When investigating and performing your due diligence on a potential business to acquire it is very important to determine whether the business has been “set-up” for sale. When I use the term “set-up” for sale I do not mean that the walls have been freshly painted or the lawn has just been manicured.
It is possible and relatively easy to dramatically increase profitability on a short-term basis. More buyers of both small and large businesses overpay and get stung because a business was set-up for sale then for any other single reason.
As an example let’s look at an electronics company. Their sales and profit history looks like this:
Year |
Sales $M |
Net Profit $K |
% Profit |
2005 |
4 |
400 |
10 |
2006 |
5 |
500 |
10 |
2007 |
5.75 |
575 |
10 |
2008 |
6.5 |
1,300 |
20 |
2009 |
7.5 |
1,500 |
20 |
The current owners have listed the company for sale. They are stating that the profitability of the company is 20% per annum and it has been the last two years and are basing their selling price on that 20% profit number. They are asking for goodwill of $4.5M (three times last years profit). What you must ask yourself and truly understand is how did they get from an average of 10% profit per annum to an average of 20% profit in the last two years.
There may be a lot of very legitimate reasons to explain how their profit margin has increased from an average of 10% per annum to 20% per annum. One or more of those reasons could be:
- A new product with excellent profit margins that was in design and development for a number of years went into production in 2001 and is now being actively sold. Not only does the company benefit from the increased sales numbers, but it has absorbed all of the development expenses and those dollars are pure profit.
- A large loan with a heavy interest burden was paid off or refinanced at the end of 2001.
- New machinery in production or other processes was installed which increased productivity and hence decreased costs and increased profits.
- Sales and/or production volume surpassed a threshold point. A company may need a certain group of skills in order to produce a product. As an example, a company may require a machinist, a welder and a spray booth painter in order to build one unit. This group of individuals is capable of building 10 units a day, however the company’s order intake is only 5 units a day. As the company cannot hire half a machinist or half a welder or half a spray booth painter and the individuals do not have the skills to do each other’s job functions, it must absorb the nonproductive time. In this case sales could increase by 100% without the need to increase staff. If sales did in fact increase to 10 units a day, the cost of labor per unit would decrease by half. Increasing profits dramatically.
- The company could have entered into licensing agreement(s). If the company has entered into an agreement(s) whereby they are licensing their technology to another company the resultant revenue is as close to 100% profit as is possible. A licensing agreement can have a dramatic effect of profits. If this is the case make sure that you do due diligence on the agreement and determine its future value.
- New products to sell. If the company has added to its product line without expending large sums on design and development it will definitely have a very positive effect on profits.
- New location. Remember the old adage, the three most important things to a successful business is location, location, location. Although if one is considering a manufacturer a new location would only affect the bottom line if it enhanced productivity or reduced facility costs dramatically.
- Demise of a competitor can have a dramatic effect on sales and profitability, however it would be wise for you to find out why the competitor went out of business.
- Leases on equipment were satisfied (the company has paid out the leases and now owns the equipment outright) which has reduced expenses and increased profits.