[EP 299] Avoiding the Lemon: Smarter Business Buying Strategies

Introduction [00:00:00]:

Ladies and gentlemen, good evening. Are you ready? Okay, here we go. You’re listening to the Deal Room Podcast. Join us as we bring you the inside scoop on business sales and acquisitions. Get across trends in the area and hear the industry’s best recount their real life tips, traps and experiences. Now, here’s your host, Joanna Oakey.

Joanna Oakey [00:00:24]:

Hi, it’s Joanna Oakey here and welcome back to the Deal Ribbon Podcast, a podcast proudly brought to you by our commercial legal practise, Aspect Legal. In this episode I’m talking with two brilliant guests, Brett Goodyear and Alex Gilchrist, all about how buyers can avoid the common traps in business purchases and how better due diligence, valuation knowledge and acquisition strategy can protect and even grow value.

Joanna Oakey [00:00:54]:

Alex joins us from Seek Business where he works closely with brokers and business owners to connect buyers with the right opportunities. Brett is a business valuation and forensic accounting expert with decades of experience helping businesses make smarter data driven decisions. And in this episode, Brett, Alex and I talk about how to avoid buying a lemon through proper due diligence and the right advice. Why not all businesses are valued the same and what influences valuation multiples, how smart acquisitions can grow business value through valuation arbitrage and a whole lot more. P.S. this episode builds on insights from our recent webinar which is now available on demand. Check out the show notes on our website for a link and why don’t you brew yourself a coffee, settle in and let’s kick off with part one of our two part series with Brett and Alex. Here we go.

Joanna Oakey [00:01:54]:

Brett, Alex, I just want to say thank you so much for coming onto the Deal Room podcast to continue that epic conversation that we’re having in a webinar. There were so many questions that were just like oh my gosh, we’ve just got to have a podcast after it. So guys, firstly, thanks for jumping on that webinar with me. I loved it. And number two, thanks for coming back right now.

Alex Gilchrist [00:02:16]:

Pleasure.

Joanna Oakey [00:02:19]:

All right, and as I would have said in the intro to all of you would have heard this. If you miss the webinar, not too late, make sure you check out the show notes and we’ll give you a link to the webinar. But here we I just as a bit of a pre face we’re not going to attack this in any sort of order. So this is going to be a crazy like just run through different questions that have been asked along the way. But one of the. So I’m just going to get started. So one question we had in one of the pre registration Questions and actually, I think we, we had over 700, almost 800 registrations in. So we have a lot of questions. So we’re not going to even be able to get through them all today. But one of the questions that I thought was interesting is someone asked, how do I make sure I don’t buy a lemon? And how do I use due diligence of making in a way to make sure I’m not buying the lemon? That is such a good point because I think we’ve all probably seen examples of where buyers have been a bit too excited and perhaps gone into the acquisition process without even thinking about how do I absolutely make sure this is the right business to purchase at the right price. So I don’t, why don’t we go, Brett, why don’t you kick that off first? What do you think is most important?

Brett Goodyer [00:03:37]:

Advisors. The right advisors. That’s the first step. I’ve lost count of a number of times where I have been asked to look at a business after the dog has bolted. We’ve been asked to come in and have a look at something they’ve already agreed, they’ve already paid, and I have a look at it and I think that they’ve massively overpaid. Sometimes it’s years down the track. I can only think of one, one time where someone said, my client. Cause I was talking to their accountant.

Brett Goodyer [00:04:05]:

My client turned up and has bought themselves a candle manufacturing business for $700,000. And it turned out to be a really profitable, great business. And that was really unusual. Most of the time it’s along the lines of my client turned up, they spent a million bucks, all of their savings because they just got canned from, I don’t know, Bluescope or something like that, where they’ve spent the last 30 years and decided they’re going to do something completely different. And so they jumped into an area that they didn’t truly understand and massively overpaid before they even spoke to an advisor. And that’s the critical thing here. There’s people who know what you should be doing and it doesn’t take much. Usually a 15 minute free consult with you, for instance, would go, hey, have you considered X, Y and Z? Have you talked to even just your own accountant, let alone a professional who looks at valuations? Have you talked to someone just to do an initial sniff test? That’s the thing for me is there’s so many steps to this that often just get completely left by the wayside.

