Used Car Salesmen and Business Brokers
When used car lots put lipstick on a pig, they have a bunch of ways to make it seem like you are getting a good deal. Some go so far as to add sawdust to the transmission, extra heavyweight oil to the engine, or resetting the engine’s trouble light. They also have other tricks. For example, like running a CARFAX and when it comes back clean with no accidents, they tell you it has been in no accidents. Now, the reality is that a good deal of used cars that make it to the used car lots, have been in unreported accidents. A clever observer can look at the fender bolts and see paint missing, or look at panel spacing and see it isn’t perfect. A sophisticated observer can take a paint thickness detector pen and test the paint on the car.
These buyers can observe and dodge the lemons, which leaves the not so clever or observant buyer with a higher percentage of lemons. For $20 one can buy a paint detector pen on Amazon. With this tool, a not so clever car buyer can have a better chance of buying a good used car, but it took knowledge of the existence of the tool. How does this analogy apply to business acquisition?
The same is true with brokers and businesses. They have all kinds of ways to make the businesses they sell appear to be highly desirable, and if the buyer is not clever, observant, or sophisticated they end up with a much higher percentage of lemons. Of course, just like the used car dealer they want to present their best foot forward, and minimize the negative aspects, which, I think, is only natural. But just as there are unscrupulous used car dealers, there are also unscrupulous business brokers. And just as there are some great honest used car dealers, there are also great honest business brokers.
As an example, I recently reviewed a small manufacturing business that was doing $1.6M in revenue with a listed cashflow of $500K. They were asking a reasonable $1.5M for the business. It had under 10 employees and really fit well within my desired geography, if not my industry focus. While at the bottom end of my desired earnings, it was priced correctly at 3x SDE. Once I received the details, I found the add backs where over $500K, so it had actually been negative in tax reported income. Yet, some of those add backs were totally legitimate, such as the retiring president’s salary, and the Private Equity fee, who were the owners. Those add backs were about $300K. What seems to me to be out of the normal was a sales person and an accountant were both added back. They claimed these folks were not needed or helpful and only brought in by the private equity group for their own purposes, and as such didn’t add to the bottom line. Well, I am glad they made that determination, but from my risk perspective that is a judgment call they don’t get to make.
Imagine I buy this business only to find out that those two were doing work that must get done. I would certainly have to pay for accounting, but maybe only on a part-time basis or more than likely outsource this function. This would likely cost less than a full-time accountant, and result in some additional SDE. As for the sales person, I am sure I would either have to pick up that duty or hire someone because if they truly were not adding any value, why were they on the books for at least 2 years? Am I to believe that a sophisticated private equity group is in the business of paying for staff they don’t need? Suddenly, these “saving” would be largely gone and further, since I would be buying with a highly leveraged loan, I also would have debt service. It could put me in a position where I wouldn’t even be able to pay myself a salary.
Further, they added back their CRM cost and then credited about 1/10th of that price toward the CRM of my choosing. That was mighty nice of them to help me save money, oh wait I would be paying for these savings in the asking multiple. The other fun thing that they mentioned is the only innovator that created the products is the retiring president. What this would mean for me is that they either I would have to stick with the current product offering and hope no supply issue or regulation gets in the way of making them, or hire an innovator with specific knowledge that I don’t have.
Essentially, if this was priced at 3x of what I consider to be the correct seller discretionary earnings (SDE) of approximately $330K for a total of approximately $1M instead of $1.5M, that would be an acceptable price for me to pay. It would still be a pretty big risk not having the knowledge to innovate, but one that might be worth it. I could put in what might be considered a low ball offer, and hope the sellers accept. But, early on I had looked at a $330K SDE business and determine it was too little for the debt payment and risk, which would also leave me with no money to grow the company. This is why I set my minimum to $500K in SDE, but my desired goal is north of $1M in SDE.
What I learned from this exercise and frankly writing up this analogy, is that I either have to be clever, observant, or sophisticated. My wife says there is not much chance of me becoming sophisticated, so that’s out. All kidding aside, I want to avoid investing too much time trying to get sophisticated, but I am looking for tools that enable me to be clever and observant. I would love to get feedback, especially if there is a flaw in my logic, my position is ignorant in some way or completely, or you know of some tools that will help. Please comment below, or shoot me an email: jordan@sleepycreekcapital.com