You don’t get what you deserve, you get what you earn.

It’s said a deal will likely die three times before it closes…or, before it dies. There are many factors within a case that can kill it. PEGs in the lower middle market will look at 100-150 potential deals in a year, request 20 books and move forward with maybe 2-3 deals. Equity capital from investors must be put to work, but they’re not going to take unnecessary risks for the sake of closing a deal. Putting that money to work creates a liability, and PEGs won’t invest foolishly. They went to business school, and they know how to run a case study. They identify as many risks as possible through the never-ending proctology exam called due diligence. Here are seven of the most common deal killers – there are many more, too!

Deal Killer #1 Customer Concentration

We often find companies that have a taproot customer generating 30%, 50% and sometimes 80% of a company’s revenues. The dialog is always the same, “…we’ve been doing business with them for over 30 years…” We get it! From your perspective, everything’s been rainbows and unicorns forever. At some point, someone at your customer will retire, leave or be terminated and things will change. Let’s call this situ an external factor. You get things done (the internal factors) and no one’s better than you at that. However, what’s preventing you from preparing for and mitigating the potential external factors impacting your revenue, your bottom line, etc.? It’s never a question of ‘if’, it’s about ‘when’.

Customer concentration presents many different issues you might not even think about. When you take on a process, working capital is a huge component of your transaction. What are you going to do when one of your larger vendors demands their terms be changed from net 30 to net 90? Do the math! If 50% of your revenues come from one customer, or 50% of your purchases come from one vendor, then you’re screwed; it’s a significant cash hit. Most PEGs will scrutinize and ask questions of your top 5-25 customers. Many of the PEGs we work with understand “this is normal” for business owners. They want you to be honest and humble about where you are so they can be creative and flexible to structure a deal that’s mutually beneficial.

PEGs won’t move forward if your CC is 50% and above and have zero interest in combating that anomaly. Strategics take a different approach. Some will simply lower their price offering, and others will be more concerned with customer overlap than concentration. Your option is the buyer backs down the revenues from that customer to create a proforma where that customer only has 25% or less of the revenues. It’s obviously a major hit to earnings and thus the valuation for the business. Another option would be having a contingent payout.

If the buyer can’t reduce the customer concentration over time the next buyer is going to have the same issues. It’s not just about making sure the buyer keeps the customer for the next three years. It’s making sure the buyer keeps the customer for the next three years and being able to build out the other customers – add new customers so the customer concentration is favorably reduced to a more manageable level. PEGs have levers to pull to reduce imbalanced concentrations by purchasing like or adjacent company’s where they could blend the revenues and the other customers of that acquired company. They’re also going to look at customers by location and for each legacy company to see the facility or a particular location of the concentration.

Deal Killer #2 Age of the Owner

Most of our clients are 55+ and many are 60-70 having been in the game for +30 years. Some of you have enough energy for the 4th quarter and some of you have been done for years. To many of our clients’ surprise, they think once the business is sold, they can sail off into the sunset. You will need to stick around guiding the buyer through a transition period. Most deal structures will have you be a part of the new company for a couple of years in either a rollover equity and/or an earnout situation to achieve the dollar amount you want. At this stage of life, we know you’re tired and would prefer to sail off into the sunset.

If a buyer gives you $30MM tomorrow, then you’re not the same person. If that same buyer purchases your business and you leave, they have to hire someone because they’re not operators, and there’s no one sitting on the bench waiting for a deal to occur at the PEG. They don’t know what you know! You’ve been the head of a successful company for decades. Once you sell your life’s work, you will become an employee. For many business owners, that’s more than a bitter pill to swallow. Countless times we’ve watched owners sabotage themselves and future earnings of the deal by not behaving like the successful owner they were prior to the sale. There are three mindset shifts of an entrepreneur:

• a courageous owner who’ll do whatever it takes to become successful,
  
  
• moving from a business owner to a business seller, and
  
  
• finally moving from a successful seller to a successful bridge builder

to earn that second bite of the apple. Age is a big factor in a successful deal versus a deal that dies. Financial buyers are experts at buying successful businesses. They wake up thinking about buying businesses, and they know what someone your age is going to do once they receive the wire. It’s your job to not be that foregone conclusion.

Deal Killer #3 Cyclicality

Many of our clients are a part of an industry that experiences results reflective of the broader economic cycles. The easiest one to talk about is the construction industry. We all know construction rides a rollercoaster every 5-7 years; it goes up and down it’s a bellwether for the economy. It’s why construction is typically not of interest to most private equity firms. Now there are some construction-oriented PEGs it’s important to, but it’s also challenging for them as they generate a lot of money. There’s billionaire construction industry and associated company owners and CEOs walking around. These folks are the ones flying around on Gulfstreams. The problem is there will be downturn periods and as a buyer, you don’t know when they’re going to happen.

Some PEGs will base their valuation of the company on what we think that bottom might be. So, what can you do if you’re in a similar cyclical situation? Over the last few years transforming construction related businesses has been the darling of private equity. If new construction is hot, then remodeling and repair usually isn’t and vice versa. Unless…you reengineer your business model to create annual recurring revenue. Enter HVAC and Landscaping businesses for example. The ARR service contract model levels out the rollercoaster by securing subscription-based services delivering overhead cover and incrementally growing revenues with high margins. What used to be a commercial and residential HVAC contractor focused on new construction is now focused on the R&R segment implementing service contracts where customers pay a monthly or quarterly basis for the security or the insurance of being able to call Mr. HVAC if anything happens to their system.

We aren’t necessarily reinventing your life’s work to build something valuable. We’re adapting the business to appeal to the end user where it makes the most sense for them. In this case, you’re selling peace of mind. By going about business, a little bit differently to mitigate the cyclical risk owners and entrepreneurs can leverage a revenue stream making their business more attractive to buyers.