Brett Goodyer [00:05:11]:

A business purchaser should be looking at multiple Businesses and then having a look at each of them and giving them all a bit of a sniff, bit of a kick in the tires to work out. Okay, these, this, these two out of the five seem to be about what I’m looking for. Take those to an advisor and say, okay, in terms of the quality of this deal, what do you think about the risk and the return of these as an asset? What can we do? What do you think? They’re going to suit me? And then spend a little bit of money on that initial DD before you then go and spend your life savings and potentially it just evaporates because you might not be able to find someone else who’s going to buy that lemon off you. You know, if you hit like the used car market, you probably take it to your mechanic and say, hey, could you have a quick look at this before I buy it? Because if the head gasket’s about to blow, I’d really like to know. And that’s the, the same thing. It’s the exact same process. Building a pest inspection on the house before you buy it, that’s standard. But you’ll spend a million bucks on a business because the broker or the, the vendor has said, oh no, it’s a great deal and you get excited and you just move. And that’s the thing we’ve got to.

Alex Gilchrist [00:06:25]:

Caution and I guess to follow up on that as well. With some of the research that we did at Sick Business on a sample size of around four to four and a half thousand business buyers, we saw that people were still putting their friends and family above professional advisors when it came to who they’d go to advice when they’re buying the business, which is really interesting. And obviously if you invest in professional advice, you’re going to get like a 5 times return or 10 times return if compared to if you’re just listening to some advice you see online on social media, which is really kicking off these days, which I’m really surprised about or just. And the other part with talking to friends and family, obviously extremely important to get their buy in, but there can be a bit of tall poppy syndrome in that as well where they’ll pull you down and you never make the leap into actually buying that business as well when it could go on to be life changing and really, really good for you and them. So yeah, just to back that up, it’s. And actually the other thing as well, which I wanted to call out was when going to some of, speaking to some of the business brokers that I talked to it’s even getting the advice from people who are in that right industry or that right type of business. It might be. It could be a lawyer, it could be an accountant who doesn’t specialise in that particular area.

Alex Gilchrist [00:07:40]:

And this is just what I’m hearing when I’m on the road. Obviously I’m not a professional business broker or a lawyer or evaluation person. This is just some of the advice I hear when I’m speaking to business brokers. It’s getting the right industry expert as well.

Brett Goodyer [00:07:55]:

Yeah, But I actually noticed in one of the questions that came up, it was, how do accountants and business brokers get valuations so wrong? It’s because valuations isn’t that easy. It’s a bit tricky. And people who say, oh, to go to their own accountant and say, what’s this worth and the value, they’ve never valued a business in their life. They look it up, they might even type something into ChatGPT. And we all know that’s not particularly useful across all types. And so all of a sudden they just. I guess they fake it till they make it and they give some pretty dodgy advice and I guess that’s it. It’s exactly the same thing. I would say you have to get the right advice from the right people to hang your hat on it if you’re going to be making a decision that is life changing, like, it’s important to get good, unbiased expert advice.

Joanna Oakey [00:08:46]:

And can I just say, we’re actually. Seeing quite a bit at the moment, and particularly, actually over the last couple of years, inquiries coming into us from people who have bought a business. So we’ve not acted for them, but they’ve purchased a business in some other way, the business had them performed and now they’re trying to work out what they can do about it. And part of the issue is there’s a number of things. There’s due diligence, making sure you understand what you’re purchasing. But the second thing is setting the contract up, the deal structure, the structure of the dealer, when you pay, when you pay the purchase price, whether there’s any money that you’re holding back to ensure you get key assets transferred or the revenue that you expect to be there is realised in the future. Triggers. It’s all of those things that are absolutely critical to get right in the transaction, because after the transaction’s done, after you’ve finished due diligence, signed the contract, got all of that in place, it’s too late if you’ve not got that set up in many instances. And the difficult thing is when people think they’ve bought something and the value that they think is there, isn’t there, it can be absolutely devastating.

