Buying A Business with David Barnett | E096

What to consider when buying a business.

On today's episode, Jason Pereira is going to talk to David Barnett, he is a private transaction advisor. Today he is going to specifically talk about acquisitions, but not from the seller's point of view, but from the buyer's point of view. David works with people who are looking at doing the purchase or sale of small businesses. He is a former business broker, but he does not act as a business broker today. He simply works in an advisory or consulting role.

Episode Highlights:

2.30: David says that he works with business owners who realize it might be faster and easier to grow through acquisition. Another pool of buyers are people who work someplace and don't like it and typically these people are sort of in the Middle age group where they have got mortgages and families and maybe children and they realize that if they want to pursue their entrepreneurial dream the risks of a startup may just be too great, but if they buy a business, they can become an entrepreneur without the risk of starting up.
2.44: As per David the third group would be the people who need an income and for whatever reason face barriers to employment and these would be a lot of professional people moving to the country for the first time. Maybe their professional designations aren't recognized here, and they need to earn some money and one of the few opportunities that really offers, you know, the wide field of opportunity is business ownership and entrepreneurship.
04.02: For a lot of these businesses especially the smaller ones most of these businesses are owner managed companies, says David.
04.40: For a lot of these smaller businesses, the buyer is going to be looking at the type of business that they want to acquire. They are going to be examining things like their own skill set and the things that they know and their experience in the past and they are going to try to leverage that into some sort of advantage in deciding what kind of business that they are going to go and look for, says David.
06.04: In the world of acquiring businesses, we often hear about EBITDA earnings before interest, taxes, depreciation, and amortization. We hear about EBITDA multiples, and in the mid-market space people toss around ideas of what businesses are worth various multiples 4,5,6 times or what have you. In the world of main street businesses, we use a different level of cash flow is called SDE - Sellers Discretionary Earnings and it is the total amount of cash flow available to an owner manager who works full time in the business.
7.57: The reason why people buy a business isn't entirely about money, says David.
10.23: Talking about selling of franchise to another franchise David says that there is a lot in franchises where someone will offer their franchise for sale to another franchise in the same network in a different place. And these deals are made through personal networks where people try to find a buyer.
11.29: Everyone can see businesses all the people in the public know that a business is there, but business owners cannot identify people. You might want to buy them or out in the public. And so those people who are interested in buying are given a type of business, if they go and reach out to those business owners, they can identify themselves and make themselves visible. It's a very labor-intensive process, says David.
12.25: When you are trying to sell a house, you put a sign on them on, but when you are trying to sell a business, you can't tell anyone. Because all of your different stakeholder groups could react negatively if they find out a business is up for sale says David.
14.36: If you double the size of your business by buying an equally sized company in another city and you double your volume of purchasing, you might not increase sales, you might not increase margins, but you might be able to increase your leverage with suppliers.
17.06: At times people think that they can turn over their accounts or can only provide the financials. They can't turn around and explain everything that people are asking for in terms of operations, says Jason.
18.46: When there is momentum in the transaction, when the buyer is eager and they want to make a deal, it benefits the seller to be ready to feed that desire with all the information they're looking for so that you can move quickly.
19.06: For a lot of bigger companies, you have got more management capacity, you have got more formalized systems, you have got better depth of information, you have internal management systems, ERP's, all that kind of thing. And so, you can actually do a very good due diligence process and be reasonably sure what it is you're buying, says David.
22.01: If the seller believes that the future is far brighter for the business and the buyer does, then they might both agree to make part of the ultimate price contingent upon future performance.
25.02: The reason someone is buying the business, the reason someone is going to be willing to pay some amount of money towards the goodwill that's been built into the business, is because they want to avoid the risk of a startup, says David.
29.46: Buyer needs to be aware that the information will never be complete and that you have to be comfortable knowing that you are not going to get everything that you want. It also would be comfortable with the fact that the information may be erroneous, and it's not because anyone trying to fool you, says David.
31.02: When you go to do the due diligence on that business, what you do is you, you check the bank statements to make sure the deposits are all correct and then you go through the box of invoices from all the suppliers, and you add them all up and you compare it to your income statement. If it looks kind of closely then you can be reasonably certain that the financial statements are likely close, but they are never exactly correct.
32.05: Most of the though tend to be people that are coming from some kind of background, usually in a larger organization where they have learned some kind of management skills and those people are going to be able to take that business once they learn how to run the day-to-day, then they are going to be able to step back and really create some operational systems efficiency, some better processes.