Deal Killer #4 Business Size

Many sellers think their business will be attractive to private equity or a buyer because of their capabilities. If it doesn’t hit certain size requirements, then the business is a non-starter for private equity and other types of buyers. Some owners will overstate how large their business is. We might be having a conversation with a potential seller and tell them what gets us excited are companies with $20MM or more revenues with a $3MM or more EBITDA. Many of these same owners will say “I’m not quite there yet, but you know I’m pretty close.” As we transition to having more strategic conversations we’ll ask, ‘What does ‘pretty close’ mean exactly?’ The conversation rolls on…“…we’re only running one shift…if you want to run 3 shifts, we could triple the business overnight!” (insert face palm here) So, you have that much backlog AND you have that many employees you could hire overnight to support three shifts and triple your business. That’s amazing!

The sad truth is business owners base their estimate or their desired value off what the business could do! In many cases, the business in its current state is actually worth more to the owner than it is to any outsider because they’re acutely aware of its risks. The business could be in an inflection point. A buyer may perceive the business as too risky whereas the owner understands the risk and they understand the potential. Maybe a good analogy is that of a used car. If you’re selling your used car to someone you know how often it’s serviced, you know how many times it broke down, you know if the battery ever died in the winter. You know how reliable your car is, and you’re comfortable with its risks. You’ve owned your car for a while and you’re comfortable with its risks. It’s the same in buying and selling a business.

 

Deal Killer #5 Creative Accounting

What is creative accounting? It could be sloppy accounting, non-GAAP accounting, cash-based accounting; there are a lot of different flavors and varieties. Sometimes it simply includes a seller with a lot of personal expenses running through the business. We’ve seen mortgages, luxury trips, grocery bills, and a deceased brother-in-law on payroll on company income statements. If the seller wants a benefit for the add back, they need to be able to track that dollar figure. In certain circumstances where appropriate, we’ll perform a quality of earnings report (QofE) to get a realistic expectation of earnings going forward.

The most egregious example we uncovered was a company reporting around $3MM EBITDA. How they got to three million was absurd – assuming their customers were going to continue buying at the same pace, renewed to 80% and stuck around for four years. They reported a historical trend for their current EBITDA period. The sellers were expecting to be in the $15-$25MM range was decimated closer to $2MM. What it did was raise flags about every other area of the business and at the end of the day it was absolutely a deal killer .

There’s a psychological phenomenon that happens every time inside a seller’s mind. They see a headline number of $20MM, $50MM whatever that number might be AND THAT becomes the number a seller wants. Let’s say the QofE suggests the enterprise is $4MM instead of $5MM and keeping the multiple at 5X; let’s follow the math. Instead of $25MM, the seller would get $20MM. Sometimes the seller would be okay with the $20MM, but in our experience the seller can’t get off the $25MM figure.

Deal Killer #6 Off Balance Sheet Liabilities

What’s an example of an off-balance sheet liability? Any liability, not necessarily financial, a buyer might be required to pay if certain events you might or might not know about. An example we’ve worked on that had about $5MM Adjusted EBITDA. Their tax returns and some of their internal unadjusted statements showed earnings of somewhere in the $3MM range tax liability. That’s a $2MM difference between their actual earnings and what they’re reporting as taxable income. Is this legal? Is this allowable?

Well… in our experience it’s usually not, because the seller doesn’t want to pay taxes. If Uncle Sam wants his cash, he’s going to get his cash, one way or another. Uncle Sam will also be very interested in you once you sell your life’s work. There’s some pretty scary successor liability laws out there. Successor liability means if you take over a business that operates largely in the same way as it did prior to a transaction you are what’s considered a successor even if it’s an asset sale, and it’s not a completely cut and dried situation. You can’t scribble what you want in the contract and specify the buyer is not assuming any liabilities.

The government doesn’t care what your purchase agreement says they’re coming after the NewCo buyer, because you’re the one with the pockets that just bought the business. The solution – don’t lie! Either come to terms that you’re going to have to pay income taxes on your business or you’re going to have to escrow a certain amount of the proceeds to make sure your buyer feels confident to any potential successor liability has been covered. We are proponents of reps and warranties insurance for sellers to make to buyers and vice versa. There’s not enough time to get into RWI, caps and baskets, indemnity and clawbacks.

Other off-balance sheet liabilities can involve employee interactions whether that’s sexual harassment, a claim an employee makes against the employer, unsafe working conditions, etc. We know in many states it’s wise to obtain a tax clearance certificate from the state before you close and there’s a lot of liability there as well. Part of the diligence process will be a legal due diligence to identify any past litigation, ongoing litigation or areas where there might be an issue.

 

As your advisor, we’re trying to get you to the closing table and there’s thousands of different areas you’re focusing on and sometimes there may be an issue that falls through the cracks. It’s usually an issue the owner doesn’t want to deal with. Think about it this way; imagine you can slip something by Scott and the team sweep it under the rug. Your sell side attorney probably covered that crack with a knowledge qualifier in the purchase agreement. However, the underlying concept is if something happens on your watch, then you’re responsible for it even if you don’t know about it.

There’re dozens of deal killers and some are more threatening than others depending on the buyer and buyer type. When a client decides to invite us to assess their business and what lies ahead in a sales process, we’re going to walk through the 7 major workstreams of a process to give you a heads-up as to what’s coming if unaddressed. Much of that forward work can be implemented by you and your team.

After you start a business, you almost need to start thinking about the exit immediately because that’s how long of a mindset you really need if you’re going to command the highest dollar amount and the best deal structure for you and your family. And for many of you that was +30 year ago or more. It’s time to stop kicking the can down the road and tighten that chin strap for one more quarter.