Joanna Oakey [00:09:59]:

It can be because quite often buyers will be financing their acquisitions as well. So it can be business and life destroying not to make the big financial decision, having undertaken the right checks and then having the right contract in place. I just want to add one other thing. It’s quite interesting because quite a few approaches we’ve had where issues have come up have been people who otherwise thought they were good with financials. And I just want to say that being good with financials is not the same as being able to assess a business and to understand what the value of a business is. And I find like whether it’s an accountant that you know with purchased the business but doesn’t, hasn’t had a regular experience of purchasing businesses, doesn’t exactly know what they’re looking out for in that space, or someone that otherwise thinks that they more so sophisticated buyer in the acquisition, but without actually having had that right advice next to them. I don’t know. Do either of you have anything to throw in there?

Joanna Oakey [00:11:05]:

I agree 100%. Yeah. There’s plenty of people who can look at a P and L and understand what the profit is, but they have no idea how you might get to a position of trying to determine what the earnings are into the future and on a normalised basis. That idea of getting it back to what an arm’s length owner might earn as a return on investment, which is how you value businesses, they just never have considered that. And I don’t know how many times I saw in that chat was how do I account for cash in a valuation where the cash never hits the books? Here’s a tip. You don’t. You can’t have both. You can’t have it both ways.

Joanna Oakey [00:11:44]:

You can’t pull cash out of a business year on year and then when it comes time to sell it, go, oh, actually don’t tell the tax office, but there was an extra 100 grand a year profit on top of that. So I want my multiple times that as well. No, get one or the other. You can either have the book value or you can have the cash. Or one or the other. Yeah.

Joanna Oakey [00:12:05]:

And I think one of the things I really also noticed in the chat, but also really in the. In the questions that came in before the webinar, was like the concern about identifying red flags. What are those red flags? How do we see, how do we know what to look out for and I guess ale throwing to you from sex business market data, have you noticed any correlation between business characteristics and difficulty selling or lower buyer interest that might serve perhaps as a bit of an early warning sign?

Alex Gilchrist [00:12:38]:

Yeah. So while our data doesn’t directly measure problematic businesses, we can identify several patterns that potential buyers should be aware of. And so firstly, on seek business, if there’s a listing on there for an unusually long time, it usually can represent underlying issues. So on business, on SEQ business, the average listings to sell usually take around 90 to 120 days. So when a business has been listed significantly longer, it could indicate unrealistic pricing or undisclosed problems. Second, we also see lower interest buyers in where there’s businesses that lack financial documentation or there’s a problem with transparency. So listings with detail with detailed financial information typically receive 30 to 40% more inquiries than those with very minimal data. So I guess buyers should be cautious of sellers reluctant to share comprehensive financials.

Alex Gilchrist [00:13:35]:

And third, businesses that are heavily dependent on the owner tend to attract fewer qualified buyers and often sell for lower multiples as well as. That’s just some of the advice I’ve heard when I’ve been on the road. So Brett could probably talk to that a bit more. But our data shows businesses marked as under management or with strong operational teams consistently attract more interest.

Joanna Oakey [00:13:55]:

I just want to throw in really quickly there because really interesting two things you touched on that I thought I just wanted to highlight those listings that have been there for a long time. One of the things that I see repeatedly in the market is, is sellers who aren’t prepped for sales, who don’t have a good understanding of what, what value of the business is and what their value is likely to be, come onto the market with unrealistic expectations. They come onto the market with what do I want out of the sale from the sale of my business, not what is my business objectively worth. And I think that can be a reason for that long listing try. And the second thing I want to add there is sellers being ready, just like buyers being ready. Like actually this is a message to both ends of the market, but sellers not being ready for due diligence for the listing process, for the questions that a buyer is going to ask you just wasting your time because buyers absolutely red flag for buyers if you can’t come up with information quickly or the information you come up with is not clean. So I don’t, I don’t know. Brent, Willie, you have any thoughts on that as well?