3 Key Points:

David explains the details between EBITDA (Earnings Before Interest, Taxes, Depreciation, And Amortization) and SDE (Sellers Discretionary Earnings).
David talks about the factors that prompt a seller to sell their business.
David shares how a buyer has to be ready to be able to deal with the unknowns and a lot of the times those unknowns are managed through the structure of the deal.

Tweetable Quotes:

"For the smaller businesses, a lot of these sellers are still. In that day-to-day management role and it's not necessarily to their detriment because a lot of the buyers while they're looking to invest by buying a business, they are also looking to acquire a job." - David
"Economics of buying a job is different than the economics of - hey I have got an enterprise already in place I am buying your client list right at you know will be preferred to as a strategic buyer." - Jason
"The best estimates though are that only about one in five businesses trade hands through an intermediary in the Main St space, so the majority of businesses are not changing hands in that way. What tends to happen is that a seller will become motivated to want to sell their business because of some kind of personal situation in their life. The top ones are burnout, boredom and fatigue, divorce, poor health, need to relocate, the last one being retirement." - David
"I have also had clients who have mailed out letters in more than two years later, people have picked up the phone and reached back out to them." - David
"If there are two companies in the same industry in the same town competing with each other and one finds out the others for sale, they would actually have a market advantage in letting that information leak. And so, it's very unlikely actually that two direct competitors will talk to each other about a potential acquisition." - David
"A properly prepared buyer knows that there are always going to be these unknowns within the diligence." – David
"If it turns out that the seller was saying certain things about the business, and it turns out after the fact to be untrue, the buyer has an opportunity to basically rewrite the deal after the fact because it turned out that the information provided didn't tell the whole story." - David

Resources Mentioned:

Facebook – Jason Pereira's Facebook
LinkedIn – Jason Pereira's LinkedIn

Full Transcript;

Producer: Welcome to the Financial Planning for Canadian Business Owners podcast. You will hear about industry insights with award-winning financial planner and entrepreneur, Jason Pereira. Through the interviews with different experts, with their stories and advice, you will learn how you can navigate the challenges of being an entrepreneur, plan for success and make the most of your business and life. And now, your host, Jason Pereira.

Jason Pereira: Hello and welcome. Here on the show with David Barnett. He's a private transaction adviser, and I brought him on the show specifically to talk about acquisitions, but not from the seller's point of view which we carry multiple times but from the buyer's point of view. And with that, here's my interview with David. David, thanks for taking the time today.

David Barnett: Hey, Jason, thanks for having me on.

Jason Pereira: My pleasure. So David, tell us a little bit about what it is you do.

David Barnett: Sure. So I work with people who are looking at doing the purchase or sale of small businesses, and I'm a former business broker but I do not act as a business broker today. I simply work in an advisory or consulting role for either one of the parties, and the vast majority of my work is with buyers.

Jason Pereira: So we've covered on this podcast several times now the dynamics of selling a business, you know, how you wanna get to maximum enterprise value, how you basically standardize process trying to make yourself a little bit irrelevant to the business so that it's more of something you can sell on the types of buyers. But, you know, when you reached out to me I thought that's funny, I've only ever looked at it from the one angle on this podcast. You know, the second one is, is actually, just the other angle absolutely needs coverage. So let's talk about what it is to basically be a purchaser in a transaction. So first off, let's talk about where these opportunities come from. Um, you know, where do typically business owners end up getting the opportunity to buy another business?

David Barnett: Sure. So buyers fall into a couple of different categories, and the vast majority of the work that I do is what we call, in what we call the Main Street space, which is businesses with cashflows of under half a million, so if you think of **** half a million and lower. Typically where I'm working I straddle that line a little bit and get into some of the bigger ones, but see, we have business owners who realize it might be faster and easier to grow through acquisition, so that's one pool of buyers. Another pool of buyers are people who work someplace and don't like it, and typically, uh, these people are sort of in the middle-aged group where they've got mortgages and families and maybe children and, and they realize that if they wanna pursue their entrepreneurial dream the risks of a startup may just be too great, but if they buy a business they can become an entrepreneur without the risk of starting up because they're gonna get the sales and the revenue and everything right from the moment that they buy the business. And then the third group would be the people who need an income and for whatever reason face barriers to employment, and these would be a lot of professional people moving to the country for the first time, maybe their professional designations aren't recognized here and they need to earn some money, and one of the few opportunities that really offers, you know, a wide field of opportunity is business ownership and entrepreneurship. And so those were, are the three big groups of buyers that I meet.

