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Why the motto ‘Be Prepared’ applies to your business

August 2, 2018

By Martha Sullivan, CPA, CVA/ABV, CM&AA, CEPA
Partner, Succession Planning Practice Leader

    Martha leads HK’s succession and exit planning services division and is a regular contributor to Wisconsin’s InBusiness digital magazine.

    No doubt you’ve heard the motto “Be Prepared.” “Be Prepared” urges you to be ready to do the right thing at the right moment, always. The motto holds water in all aspects of our lives, whether or not you were a Scout at some point in your life.

    As a business owner, this is true for your business, as well, so that you and your company are ready to handle whatever opportunities or issues that arise.  The consequences of not living up to “Be Prepared” can be significant. I’m working with a client looking to acquire a manufacturing company and this hit home in a striking example this past month.

    The target manufacturing company has a unique place in its market, a good team of employees, and many things a buyer might be interested in. The owner has lost interest in the business. He has other pursuits that he wants to be involved with, so he is ready to sell.

    A deal has been struck, and both buyer and seller are looking forward and motivated to close the transaction soon. Unfortunately, the target close date will be delayed due to the seller’s lack of a “Be Prepared” attitude. As you’ll see, some of the preparedness issues will cost the parties in time delays and opportunity cost. Other issues may directly impact the economics of the deal. Consider the following issues, all of which could have been avoided:

    State of the inventory records

    The seller runs his inventory system through a series of Excel spreadsheets, performing a periodic physical inventory. There is no integration between an accounting module in the accounting software and the spreadsheets. The Excel spreadsheets do not reconcile with the numbers reported in the financial statements by six figures. The balance sheet is overstated.In a deal that has a working capital target to be met, this is problematic. It also calls into question the accuracy of the historical financial reporting. Where did the other side of the error land? If it is in the income statement, the entire earnings before interest, taxes, depreciation, and amortization number is off, which is then magnified by the multiple. This will give any buyer pause and cause them to reconsider their purchase price.

    State of fixed asset records

    The shop floor houses many different pieces of manufacturing equipment, all of which are being purchased by the buyer. Two weeks before the scheduled close date, the seller realized that there were items on the shop floor that were not included in his fixed asset records despite the fact that the items had been used for a number of years. There were also pieces of machinery and other capitalized items that were in the records and on the balance sheet that were no longer in use and had been disposed of. Lastly, there is a major piece of equipment that the seller believed had been fully depreciated but actually had not been depreciated at all. Hundreds of thousands of dollars are entangled in these fixed assets issues.The buyer is purchasing the assets. The lack of accuracy in this area is a big deal, particularly when it comes to knowing what is really there, what’s being purchased, and assigning a fair market value to the equipment in the purchase price allocation.

    Availability of key legal documentation

    When a transaction is an asset deal, the seller’s contracts and agreements don’t naturally flow to the buyer. Each agreement needs to be reviewed for its change of ownership clause so that steps can be taken to ensure relationships and rights are transferable and can be transitioned in the most effective and efficient manner possible. In the event an agreement can’t be transferred, the buyer needs to know this up front so that arrangements can be made, or other steps taken. In this particular deal, no documents have been provided for review. It’s unknown as to why — is it because there aren’t agreements (which is unlikely given the nature of the customers involved) or is it that the records are in disarray and not easily retrieved, organized, and delivered? Whatever the reason, it does not bode well for the deal.

    Further, the seller was involved with a transaction several years ago that has a direct impact on the rights surrounding intellectual property. The buyer rightfully wants to have confidence that the intellectual assets he is purchasing are unencumbered and has asked for counsel to review the legal documents associated with this prior transaction. The seller can’t find the document. The attorney that handled the transaction retired.  The deal will not get done without this review.There is now, two weeks prior to close, a scramble underway to track down executed copies of documents. Without clarity around the intellectual capital, and transferability of customer and other agreements, the whole deal could blow up.

    Suffice it to say that both the buyer and the seller are feeling pretty stressed right now. They want to close but the numbers are like butter on a roasted ear of corn at the Sun Prairie Sweet Corn Festival. The legal review issue hangs heavy like rain clouds, threatening to close down the whole festival, and it all could have been avoided with a bit more of the seller’s due care, attention to detail, and organization day in and day out. The actions he could have taken are straightforward:

    Internal accounting records

    The accounting issues described above are not complicated at all. They are “Accounting 101.” The fact of the matter is that the person the seller has doing their bookkeeping isn’t well trained in accounting. The seller was aware that there were limitations but accounting wasn’t his priority.Choose good people that fit the role. Train them. Stay involved until you have confidence that they are up to the task and your information is good. Then still stay involved at some level.

    Good advisors

    The seller’s outside accountant, who should have been on top of these issues, wasn’t paying sufficient attention either. They maintained the fixed asset records. The variance between the support for the inventory balances and the balance sheet was easily identifiable. Both errors could have been fixed.Make sure you are a good fit for the advisor’s wheelhouse of clients and don’t get lost in their shuffle. Ask for their input on the state of your records and how you can improve. If they aren’t doing the job you need and striving to help you succeed, perhaps you need a different advisor.

    Get organized

    In other blog posts, we’ve mentioned the importance of good documentation of systems and information. The above scenario is a clear example of how the rubber hits the road and why it is important. Keep and store your business and legal records in an organized manner. Document your intellectual capital — i.e., systems, procedures, trademarks, patents, etc. Yes, it’s a pain, but do it anyway.

    Time will tell how this all shakes out for this particular buyer and seller. They are still both working to do the right thing at the right moment, but it sure would’ve been a lot smoother, with less negotiating and re-pricing, if the seller had been prepared.

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