F & A Advisor: Built to last vs. built to sell
By W. Hobson Hogan
ZweigWhite Principal, Investment Banking
I have represented many businesses in M&A processes and I have analyzed both great and not-so-great firms. In all of these M&A processes, I have witnessed some firms (both the great and the not-so-great), make a mistake that cost them dearly— they stopped investing in the business before they went to market. Spending money on something you are not going to have very much longer seems somewhat counterintuitive. How many people run their rental car through the car wash before they return it? (I feel pretty confident that the number is very, very low.) Your firm is not a rental car, though. Even if the time you will hold your ownership in your firm makes it seem as if you own a rental, you must continue to treat your firm as a long-term investment.
Your firm is more than just an asset; it is an entity that could last generations, provided it receives the proper care and feeding. Owners with an eye toward the future make investment decisions that will protect and enhance the value of the firm for the long term. What happens, though, when the owners become short-timers and they begin to think in terms of months, rather than years? Sometimes owners become obsessed with the short-term results and often put off big decisions, table large capital projects, and generally stop doing things to improve the firm for the long haul. This seems like the right thing to do; firms are valued on their free cash flow and any reduction in capital expenditures will increase free cash flow. The problem is that astute buyers can tell when you stopped building your firm for the long term and began to manage cash flow for cash flow’s sake. The buyer will likely subtract the value of investments that you put off from the value of your firm.
Often, the signs of under-investment are obvious: the computer hardware budget gets slashed, training gets curtailed, and the holiday party went from a full bar at the country club to a cash bar in the conference room. From the seller’s perspective, things are good— the income statement looks better and there is more cash to distribute at the end of the year. Things from the buyer’s perspective, though, are a bit different. Buyers are skeptical by nature because they were not there for every business decision and they can’t glean all of the information they require to make an informed decision by tearing apart financials or looking through every file in the seller’s office. Buyers are looking for smoke because, as the old adage says, “Where there’s smoke there’s fire.” Buyers who see smoke but do not find the fire often get fired, so expect them to be diligent. If they see that the firm has begun to stop reinvesting in the business, it could raise issues during the negotiation process.
When a buyer asks for due diligence items, the purpose is twofold: 1) ensure that there are no skeletons in the closet, and 2) get enough information to make a determination of the firm’s future sustainable earnings. In most cases, the buyer will go through an exercise of justifying the cost structure and eliminating redundant costs. After looking through a seller’s disclosure, if a buyer begins to pick up on a trend of under-investment, then they will begin to dig deeper into the issue. Sometimes this practice will paint the entire deal in a bad light or it will cause the buyer to make assumptions about other costs that will hurt the seller’s value. In order to combat this negativity, the seller usually has to provide more information and guidance about what investments were deferred and where the firm may have skimped.
As a banker, I am not always thrilled about having to make lots of projections for the future. First, I never want to temper the enthusiasm of a buyer by undercutting his projections. If the market wants to go crazy, then by all means, let it. As I said before, buyers are naturally skeptical, so if you have a projection, the buyer is likely to move it downward in their projections. Second, as deals wear on, your projections can become negotiating leverage for the buyer in that if you miss a number to the downside, the buyer may want a concession in price. Depending on your buyer, projections can provide them with additional ammunition for a last-minute re-trade.
So, what’s the moral of the story? Keep running your business as you always do; invest for its future. Make prudent decisions that enhance the skills and capability of your people. A business decision should not come down to choosing between doing what’s right for the sale and what’s right for the business. In most cases, doing what’s right for the business will also be the right decision for the sale process. Buyers are, after all, buying for the long haul; any decision that hurts their thesis is counterproductive.