Jason Pereira: Interesting. And all very different motivations, right? I mean, it seems like it's, uh, as I've always looked at it through my lens but definitely a lot there to unpack given, given different people **** for different things. Do you find those motivations impact everything from what they're looking at to pricing, like how does that have a play into the entire purchase decision?

David Barnett: Yeah, sure. So for a lotta these businesses, especially the, the smaller ones, most of these businesses are owner-managed companies. And you mentioned before about maximizing the value of a business, you wanna make yourself irrelevant, pull yourself out of the process, and as a business gets bigger that becomes possible because you got the cashflow to start bringing in layers of management, middle management, leaders, etc. For the smaller businesses, a lot of these sellers are still in that day-to-day management role, and it's not necessarily to their detriment because a lot of the buyers, while they're looking to invest by buying a business, they are also looking to acquire a job, so they know that when they make the acquisition that they're going to step into that role and become the person that runs it day to day. So the strategic acquirer, the person who's trying to grow through acquisition, that would be the exception to this. They're looking at growing their existing business by buying another one. But for a lot of these smaller businesses, the buyer is going to be looking at the type of business that they want to acquire, and they're gonna be examining things like their own skillset and the things that they know and their experience in the past, and they're gonna try to leverage that into some sort of advantage in deciding what kind of business that they're gonna go and look for. If you just think about someone who has some sort of experience in engineering or construction or building and they're gonna go out and try to find a business related to those fields.

Jason Pereira: Yeah, that does impact the economics of it, right? I mean, we discussed this, and we're kind of off the topic, I thought it would be starting out but nevertheless important. We discussed this previously when it comes to types of buyers, right? The economics of buying a job are different than the economics of hey, I've got an enterprise already in place, I am buying your client, you know, what we refer to as a strategic buyer. You know, someone's already got the infrastructure and frankly they don't need everything else, right. They could, they could basically just buy your, buy the business, throw that on the top of their, of their, uh, income statement and most of it floats to the bottom. Uh, talk to me how that impacts – do you think that there's a, there's a, there's an issue regarding pricing in, between those two groups or is that something you're seeing a lot of, are people overpaying? You know, I'm wondering how that impacts everything.

David Barnett: Yeah, sure. So it's a, it's a different kinda mentality, and in the, you know, in the world of acquiring businesses we often hear about EBITDA earnings before interest, taxes, depreciation and amortization. We hear about EBITDA multiples, and in the mid-market space people toss around ideas of what businesses are worth, various multiples four, five, six times or what have you. In the world of Main Street businesses we use a different level of cashflow, it's called SDE, seller's discretionary earnings, and it is the total amount of cashflow available to an owner, an owner, um, manager who works full time in the business. And so out of that SDE money, it's not the money that goes in the person's pocket, this is the money they control, and so out of that SDE cashflow that owner/manager has to take home money to support their family, you have to pay the taxes in the business, they have to take care of any cap ex so, because depreciation and amortization have been added back so they gotta take care of any kind of equipment renewal and that kind of stuff out of the SDE. They also need to take care of debt service, and they need to get some kind of rate of return on the cash that they put in to make the acquisition.

Jason Pereira: Mm hmm.

David Barnett: And so there's a lotta different things that come out of that SDE number, and as a result the multipliers that we see, multiples of SDE, are much lower numbers than in that conversation about EBITDA. So when people are talking about, you know, businesses selling for 3½, 4 times EBITDA, in the world of Main Street businesses we're talking about businesses selling for like 1.7 to 2.2 times that SDE figure. And it's literally a rate of return on a combination of the money you're putting in and your full-time effort as the person who's gonna work there every day. And so a lot of the times when we're looking at the smallest businesses which don't produce that much more of a cashflow beyond what someone could earn in a, in a paid job, then yeah, a lotta people point their finger at that and they say why would you pay money to have that job. I actually had a, a banker at one of the big banks say to me one day, you know, why would this client of yours be willing to pay to basically acquire a job, and I picked up his business card and I said well, how much did you pay for this MBA and didn't you make that investment in order to be able to get a better job. And so it's, it's actually the same kind of thing, you know, if somebody is paying money in order to secure that cashflow so they have a personal income, and their aspirations for what they're gonna do with that business is, is gonna be part of that, you know. The reason why people buy a business isn't entirely about money. A live deal with a lot of **** people who have crazy working hours and they have a lotta stress and they have a lot of day-to-day, uh issues in their employment and their reason for going out and looking at a business to buy is because they wanna make an entire lifestyle change. They wanna do something completely different.