Brett Goodyer [00:15:07]:

I wrote a book on one of the things that I’ve noticed is that there’s a correlation, like if you haven’t prepared for sale, then you’re not worth as much. It’s just 100% true. Okay, so it’s preemptive due diligence. Preparing a business for due diligence before you go to market. There’s a direct correlation with an uplift in value. It simply is what happens. So where even your book block, even your book touches on this same sort of information in that we’re talking about, okay, if you want to exit a business, then you prepare it for exit and you will get an uplift in value. That’s why you buy a business.

Brett Goodyer [00:15:46]:

It’s an asset. You want that asset to appreciate as well as give you regular returns. So the thing you do with an asset is if it was a house fix, your bathroom, you’d do all of those different things to improve the property. In the case of a business, you try to do the exact same thing but in a slightly different way. So you document things. You start doing cash flow forecasts and budgets. You document a business plan that says, this is where my business is going over the next three to five years. This is how I’m going to achieve it.

Brett Goodyer [00:16:15]:

This is the marketing plan. This is everything I’m going to do about it. A part of a comprehensive business plan is the exit. Every business owner has to get out of their business at some point. So prepare. It’s that simple. Get ready for it. Because the difference between a, a business, two businesses that are, are exactly the same.

Brett Goodyer [00:16:37]:

They both turn over a million bucks, they both earn 300 grand a year. But one of them has a comprehensive business plan that includes a documented systems and procedures and cash flow forecasts and all this information so that when they walk out the door, they can pass it to the new purchaser and say, here you go, there’s the blueprint to continuing on into the future. Or you have the one next door that has none of that. Are you going to pay the same amount? The answer is obviously no. You will pay more for the business that has a lower risk because it’s got a blueprint for the future. And that’s what due diligence is really about. So if you can preemptively answer every question before anybody ever asks it, then they’re not going to ask it and it becomes a simple process. And that’s the massive difference between a prepared business and an unprepared business.

Brett Goodyer [00:17:27]:

There’s so many times that from a forensic accounting position, why I get Asked on the stand by a barrister, why did this business get valued in this way every single time? It comes down to they’re not prepared for sale. It’s not the same as this business that sold for five times its EBITDA for the following reasons. It doesn’t have cash flow forecasts, it does not have systems and processes and it is entirely reliant upon its owner. The owner can’t step away from this business for a week without it falling in a heap and you’re expecting to just walk out and someone else takes over. It’s not going to happen. So it’s worth, let’s say two and a half times, it’s half as valuable. And it’s trying to get that principle of preparedness into people’s heads. And so when someone says, oh, how do I account for cash? It’s too late.

Brett Goodyer [00:18:19]:

You should have been accounting for cash three to five years ago when you took over this business. You put the cash back in where it’s supposed to be, you pay tax on it and your business will improve in value.

Joanna Oakey [00:18:31]:

I just want to make a call that you’re talking about your book. So we will put a link to the book in the notes and fabulously titled beyond the Bullshit. A no nonsense guide to business valuations and like you said, written a book. It’s battle of the books here. Buy GrowX and of course we’ll put a link there as well and seek have got a fabulous Market Insights report and you can sign up there for free and get Market Insights on a quarterly basis. Fabulous report there Alex, that all that advice and indeed sellers and business brokers can get access to. Okay, so we’ve talked about Renfre, we’ve talked about ideally not buying a lemon. Where are we going to go to next? Okay, it bit to multiples.

Joanna Oakey [00:19:18]:

Multiples as a whole like that. That drew a lot of questions both in the webinar but also in the in the chat. I’m not even sure where to start there because there was so many questions. Here’s one. I love this question. I love this question. Why don’t all businesses have the same multiple? And I just think like it’s really good to start high level here. Let’s cut it down and talk about it in a really in the easiest sense possible.

