How much is too much "hair" on a deal?
July 27, 2020
by a searcher from New York University in Los Angeles, CA, USA
Background
We found an operation that looks good from a qualitative perspective. We've been trying to do as much diligence "in-house" before paying accountants to review financials. The deal is under $10m in revenue and around $2m in recast EBITDA. Pending deeper diligence, we verbally agreed, to a purchase price of $9-10m.
The "Hair"
The seller doesn't use an accountant for anything but taxes and isn't using a broker to sell. He has been acting as his own accountant (he has an engineering background.)
Accounting wise, the seller does some of the "standard" stuff such as funneling some of his personal expenses through the operation and artificially manipulating some numbers for tax savings. He has been honest about all of this and has been cleaning the books up to prep for a sale. All small from a dollar perspective.
When he bought the business from the previous owner, he did take a seller finance note that somehow ended up becoming an "investment" on his balance sheet. It now represents, 31% of his total assets and we are not sure why it wasn't written off or amortized as goodwill. He is now saying it should be "capital" but that still doesn't make sense. I don't think the seller is being malicious. I just think he doesn't know and we've been acting like his "broker," by trying to make sense of his financials. We can submit a vague LOI covering us for these terms and start reviewing more documents but some of these issues may cause us to substantially lower the price we said we COULD pay him and waste a lot of time.
Thoughts?
Like most first time searchers, I am not experienced enough to know how much "hair" is too much, so I wanted to get the community's thoughts here. At this revenue size, I don't expect business in this industry to be perfect. I am thinking about prioritizing the high dollar issues first (i.e. prior seller finance,) address them via clauses in our LOI, and see if we can make sense of it once the seller starts sending us more information post LOI. At the same time, I don't want to send in accountants too early.
Does anyone have any thoughts here? How much "hair" is too much?
from University of Pennsylvania in Miami, FL, USA
Per Dan, you need to do a QofE. You may be able to get the Seller to pay, but you may also offer to split 50/50 with him - coaching him that it will be needed for any buyer. Likely to cost $15-20K. Probably only need a workbook and not a full report unless there are many abnormalities.
Also- welcome to the search world. Unfortunately, it is not a no risk world. I went through complete diligence last year as a self funded searcher - qofe, legal, etc. and pulled out last minute due to something I found in diligence. Sometimes you win, and sometimes you win by not doing a deal. Dive in...spend some $$$, get dirty, gain experience and have some fun!
from University of Virginia in New York, NY, USA
1) Base valuation on a multiple of mutually agreed upon EBITDA and discuss what happens if it is determined that it is lower than expected
2) Add a clause in LOI that if EBITDA is materially lower than represented that seller is on the hook for cost of QofE - if seller balks you have your answer
3) seller is no dummy even if he gives the impression otherwise. I suspect he doesn't think you are either as he wouldn't be as forthcoming about tax issues which opens him up to liability if things get ugly.
Sounds like seller is commercial and looking to make a deal.
Good luck