Jason Pereira: Okay. So yeah, definitely a consideration. It's funny, we have a similar metric in the advisor space known as EBOC, Earnings Before Owners Compensation. It's, uh, more widely known in the U.S. than Canada, but nevertheless, it's, uh, basically the same corollary. Okay, so we've identified a business that basically is looking to be bought or could be bought. Now, what's the next step? Well, what is the first step once you've identified them?

David Barnett: So there's a couple of different ways that people find the business that they might wanna buy. So there's the world of business brokerage, so sometimes business owners will go to a business broker and say I wanna sell my business, and those are the people that will help them sell their business, and some of those brokers are gonna have a network of buyers already. So business buyers will go and meet brokers to be put on their lists in hopes of getting things offered to them that might match where it could be like a broadcast email. It might say, you know, we just listed family entertainment center or we just listed a banquet hall or something like that. So that's one avenue. The best estimates though are that only about 1 in 5 businesses trade hands through an intermediary in the Main Street space, so the majority of businesses are not changing hands in that way. What tends to happen is that a seller will become motivated to want to sell their business because of some kind of personal situation in their life. The top ones are burnout, boredom and fatigue, divorce, poor health, the need to relocate and the last one being retirement. And so something will happen and the owner realizes I can't carry on running this business anymore, it's time for me to move on, and they'll then be open to this idea of potentially selling the business. Think about someone who is part of a, a certain industry, and maybe that industry has a trade association or there's a big trade show that happens. Oftentimes a business owner will know other business owners in a similar, in the same industry in other areas, and so this is where the car dealer says hey, you know what, I know the guy who has the same brand car dealership 100 kilometers away, maybe that person will be interested in buying my business because they already know the industry or because of strategic acquisition. So you get a lot of this, particularly in franchises where someone will offer their franchise for sale to another franchisee in the same network in a different place. And so these deals are made through these personal networks where people try to find that, find that buyer. From the flip side, if somebody knows that they wanna buy a business and they've identified a specific industry, some of those people will actually engage in a, in a search where they will go out and actively try to network with the owners of these businesses to try to identify someone who is open to selling. I work with people who are doing this, and it's not uncommon for people to undertake different campaigns, like sending out letters or LinkedIn campaigns or reaching out through phone calls or emails, and sometimes you talk with people who are not interested in selling, but now that the connection's been made, sometimes then you can leverage that connection and meet somebody else. So the business owner meets someone who says hey, do you wanna buy my business? No, but I met this guy who called me, and connections are made in this way. I've also had clients who have mailed out letters and more than 2 years later people have picked up the phone and reached out back to them. You know, they've hung onto that because the difficulty in the marketplace, Jason, is that everyone can see the businesses. All the people in the public know that a business is there, but business owners cannot identify people who might wanna buy them who are out in the public, and so those people who are interested in buying a given type of business, if they go and reach out to those business owners they can identify themselves and make themselves visible. It's a very labor-intensive process. I liken it to a sales methodology. You know, if you were representing a certain kind of piece of equipment, you'd have to identify who might wanna buy this. Go out there, create relationships, and for some people it can take years to, to find that opportunity.

Jason Pereira: I mean, I think also the, uh, you know, there's, and you kinda hit upon it, the networking aspect of this all, especially if you're in a certain industry. Most people know they're competitors, I mean, depending on this, their concentration ****. So there's always opportunities there. Now, do you find, you know, when people are ready to sell and buyers are ready to buy, do you find, uh, there's always this reticence to let people know that you're, you're looking to leave, right? How much does that create a conflict or an issue when trying to market a business?

David Barnett: Well, it's got, the entire process has to become secret, and this is what makes it a little bit unique. You know, when you're trying to sell a house, you put a sign on the lawn. When you're trying to sell a business, you can't tell anyone because all of your different stakeholder groups could react negatively if they find out a business is up for sale. The average person who has a job, they only hear about businesses being put up for sale when it hits the evening news and they hear that the mill is looking for a new owner, and that only means one thing, the mill's in trouble. And so if employees find out a business is for sale, they could panic. If customers find out a business is for sale, they might be worried that the warranty or the, you know, service guarantee isn't gonna be very good. If bankers hear that your business is up for sale, they might to decide to, uh, like call or limit your credit access, you know. There's all kinds of things that can happen, and so these things have to be done in secret, and that makes it difficult. It also makes it very interesting. This is probably one of the least efficient and most opaque markets that there is. A lotta the times business owners will not want their direct competitors to know anything about their business. In fact, if, if there are two companies in the same industry in the same town competing with each other and one finds out the other's for sale, they would actually have a market advantage in letting that information leak. And so it's very unlikely actually that two direct competitors will talk to each other about a potential acquisition, but the guys in the next province over, that's a different kind of thing. They're not directly competitive, but they understand the industry. And the other interesting dynamic that happens is when you have two direct competitors, one of them is actually not going to value the other one as much because they feel like if those guys just close we'll get all the business anyway.