Joanna Oakey [00:19:48]:

What’s like the easiest way you think you can communicate about what that ultimate difference in multiples is showing?

Brett Goodyer [00:19:56]:

I think that example I just gave you a moment ago, like if you had two cafes, they were on the same street and they both Served very similar food and coffee. And they both turned over the same kind of money and made same sort of profit. But one of them had the owner not working in the business at all. It was completely run under management and they had assistance and procedures filed so that if a new employer came in, you could just go, okay, this is your role. Here it is, have a read, work it out. We’ll then give you the training required and we’re off and running. And so the speed up, the, the getting them up to speed might take two days. And then you have the other business which ostensibly is the same and it has an owner that’s pulling 80 hour weeks and is not paying their taxes properly.

Brett Goodyer [00:20:49]:

And all of these other different things that don’t have a systems and procedures manual, they don’t have that the risks being managed, they are not worth the same amount of money, even though they both earn the same amount. Because the amount of effort required to maintain one over the other is vastly different. And at the same time you have to work in one and not the other. So the difference is simply how risky is it to step into this business, take it over and continue earning the money. But also how much effort do I have to put in, Especially in that smaller end of the market where we’re talking small to micro businesses where the amount of effort required is directly correlated to the owner. If they have to work in the business and work their guts out, it’s very different to one where there is no owner working in the business. So that’s what it comes down to. It’s simply risk and reward and there’s thousands of different options I can give you here.

Brett Goodyer [00:21:50]:

But one of the things that we’ll see, for instance is accounting firms have over years developed this rule of thumb methodology of valuing themselves, which is sensing the dollar on revenue. But it’s a shortcut method. And what it’s doing is essentially saying I’m going to pay a dollar for every dollar of revenue that is earned. And so it turns over a million bucks, I’ll pay a million dollars for it. And the reason that developed is that most accounting firms over that period were making about a 30 to 35% return. So that was the equivalent of a three times multiple. So it was just shortcutting the process. But the problem with that and that carry on into the post revenue cents in the dollar sort of world is that if you looked at two different businesses that were both turning over a million bucks, but one was making $150,000 profit, one was making $350,000, then you ought not to be paying the same amount for them because whilst they’re earning the same, their overheads are different.

Brett Goodyer [00:22:52]:

And it’s no different when you start looking at risk. Okay, how risky is it that I lose my key employee who is responsible for 50% of my fees? If it’s super risky, then, you know, we’re not going to pay the same. Or let’s say it’s a manufacturing company who’s got only 10 customers. If they lose two or three of them, they are now essentially in Sullivan. Whereas another manufacturing company does something very similar but has a thousand customers, they are not the same because they’ve got that diversification of income. And so every single one of those considerations lets us build a picture of risk that allows us to then say, how much would I be willing to pay for that income stream that’s derived from this business type?

Joanna Oakey [00:23:44]:

And I think the one thing that growing there as well is across. You were just talking about what different industries do and how different industries work in terms of base valuation approaches, because there are movements. So accounting industry. Yes. There’s a particular approach that many people in the industry will adopt to valuing an accounting practise that’s different to if they’re valuing an event practise or a legal practise or a. So I guess that’s another point of the important thing is to understand the industry in the market that you’re buying into, in the way valuation will happen within that business. Because valuation is not just a function of the business in and of itself, it’s also business within the industry that it sits in and the way that.

Brett Goodyer [00:24:29]:

It operates with the economy as a whole. Yeah.

Joanna Oakey [00:24:32]:

And actually when I was having this discussion just yesterday with a buyer and I was saying, I think it was with a buy. And I was just talking about this. I had a podcast ages ago where I talk about. I love the concept of growth through acquisition. And we saw a lot of people on that webinar today who were looking at. Also in the sleek data, I think Alex, we talked about, who were looking at acquiring a business as part of their growth plan rather than just organic growth. And I just think, like, really interesting when you have people who. So business owners who are looking to sell.

