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There are no absolutes when it comes to ‘warning signs’ and just because a warning sign exists doesn’t mean there is a substantive problem with a deal.
Warning signs are merely what I call notifications for specific due diligence.
You may see warning signs in the initial numbers, the shared business plan, or other documentation. It is equally valid to explore warning signs that you just sense. If something feels off to you, explore that feeling enough to find verifiable ways to either confirm or disprove the concern.
Today we’ll cover three specific warning signs to watch out for.
Reason for Selling
Price vs. Value Proposition
3rd Party Anxiety
Contact
stephen.krausse@b50p.com
https://beyond50percent.com
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Businesses are bought and sold based on the perception of future value.
Business owners are often experts in fields outside of business.
We developed Business BeyonDIY to help you cross that chasm.
Show Topics:
Buying a Business
Selling Your Business
Preparing Your Business for Sale
Practical | Actionable | Sustainable
Business owners and entrepreneurs are go-getters. We start things other people don't (sometimes too many things am I right?) and we push through hard times. That means that entrepreneurship involves a lot of DIY.
Some of the most important transactions we make are buying a business; preparing a business for sale and selling a business. We'll almost always want/need help to make these successful but there is still a lot we'll need to do ourselves.
Business BeyonDIY is a Livestream/podcast where we own our DIY nature but find that sweet spot where doing it yourself doesn't mean going it alone.
In this introductory episode, I'll let you know the format of the show, what to expect, and when I'll be live.
I'm looking forward to getting to know you and your business and sharing practical tips that will make your DIY more like DI-Us!
Stephen Krausse
So I was working with a buyer. And as we talked about the valuation of a company, they were looking at the seller had given them a valuation that that they were proposing and set of financials. And what I explained to the buyer, excuse me, was that they weren't consistent that the financials that they had been given weren't consistent with the valuation, at least at first blush. And, and so I suggested a few questions so that we could get a little more information and try to validate the the number that the seller had provided, and the buyer got shut down by the seller. And there were, there were three specific warning signs that came right out of this, and they happen to be three of the ones I think are very important when you're talking about buying a business. So I thought I'd talk about them today, the seller couldn't articulate why they were selling, they didn't really have a good explanation. They had anxiety over having a third party. And the valuation was inconsistent with the financial data. So today, I want to talk about these three warning signs, what to look for, how to look for them, and how to respond to them if they occur. Hi, business owners and entrepreneurs. Welcome to Business beyond DIY, where we get you from here to what comes next. I'm your host, Stephen Krausse. E, and I'm a, I'm a business person by trade, education, and passion. And I want to increase the value of your entrepreneurial journey. Business beyond DIY is about understanding and developing the value of business, your business. So let's get started. Alright, so these three warning signs I, when we talk about warning signs, I want to talk about something before we get into specifics, I want to talk about the fact that a warning sign does not necessarily mean that it's a no go. Think of the more as a notification for specific due diligence that you want to incorporate into your purchase plan. Or into the selling plan. If you're on the other side, and you're negotiating terms with a buyer, it can still come up. So it isn't a go, no go. And if you if you go with your gut, and something doesn't feel right, explore it, be curious about it. But don't just abandon the project. If you're passionate about it, if you're not, and it feels uncomfortable to you for some reason, or you don't like it, then by all means, you know if that's what it takes to let it go. Or if you feel like you know, this is not something I can overcome great. But most of the time, what I've found is that these are just in indications of specific things you're going to want to look at, as you go through the deal. Go through the due diligence. Alright, so this first one, and this is a big one. I've talked about this before, in from a different perspective. And that's understanding the reason for selling. So when you talk to a seller, you want to ask them in some way, why are you selling this business? And I talked about why being a kind of a confrontational word. So maybe you say what comes next for you. There are other ways to put it. And I'll leave that up to the previous episode. But you want to get to the point of understanding why they're moving on. And there's really just a couple of ways that people move on from a business one is they have a plan to exit. And let's call that. You know, you've got two conditions there. You've got a serial entrepreneur who says, Okay, I built this, I've done the fun part. I don't want to do the, the part of the business where it's growing into an existing market and stable and that's not fun. For me, I'm more I like the adventure of the startup sequence or the beginning of the process. Fine. So you have a plan to exit. And as the seller, you should be able to articulate that. Because it's probably what you it's probably what you thought of to begin with. When you started the business. You're like, Okay, I want to do this. This is exciting. And then when we get it to the point where it's in the growth phase or whatever, we're going to move on to something else, we'll sell it somebody move on. So great. Or you can have a retirement exit where you say I'm going to run this company until I reach a certain age until my retirement account hits a certain value.
