” to forward pace and minimize the impact on the management team. Going it alone can be daunting.
Assuming you avoid the mistakes, there is still more to do to get ready for a transaction.
It is important to get organized in anticipation of a transaction. Here are just a few questions to ask yourself (and your advisors):
- What is a “Quality of Earnings” report?
- What is the difference between selling my equity or selling the assets of the business?
- Does my choice of entity type impact the sale? (Corporation; Limited Liability Company, etc.)
- Do I file tax returns in every state where I have “nexus”?
- Do I collect sales tax exemption certificates from my customers?
- Am I registered to do business in the appropriate states?
- Are my legal records ready for due diligence?
- Do my customer contracts have change of control provisions?
- How does my Phase I Environmental Site Assessment impact the sale/protect me?
- What are reps and warranties?
Ultimately, by taking time to evaluate these critical questions and avoiding common due diligence mistakes, you take an important step in ensuring a smooth transaction. If you have any questions about transactions and the due diligence process, please reach out.