Joanna Oakey [00:25:08]:

And I was, I had an episode talking about all, all about the benefit of acquiring before you sell to increase your size and potentially also increase the multiple. And so then I have this seller approach me and he said, oh, look, I’ve been listening to your podcast and I was Going to come to you to help me with the legals of selling the business. And then I pulled out of the sale because I thought, actually, maybe I’ll come on by, have a look at buying a business, get my head around the values in the industry first. And he went in, had a look at the values, you know, what’s there.

Joanna Oakey [00:25:38]:

Sitting in the market.

Joanna Oakey [00:25:39]:

And he said, oh my God, this is amazing. I’m being told at the moment I’m looking at a sale on the basis of four times my ebitda. I’m sitting here, I’m seeing businesses for sale at two times. I reckon, because I know that business, I can roll them in immediately and get that increase in the value of the two times to the four times once. And we call that valuation arbitrage for acquiring a business and then being able to get the uplift in the value. And he did that, he went out and did that and I thought, I love it. That is absolutely epic. Because it’s rare that lawyers get the opportunity to help guide people in ways for growth of the business.

Joanna Oakey [00:26:16]:

And really is an opportunity, isn’t it? But it just shows you how those multiples can, even within the same industry, act differently depending on the size and other characteristics of the business that you’re talking about.

Joanna Oakey [00:26:29]:

Right, well, have a look at those slides that we did in our webinar. And I was showing you what the, the multiples look like in a few businesses that were turning over less than a mil, and for businesses that are turning over less than 5 mil. We have data post 20, $50 million revenue. And you’ll see that the growth in the multiples is significant between each of those. And so one of the things I’ve always recommended is aggregating growth by aggregation and acquisition is you cobble two, three, four businesses together and ensure that they’re now running as a cohesive whole. You know that you might have paid two times for them, but you can sell them for six. And that’s what private equity does. But they’re doing it on a scale and they’re usually starting with bigger businesses to make very large businesses.

Joanna Oakey [00:27:14]:

But there’s no reason why we can’t be seeing that in this SME market much more often.

Joanna Oakey [00:27:20]:

That’s exactly what I think, Brett. I just think it’s the real opportunity out there. And I get really excited when I see things like this because I think SMEs so often just don’t get the access to the sort of information that corporates, because corporate Australia, corporates all around the world use M and A for for that exact reason for growth, but it’s just such an opportunity that’s untapped to the potential that it really is. Anyway, I could talk all day about that. Of course. I’ve got loads of content on growth through acquisition and I cover it in the book as well, of course.

Joanna Oakey [00:27:55]:

Well, that’s it for this episode of the Deal Room Podcast. We hope you’re now primed for your next deal with these pointers and have enjoyed these fascinating insights. Now, if you’d like more information about this topic, then head over to our website at thedealroompodcast.com, where you’ll be able to download a transcript of this episode as well as access any contact details and any other additional information we referred to in today’s podcast. Now, if you’d like to get in contact with our guests today and the services they offer, you can go ahead and check out our Show Notes for a link right through to them and their details. You can also book in directly with our Legal Eagles at Aspect Legal if you’d like to soundboard your next steps, discuss a legal question, or find out more how we can assist, whether that’s with buying or selling a business, or perhaps somewhere in between. Now, don’t forget to subscribe to the Deal Room Podcast on your favourite podcast player to get notifications whenever a new episode is out. We’d also love to hear your feedback, so please leave us a review and rating if you’re already one of our subscribers, or even if you’re listening to this podcast for the very first time. Every review helps our team produce valuable content for you.

Joanna Oakey [00:29:14]:

Well, thanks again for listening in. You’ve been listening to Joanna Oakey and the Deal Room Podcast, a podcast proudly brought to you by our commercial legal practise, Aspect Legal. See you next time, ladies and gentlemen.

Joanna Oakey [00:29:28]:

That will conclude this evening’s entertainment. Thanks for listening to the Deal Room Podcast. To find out more about this episode and other episodes in the series, check out the show notes or head over to our our website at thedealroompodcast. Com AU.