And then I want to move on, and that's okay too. But a planned exit is that you can articulate his problem Probably the best answer you can give a buyer, because it doesn't demonstrate any kind of potential weakness in the business. That is not to say there isn't any. And it's not to say that these other reasons that I'll go over are negative by nature. But a planned exit is a pretty awesome position to be in a change in your life or health. You know, you don't have to overshare. But it is important to be able to share what makes you want to sell a business. And so if you if there's been a change in your health status, or the health status of someone in your family or something like that, it stuff happens, and people understand that. And, again, you don't have to share all the details, but you can articulate what is prompting you to sell the business, and it helps the buyer understand the scope of the transaction. Ready for a change is another one, you might call that burnout, I would call that burnout. You know, if you're, you've been doing something for a while, and you don't like it anymore. You know? Okay. The question that I would ask around this, and this is, you know, we don't ask a direct question on this, but what I would explore, you know, without knowing anything else about the deal is ready to for a change, masking fear? And how do you overcome that? Or not overcome it? How do you explore that and find out? Is the owner afraid of the future for this business? Someone in some way? Because that that's the first question I would ask, okay. Or I would explore those things. And that might also be fine. Let's say that the owner is afraid. And you uncover that fear in your discussions in a positive way, we're not looking to put them on the spot or, or create a negative environment for anyone. But if we find out that they're, they're afraid of some part of the business not working like they expect, or they don't feel prepared to deal with the next stage of the business lifecycle, that's not a non starter. You just have to decide as a buyer, can you overcome that obstacle? Can you incorporate what needs to be done to bring the company through that to the next place. So the business performance is another reason that sometimes people leave. And that kind of folds into what I was talking about before, sometimes an owner is going to say, this has been great, but I'm not the person to continue doing this. I don't have the skill set. Again, you go back to that person who likes the adventure of the startup, maybe I simply don't have the interest in running a company, I just like starting them. And so you start the company, you get it to the point where it's, it has market value, and then you move on and and sell it, find something else to do find another business to start. That's okay. And again, well, like I said, That's okay. It's just important that as the buyer, you understand where they're coming from, and what you're getting yourself into. And so while I'll say that your due diligence, should be complete enough, that the sellers position isn't part of the equation, how they respond to that question does lead to the nature of the due diligence that you're going to do, and it also will impact your relationship with them, and the negotiations to come. So it's important to understand as much as you can about the buyers, selling, or the reason the buyers selling. And if they can't articulate that. Digging into that more is going to be the way that we handle that warning side. That's number one. Number two, price versus value proposition. And this one comes up a couple in a couple of ways. First of all, there are a number of ways to value a business. And a seller is naturally going to gravitate toward a valuation method that works in their favor that in that provides them a selling price. That is a higher value than some other method of
evaluation. Buyers, on the other hand are going to look at valuation methods that favor their position. And that's all part of the negotiation is what valuation method are we going to agree on instead? Sometimes they will be close. And so it won't matter. And so you can say, Okay, I valued it at a half a million dollars, they valued it at $600,000. And we can negotiate the difference and, and discussing the valuation method might be a preliminary issue. But when we're close enough, maybe it doesn't matter. And we don't have to agree specifically on the valuation method. But we can then start working through the terms of the deal. And negotiating the price and the terms to a point where we can both agree. So that's great. But if there's a serious difference, we do have to agree on a methodology to getting that base valuation. That doesn't mean that we just strictly go by the numbers and say, Okay, we're going to use the the the, you know, we're going to buy an, we're going to do an asset sale. And so we're going to value the assets, and that's going to be the valuation, you don't have to necessarily do do that. I'm sorry, I lost my track my train of thought there. The point is, you do if there's a serious difference, you do have to come to an agreement on what valuation method makes the most sense