Jason Pereira: Yeah.

David Barnett: So it's, it's hard for them to rationalize why they would pay someone money to acquire those customers when in a certain way they feel kind of entitled to those customers anyway, like if those guys just went away. But to the business that's far away that wants to grow geographically, it's a whole different angle to look at. For them it's a way to plant flag in a whole new market and then to gain other advantages, you know. If you double the size of your business by buying an equally sized company in another city and you double your volume of purchasing, you might not increase sales, you might not increase margins, but you might be able to increase your, your leverage with suppliers. You might be able to earn more money simply 'cause you pay less for some of the inputs.

Jason Pereira: All valid reasons for why you would do that, uh, and I've seen them firsthand. Uh, the entire feeling in **** is kind of interesting. You know, I think sure, if there's two, if there's two guys in a town, uh, then you got an issue. If there's seven in that, in that geographic area, then I think it changes the dynamics a little bit, right, 'cause –

David Barnett: Yeah, kind of, yeah.

Jason Pereira: Yeah, it comes down to another reason why we don't need ****. Okay, so identified buyer, what's the first step in the process? Um, once the buyer's identified, how do these two start talking about getting married?

David Barnett: It depends on whether or not the seller is actually prepared. So if there's a broker involved or if the seller has done some work to actually prepare themselves, then they'll have some kind of package of information they can share with the buyer, and it may be redacted, it may be limited information, but it should at least show some, some key highlights about the business, about what their cashflow is, revenue, that kinda thing. From that information, a buyer can then make a conditional offer, and the conditional offer is conditional upon an actual diligence process of investigating all the information and making sure that everything is the way it's been represented. And this is key because you don't wanna get deep into due diligence before you put any kind of offer on the table because sometimes you can never come to terms, and so buyers want to avoid that kind of heavy investment until they know that they're actually in the same ballpark with respect to an agreement on valuation and terms. So if the seller is not prepared at all, then it can be a little bit difficult because oftentimes buyers are left asking for certain basic pieces of information and they often have to wait, and when they get that stuff it can be easy to start getting into a cycle of continuously asking more questions. But once you've got the basic information, you make that conditional offer and then the seller will respond, and if you can't agree on what kind of valuation or terms are reasonable, at that point then, you know, the buyer needs to walk away. But if you can agree, that's what opens the door to a more in-depth diligence process where the buyer's gonna start investigating everything that's been represented.

Jason Pereira: Yeah, the entire not ready to sell, it's interesting. There's the mentally and then there's actually the organizationally ready to sell.

David Barnett: Mm hmm.

Jason Pereira: And I've had this conversation ****, you know, on both sides where it's just like well, why do they need all this. It's like why do they need all this? They're looking to buy you, are you kidding? And I know it's annoying that it's administrative and, you know, a lotta times people think they can just turn it over to their accountants, and the accountants can only provide the financials. They can't turn around and explain everything these people are asking for in terms of operations and everything else. So yeah, it's a, it's a due diligence process that can be onerous, but it's one that needs to happen, otherwise, you know, I would say two things. A, I'm sure many sellers want, basically want to be caveat emptor and just buy it and you take all the risks, but no buyer wants to subscribe to that unless the price has been hammered to the ground, so it's, it's a challenging one. And then from the buyer's standpoint, I mean, it's always, I would say too, and then I'm sure from your perspective, if they can't get you basic information in a reasonable amount of time, isn't that a huge red flag as to the operational efficiency of the company?

