Too often due diligence is focused on asset valuations and the price/earnings ratio, with insufficient consideration given to a third aspect: the aspect that makes the enterprise worth more than the sum of its chattels. I look at three pillars of due diligence: Chattels, Records and Know-How. Examining and understanding the Know-How is the most important of all.
(1) CHATTELS
The Chattels should be easy to identify and value – the asset register and stock list should be up-to-date and checked item by item. The Records will show a current book value but that should of course also be considered at a reasonable market price. For instance, freehold property may have been depreciated to a sum far lower than its market price and the vendor will expect the market price. Stock will be recorded at its cost price, the potential pitfall here is aged, obsolete or slow stock that may realise a lower price than the Records show. Crossing over between Chattels and Records are the cash position, debtors/creditors and work-in-progress – which should all be verified.
(2) RECORDS
The Records for as many trading years as possible, plus up-to-date management accounts, will show margins and trends. It is important to understand the business’s practices for sales discounts and cost charging as some practices may have to change post-transaction. If the vendor is the founder, sole/majority shareholder and director it is likely that ‘special relationships’ may exist with established customers and that their total income may be charged into several operating cost lines beyond wages/remuneration. Poring over every nominal/general ledger is obviously crucial to checking that trends and margins can be maintained, where improvements will be possible and – importantly – where deteriorations may occur.
(3) KNOW-HOW
The Know-How is the biggest potential pitfall of all. The Know-How is the component of the acquisition that makes it worth more than the sum of its chattels. Competent accountants and lawyers are comfortable with the objective Chattels and Records reviews but Know-How, unless exceedingly well packaged, can be highly subjective. A business is not just about price/earnings (P/E) ratios and margins. It is people and processes that generate the trade and market position in a particular way. The processes must be clear with a transparent audit trail. Remember that people are not obliged to stay post-transaction and the sensitivity of the business to employee departures must be fully understood. It is not only the senior individual, or team, that may be ‘key’ people – there will be accumulated Know-How locked in throughout the organisation, its supply chain and sales channels. Availability of equivalent personnel – and a clear definition of what ‘equivalent’ truly means – is the most important aspect of due diligence. In the happy world of spreadsheets, doubling sales is simple but it is wholly dependent on available capacity throughout the greater organisation. How that capacity is and can be created, and protected, impacts the price for the enterprise and post-transaction investment.
On the face of it, businesses bought from administration are a cheap source of potential money-making machines. The Chattels are available for fire-sale prices and the Records will doubtless show a golden era at some point in the past. But in what condition, and how visible, is the Know-How? It is surprising how little attention is paid to fully understanding the cause of failure and considering the cost or remedy – especially if the founder(s) and other key people (remember, that is not only the bosses) are absent. It is never cheap, even if you have considerable Know-How of your own to deploy.
Buying broken businesses can be likened to restoring classic cars: compare the cost of buying a fully functional and pristine concours example (analogous to a healthy going concern) with that of procuring a barn find (analogous to a failed business) and rebuilding it. Restorers will advise that luck and a rising market have a big part to play in whether or not the restoration path proved lucrative.
And remember, even concours cars require inspection and will incur costs to retain or improve their pristine condition and value.
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