in the situation that you're in, or walk away. If a seller is asking you to value a company in a way that you're not comfortable with, that's fine, let them and you can tell them, Look, we're really interested in this business, if we can value it, using this methodology. And if you want to re enter negotiations sometime in the future, please give me a call and let it go find another business to buy that's okay. So valuations can typically be just to kind of round out the valuation itself. valuations can be validated by the type of valuation use, they're not complicated, most basic valuation is not rocket science. That doesn't take a lot for a small business to be valued. Using standard valuation methodologies, you can do a pretty easy back of the napkin calculation and get close, is it going to be perfect? Probably not. But it doesn't have to be perfect. That's what negotiation is for. But it can get you in the ballpark. The other thing is, so the type of valuation matters, but then we also have the assumptions that were used. So if the seller is creating evaluation, not only do you need to know the type of valuation that they decided to use the calculation that they chose, but what assumptions did they use to make that calculation? And there is a and the next one, which is the financial figures is also critical. You know, are they verified by a CPA? Or are they printed off of of an accounting system? Are there is there a difference, you need to understand that to get the, to get in the ballpark. So if if there's, again, I go back to you do not have to agree 100% with the valuation of either a buyer or seller, but you do need to understand how they got to the number they arrived at, and you need to arrive at a number you're comfortable with, as a buyer. Don't assume that if a seller gives you a valuation number, that it was that it's right. And right is probably not the word, or that it's appropriate for your purchase of that business. It may not be and that's okay. So, the,
the, you can, like I said, you can valuate you can validate the valuation. By understanding the type of validation they used, the assumptions that they used to do it and the financial figures that they used. And if you have any questions about those, and you should make sure that the assumptions are valid and the financial figures have been certified by a CPA. Alright. So keeping in line with price versus valuation, the selling price can be influenced by any number of factors, the the base, or what I'll call the base price, should be fairly easy to calculate using a standard methodology. However, the actual selling price could have. There could be a lot of factors that go into that some of those might be the asset value, the multipliers of sellers discretionary earnings and that's a that also adds to, or influences which methodology you're using. So may acid value, market based evaluation, things like that. I want to say one thing about the methods that people use, if someone wants to sell you accompany and they do their valuation based on revenue. Find your own valuation method. Absolutely, for sure. 100% Because revenue is it doesn't tell enough of the story of the operation profitability and success of the business to be a good valuation method. That's just it find another way. So what we want to watch out for, when we are looking at the price that someone's asking versus the value proposition that we see. You know, if you have if someone says, Okay, we're going to do sellers, discretionary earnings multiple, and that's how we're gonna evaluate the value of the company. And they and they want 10x The the SDE or seller's discretionary earnings in an industry where Forex is pretty standard. Again, I go back to what I said earlier, that doesn't mean it's a no go. But it's a warning sign that they may not be valuing the company appropriately or realistically. And sometimes sellers have an unrealistic idea about what their company's worth. So if they're valuing it, outside of a norm for their industry, we need to look at that. If the market if you're using a market based valuation, and there are no company comparable businesses that are cited, or the or the businesses that are cited, aren't actually comparable. That's a huge warning sign. And it's important to talk about this because a market comparison for small businesses can be very hard to get. You can end up saying, Okay, there's there's a shop down the street that's very similar. But how do you know anything about their financial status? Because they're private, they're not required to share that with anyone. If they submit tax returns, that's not public record. That's still private. So it when you're buying a small business, and someone wants to value it based on comps, or comparables, we have to understand how they're validating those comparables, what are they doing, it's not like the real estate industry, where you can go actually look at the selling price of similar properties, and do what we call what they call comps in that industry. Because that isn't public record for private companies. So bits not always available. So that's something to be very concerned or to, to take with a grain of salt.