David Barnett: Well, all kinds of ideas can start to creep into a buyer's head if you can't get them information in a timely fashion, such as oh, do they need the time to create it, are they making it up, like they know why is it taking so long. And, and honestly, most of the time it's simply that the seller is engaged in the day-to-day operation of the business and that they're literally busy. I know that, um, when I was a business broker and even with the sellers I work with today, I'll be asking for tons of this information in helping to evaluate and prepare the businesses for sale, and I get the same pushback from these business owners saying, you know, do you really need this, do you really need this. And I'll say listen, when the buyer arrives on the scene, they're gonna be asking for all of this and more, and if you can't get it for me, and I'm more patient and we are not under the gun right now, then just wait until this buyer arrives. A good intermediary is going to prepare the seller by making them produce all of this stuff upfront so that it's all ready to go, and that preparation is key. Just like any sale, when there's momentum in the transaction, when the buyer is eager and they wanna make a deal, it benefits the seller to be ready to feed that desire with all of the information they're looking for so that you can move quickly. There, there's always gonna be these questions and there's always going, and a properly prepared buyer knows that there are always going to be these unknowns within the diligence. I've seen many due diligence checklists that you can find online, and I'll read through them and half the things I know that most small businesses don't even have. And so the buyer has to be ready to be able to deal with the unknowns, and a lotta the times those unknowns are managed through the structure of the deal. And so this is what makes things a little bit different on Main Street from some of the bigger companies that get sold. A lotta bigger companies you've got more management capacity, you've got more formalized systems, you've got better depth of information, you have internal management systems, ERPs, all that kinda thing. And so you can actually do a very good due diligence process and be reasonably sure of what it is you're buying, and a lot more of those deals are done on what I call cash terms, there's some kind of payment that occurs. In the world of small businesses there's a lot of black holes in the diligence, and so what ends up happening is you end up far more frequently with terms of sale that have some amount on closing and some amount of money over time, some kinda seller note, and the seller note is almost always subject to offsets in the case of material misrepresentations. And so if it turns out that the seller was saying certain things about the business and it turns out after the fact to be untrue, the buyer has an opportunity to basically rewrite the deal after the fact because it turned out that the information provided didn't tell the whole story, and I've got some great examples of that. There was one case where it was a construction materials business, and they used to go and talk with architecture firms about the material, the goal being to try to get their particular product specced into the design so that no matter which contractor built the project they would end up making the sale. And the seller told a story about a certain architecture firm and the buyer believed them and then later after the fact discovered that what he had been told was, was blatantly untrue, it was a lie, and it was important. That was an important firm and the relationship there had been tainted, and the seller hadn't revealed anything about that, and it took the buyer years to be able to work his way in to being able to get meetings with those guys. And so he felt that that was definitely a problem, and he put the seller on notice and he made an adjustment to the seller note, and this is the kind of thing that buyers need in order to feel comfortable with this lack of information.

Jason Pereira: Absolutely. So the due diligence process is done, they decide that they're gonna, one's gonna sell to the other. What are the big kind of negotiating points, besides like the total price. You already mentioned one of 'em, kinda structuring, kind of an escrow amount or an earnout. What are the other big negotiating points that come up besides those two?

David Barnett: So basically it comes down to the price and the timeline that the payment will be made over. You mentioned, a couple of things, you mentioned earnout and escrow, I mentioned seller notes, and all three of those are very different. And so this is where we start to get into, into splitting hairs because if we have an agreement on the price, that's one point, and now we have to agree on the terms, how will that price be paid. Something like an earnout, for example, that is when we can't agree on the price. So if the buy, a seller believes that the future is far brighter for the business than the buyer does, then they might both agree to make part of the ultimate price contingent upon future performance. That's where the earnout comes in, so we have some kind of function of earning of payment for the business based upon what happens after the buyer takes over. An escrow means that the buyer actually provided the money and some other intermediary like Al Royer is holding the money for a certain period of time against certain things. So an escrow is common on, at closing time when we have certain accounts that need to be reconciled on the balance sheet and we just don't know what the final numbers are, attorneys might hold back money for 30 or 60 days waiting for accountants to finish that reconciliation, then that is taken care of. One interesting one, during the pandemic here I was a party to an agreement for the sale of a restaurant, and it happened, the transaction occurred after the original COVID lockdowns in 2020, and one of the conditions was that there was going to be a sum of money, I think it was about $20,000.00, was gonna be held in escrow for 12 months by the attorneys, and if the government closed dining rooms again during that period, the money was gonna go back to the buyer. If not, it went to the seller. And so this was addressing a fear that the buyer had. They said what if the government closes the dining rooms again, I'll be, I'll be in a, in a hot situation, I'll need my, to get my hands on extra money. And so the seller addressed that fear by agreeing to this escrow component, and the government closed dining rooms again, and so the money went back to the buyer. So in effect, the buyer ended up paying a lower price for the business because of this completely outside external threat to the business, but that's an example of how we deal with these fears or unknowns through the deal structure. The other thing is, is about the training and transition. What sort of involvement is the seller gonna have after the transaction occurs? And there's sort of the formal training where the buyer arrives on the scene and the seller helps them learn the business and everything they know day to day, and then there's the more informal stuff, the kind of coaching and advice and tapping into the, the wisdom of the person that used to be, used to be the person that ran the business. And this is another reason why I'm such a big fan of, of seller financing to a material degree, because if you are paying someone for the business and making payments over 5 or 6 years for example and some new thing occurs to you in Year 3 that you've never seen before, that person, that seller has an interest in your success in order to collect the balance of payments. And so do you think they'll take a phone call where you ask them for some advice about this situation? Of course they will. And so the seller note helps to tie the seller's interest into the long-term success of the buyer. There's many situations that have occurred where businesses have been sold on a cash basis, and to your point earlier what you said, caveat emptor, the seller gets the money, they take off, they don't want anything to do with the buyer again. And it can really be a tragic situation because the reason someone is buying the business, the reason someone is gonna be willing to pay sone amount of money towards the good will that's been built into the business is because they want to avoid the risk of a startup. They want access to the fact that this is an economic thing that has momentum in the marketplace, that there are customers that already know them and, and people are familiar with the product and the employees are there and they know the job that they're doing, etc.