And and sometimes sellers will overly leverage the similarities of a comparable business where it isn't actually similar. So if a business is operating, let's say your the business you're looking at does everything by hand. There's another business across the street that does the exact same thing, same footprint, you know, in terms of floorspace, same number of employees, but they have automated machinery, saying that they're comparable, may not be accurate. And so again, we go back to how do you identify and compare comparable businesses in a way that applies to your buying experience? Alright, things that modify the price these happen. And, you know, if they have a broad customer base, or search engine rankings, where they've got really high search engine ranking, or they have a demonstrable growth plan that they've already implemented, and so they're in stage three of a 12 step plan to increase their their business, and you can see the action plan in place that's has value. Intellectual property can have value, they have a big a large email list that may have value to you. What's important is does it have value to you, as the owner of that business, it might have had value to them, or they might perceive it as valuable. But if your execution of what comes next for that business is not going to be related to their search engine ranking. Then that doesn't have value to you. And don't pay for it. Don't pay for something that doesn't have value to you. So those are the modifiers that that a seller might be baking in to that price. When they give you a evaluation that may not be validated by the strict financial information, when you go to do a just a numbers valuation, and again, those things can all tip the price up or down based on the the information provided. But the base valuation should be something you can agree to, at least the method should be something that you can agree to. Alright, so let's talk about that last one. And that's third party anxiety. And as a consultant myself, this one is very near and dear to my heart. Again, it so so if somebody this particular, the seller that I mentioned in my intro, was concerned about having a third party involved. And so, to some degree, maybe that's justified. But let's talk a little bit about it, it doesn't necessarily mean and this is the first thing that comes to mind is that they have something to hide, it doesn't necessarily mean that it might just mean that they are uncertain about what that interaction might look like, or that they're going to get taken advantage of. Because you're going to hire somebody who's going to twist and turn the deal until the seller is getting a bad deal in favor of you getting a good deal. Now, if you have a high quality consultant that's helping you work through a business transaction, you know, if I'm working for a buyer, I work for the buyer. But I am never going to manipulate a seller into doing something that's inappropriate for a business transaction, I will walk away from a deal before I would do that. And so I think the goal here is to make sure that you have someone who has, you know, articulates lines, they won't cross for you, and and be able to, you know, be comfortable with the fact that you're bringing someone to to into your transaction that is going to approach both parties with integrity. Having said all that, it does indicate if someone gets anxiety around having a third party involved, it does indicate a defensive posture. And that's worth noting. Now, they could be trying to hide something that would impact the valuation. They might be uncertain how to answer questions that a professional business person
might ask, they might not be an accountant, they might not know how the debits and credits add up or be able to answer those questions. And they may feel insecure about that. And they might honestly not know, everything that goes on in production. So you walk back on the floor was somebody, we're in logistics, and you have a third party consultant that comes in and says, Well, where are you sourcing these? How are these put together? What's the what's the gross margin on this particular product? The owner might not necessarily have the answer in their pocket, and they might be embarrassed about that. As an owner, you don't know everything. You know, you don't always know everything about every business. And that's okay. In my opinion, that's okay. That's why we have employees that we trust to do good work for us. And we set standards and say, employees, this is the quality of product I want to deliver or the quality of service I want to deliver. This is how I've set it up to deliver that. And, you know, the how starts to get into, you know, is the methodology critical to your service, or your product? Or can you give your employees some leeway in how but my point is, we give them the structure to succeed, and then we let them build on that. And so that results in the fact that we might not know everything that happens on every step of it, you know, in every step of the business. It's certainly important to keep in touch with your business and I don't want to be I don't want to suggest otherwise. But you don't have to know everything you may not. And if a third party is coming in and asking those questions, we need to make it safe for the owner to say I don't know, but I'll find out and I'll get back to you. That's okay. And and if you have a good consultant They should offer that up, they should say, Hey, um, you know, what is, you know, how is this process done. And if you if they see hesitancy on the part of the owner, they can sit you they can offer, you know, is that something that we can talk about later, or that's something that we can talk about later. I'm just very interested in how this works. Don't put pressure on them in the moment. If they're already feeling anxious, that doesn't make you powerful the negotiating table. That's not where you're going to get the best deal. In making the owner uncomfortable, if you want a good deal, make sure that both parties are always as comfortable as possible. And if there's discomfort, understand where it's coming from, and you don't have to resolve someone else's discomfort, but you do have to understand where it's coming from, if you can, and how it impacts the deal. Alright, so they might not know how to answer questions. To be honest, they could be sensitive about the way they're running their business, if they're not a business professional, or even, maybe even more, so if they are a business professional, if they are not doing something that they perceive that they should be doing. And you ask about it, or you have a third party that asks about it, you can trigger a defensive response. Because, you know, well, I don't have an excuse that I'm not doing that. We don't need an excuse, it's your business. And on top of that, we're human, and we don't have infinite resources, or an infinite amount of time, you can't do everything. And something that I value as, as a business professional, might not be the same thing that you value as a business professional, or as a business owner. And that's okay, we need to be able to set the stage for success for the deal, and not drive home, how smart I am, and how you should have run your business differently for the last 20 years, I've got no basis for that. Right? That's not the point of the third party. So it can be it can be anxiety producing for someone to be digging into your business, when you perceive that they might question how you've done it, it can be very personal running a business for any length of time becomes very personal. Alright, so And let's face it, buyers buy businesses because they think they can do it better. Most of the time they buy a business because they see a future outside of the scope of the seller. Other Otherwise, why would you buy it if you can buy something and create value out of it? That it doesn't already have? Why would you buy it, there's no point.