Jason Pereira: Excellent. So, all right, so those issues, which are several. I mean, honestly, I can't imagine negotiating the stuff during the COVID and the difficulty with those escrow payments, its huge, huge implications. All right, so basically due diligence is done. They've basically, I'm not gonna get into the legal side of this 'cause I covered that in other, uh, episodes about how essentially we go to, you know, we start off with nondisclosures and letters of intent and then move on to actual full contracts, and then eventually that all closes. Okay? So, so the deal is closed, the business has been purchased. What does that transition period look like and, you know, what needs to be thought of during that transition period?

David Barnett: Yeah, sure. So one of the things that a buyer is gonna be looking at during due diligence is they're gonna be examining what kinda processes and procedures and standard operating procedures are in place. What are the tools that allow this owner to manage the business? And they can range from, you know, businesses that are highly organized, think of something like a franchise, someone who read the **** revisited, right, and they implemented all this stuff into their business to someone who just runs a business by the seat of their pants. And so when a buyer looks at a business, they ask themselves two questions. What is the cashflow, and the cashflow will determine the price. The second question is will that cashflow continue under my stewardship or do I believe it will continue under my stewardship, and if that answer is no, then likely the buyer is not gonna do the deal. And so this is why creating all these systems and processes is important because let's take, for example, a roofing company. If you're running a roofing company and you're doing everything by the seat of your pants and you're managing your crews during the day and you're doing quotes at night and you're sending out invoices, you know, after that in the evening and you don't have any kind of systems at all, the only person who will seriously look at buying your business is someone who has experience in the roofing trade because they're the only ones that are gonna feel that they can actually do what you do because they've got some idea of what it is, whereas if you have tools that you built on Excel that allow you to quote a job and you have a methodology, you're using a project management tool like Asana that allows you to schedule your crews, create your work schedules and you tie in your suppliers so they know where to deliver the shingles and all that kinda stuff, well, then you can take somebody who's got some kind of management experience in almost any company and you can sit them down and show them how you do this stuff, and they'll see that they can learn how to do it too and that, you know, the quoting tools can allow them to make the proper bid on the job and, and all that kinda stuff. And so what you do is you widen the pool of potential buyers by being able to demonstrate that they can see by being able to demonstrate that they're gonna be able to do it too. So that training and transition period is going to be teaching the person what all these tools are and how you use them and how you, how you run the day to day. I'll tell you a great story. There was a guy, he was buying a restaurant and he had never owned a restaurant before, and at the, one of the meetings between the buyer and the seller, the buyer asked the seller, her said, you know, do you really think the employees are gonna stick around. I've never run a restaurant before, I know I'm gonna be relying on their experience quite a bit, to which the seller responded I run a restaurant, I guarantee within 12 months all of them will quit. And he said and that's why I have a process that I've developed of how to run carefully worded advertisements online, and I have a process of how I manage the responses to sort out who are responsible versus non-responsible people so that I only interview people that I think are gonna be good candidates and I've got all these different job descriptions and packages put together to allow me to get them up to speed quickly. And so he addressed the buyer's concern by demonstrating that it didn't matter if these people stayed or not. He was gonna teach this buyer how to run his system for finding, engaging and, and, you know, getting new employees up to speed.

Jason Pereira: Yeah. It's, it's just amusing the entire, like why don't they tell you what you don't know about this business, like that's, you're worried about that happening, congratulations, you're gonna have that happen every month. Yeah, so it's just funny. So the, the post-close, we covered that. So, you know, in closing before we wrap up, as a buyer, okay, what is, in your opinion, like if you had to give me like your top three or top five things that they have to be aware of, like what is the top of the list as a buyer that buyer needs, buyers need to be aware of when looking at buying your business?