So they have to see a brighter future for the business under their leadership than it currently is. Or the valuation number is not going to have a return on investment. So there's not gonna be any point in purchasing it. So if somebody is having trouble with a third party, first of all I talked about third parties should be have integrity and be aware, you know, read the room understand what's going on, and put people at ease people who are defensive, don't answer questions. Right. So we want to get the truth, the best way to get the truth is to be honest, upfront, and helpful to people and put them at ease. So NDAs, covering intellectual property, financial disclosures, the sale conversation, all of that can be covered by an NDA, that can help some people be more comfortable. I like to work under NDAs as much as possible, simply to protect myself but also to protect the buyer and the seller. And I already talked about this is another nine in my notes, but find a third party that really does is able to put the seller at ease as much as possible. So we talked about that. You know, they're here to review the data in the context of the buyers experience. So what is the buyer going to do with this company? And how does the operation fit into that? And that's the questions that we're going to ask. And yes, we're if something I think it's important to understand that if I don't value a company the same way the seller does, that doesn't make either one of us wrong. That just means that my that what I'm willing to pay, or what I would suggest a buyer be willing to pay reflects a value In a perceived future value that is inconsistent with what the seller believes. And that's okay, you just don't do the deal. Okay, it happens. And deals will fall apart for all kinds of things I've, I've talked about this before, maybe not on this show, but on one of my other shows, I was going to buy a company. And we agreed on the price and the terms. And the deal still fell apart, for reasons that I talked about before. And I'm not going to belabor this particular podcast with that, because I'll get into storytime. So if we get to the point where a seller won't deal with a third party, they say no, if you want a consultant, I'm not going to do this deal. My two cents is let them go. Even if it's an opportunity that looks really great. at the, at the bottom, or at the end of the day, they may be hiding something or be so insecure about the information that they have to share, that you're not going to get good information. At that point, maybe, you know, as long as as they're doing or you could go to the point where you say, Okay, well, we'll do a kind of, we'll make an offer based on something we can validate asset value or something like that, perhaps that would work. But again, if somebody is not willing to find a way to let you work with a third party, I would probably let that deal go was certainly have a long conversation with you about it, so that we could find a way to approach it, so that you couldn't be successful without me there. Again, they may be too insecure to sell, to share relevant data or the data that you really need to make an informed decision about the deal. The other piece, and this is something that that isn't on the on the tip of your tongue, when you think about this process, that's really not a good analogy, but it's not the first thing you're going to think of, and that is that they may delay giving information. And we procrastinate because they're uncomfortable with the data that pushes out the deal timeframe, it increases costs, maybe they're hoping you'll forget about the question, we're not going to forget, because we document what we ask the seller to provide every time always document what you're asking for. And
you know, whether it's an Excel spreadsheet, or a Google Sheets, or whatever, you know, asked for this, this is the date I got it. Here's where the files located, something like that. Again, I don't care what format you use, but always document what you've asked for when you got it, who provided it where the data is, and keep that information for later. All right. So that's three warning signs for business buyers. First, if the seller can't articulate why they want to sell the business, that's a pretty big warning sign. Second is third party anxiety. And third is that the sellers valuation is inconsistent with standard valuation methods for the industry and the bit type of business. Alright, so again, these questions, these warning signs need to lead to additional curiosity. They're not go no go issues. They're okay, I need to think about this. I need to address this. How do I incorporate these the concerns that I now have, into my due diligence? Or how do I create and craft due diligence that will answer those questions and overcome my objections that are naturally coming up. Because of these warning signs. Curiosity can lead to possibility just as much as it can lead to liability. And with that, I'd like to thank you for being here. Thanks for doing the hard work and being a business owner. I am enjoying our entrepreneurial journey together. I'm Stephen Krausse E. And I'm with beyond 50%. And I help entrepreneurs buy and sell businesses with an experience driven process and impartial analysis. Connect with me on one of the social platforms in the description below. If you're watching on YouTube, or in the show notes if you're listening to the podcast. Remember, doing it yourself, doesn't mean going it alone.
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