David Barnett: Yeah, you need to be aware that the information will never be complete and that you have to be comfortable knowing that you're not going to get everything that you want. You also have to be comfortable with the fact that the information may be erroneous, and it's not because anyone's trying to fool you. So I was helping a CPA the other day. He's looking at buying a pet company over, a pet supply business, over in Hawaii, and he remarked to me that he thought it was incredible on the company's balance sheet that they had accounts payable equal to 4 months of purchases, and he said I wonder how they get 120 days terms. And I said listen, they do not get 120 days terms. What they have is they've got a credit card that they're using for all their purchasing, and that's the balance on the credit card. And, and the reason, and the reason I know this is because I've just, I've seen this over and over and over again, right. And, and to that small business owner, their, the entire day is about pets and pet nutrition and what pets like to do and how people like to engage with their pets, and their day is not about bookkeeping. And so these people employ different shortcuts and different things that they do, and so the information is not going to be correct in your textbook business school fashion. And so this is why you have to go back to kinda the fundamentals and you have to use third-party data. So when you go to do the due diligence on that business, what you do is you, you check the bank statements to make sure the deposits are all correct, and then you go through the box of invoices from all the suppliers and you add them all up and you compare to your income statement, and if it looks kinda close then you can be reasonably certain that the financial statements are likely close, but they're never exactly correct.

Jason Pereira: I would say I certainly open that case. In those cases they're not letting it sit on the credit for 120 days, that is a lunacy, but that's nuts.

David Barnett: Well, you say that, but –

Jason Pereira: But what's the alternative, right? Yeah.

David Barnett: The, the way that, um, the way that a lot of these businesses are run is not necessarily by people sitting around looking at their financial statements trying to maximize return on equity or anything like that. They'll make some purchases, maybe they'll be offered some discounts if they take larger volumes of, of, uh, materials, different promotions that the suppliers have on they'll put that onto that credit card, and then they'll have some other kinda cash demand in their business more personally, and they'll take money out and they'll carry a balance for a while, and then, you know, after the, you know, big Christmas rush when they have increased sales, they'll pay it off. So it's, and that's the kinda thing that, that you see in these small businesses. They really sometimes are managed as an extension of the personality of the individual who's running it from day to day.

Jason Pereira: Yeah. There's better ways when it comes to double-digit interest. Anyway –

David Barnett: Well, and, and, and so that's a great point.

Jason Pereira: Yeah.

David Barnett: So here's, here's another thing that, that like –

Jason Pereira: But they can improve on the profitability, right, if you're gonna buy 'em out.

David Barnett: Yeah. So in my experience, the people who often are the sellers of these businesses are people who start them, and in that Michael Gerber **** kind of sense, they very much are the technicians usually, and so their, their interest is in whatever it is that the business is doing. They kinda learn business along the way, try to run their business. Most of the buyers though tend to be people that are coming from some kind of background, usually in a larger organization where they've learned some kinda management skills, and those people are gonna be able to take that business once they learn how to run the day to day, then they're gonna be able to step back and really create some operational systems, efficiency, some better processes, they're going to address the accounts payable problem that you just mentioned, they're gonna stop paying double-digit interest. They're, they're going to be able to make it into a better business typically is what I, is what I usually see because they bring a different kind of skillset than the, the founder of the business had.

Jason Pereira: Absolutely, and this is, uh, I mean, I have several buyers like that who are going around buying companies in different areas that professionalize and everything and, and streamlining and centralizing AP and AR and all kinds of stuff and get, and getting better deals. So yeah, there's, uh, **** strategic buyer they can really leverage it. So David, thank you very much. We covered a lotta the dynamics of the buy side which we haven't covered before, so I'm thankful for that. Thank you for your time, and where can people find you?

David Barnett: Yeah, sure. The easiest way is to head to my blog site, which is davidcbarnett.com, and from there you'll find links to all the different things I've got going on. I've got a You Tube channel with hundreds of videos on this, and, and if anyone is interested in the topic of buying and selling small, medium-sized businesses, the best thing is to sign up for my email list, it's free, and I send out stuff all the time as well as, uh, you know, whenever a new video is released on You Tube you get that in your inbox as well.

Jason Pereira: Excellent. Well, thank you very much.

David Barnett: Thanks.

Jason Pereira: **** buying a business with David Barnett. Hope you enjoyed that, and as always, if you enjoyed this podcast please review on Apple Podcasts, Soundcloud, Stitch or Spotify or wherever is your podcast. Until next time, take care.

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FPCBOJason PereiraNovember 10, 2022Financial Planning