On occasion, failing businesses can offer ideal opportunities for interested buyers. While it’s important to pay attention to red flags, it’s important to consider that one seller’s distressed business may be a hidden gem worth investing in.
Let’s face it - there are more than enough failing businesses to choose from that are currently on the market. This means that there is ample opportunity for a smart investor who is willing to roll up their sleeves, inject capital, and allow themselves to be patient enough to outlast economic cycles.
Simply put, diamonds can be found in the most obscure places. While most buyers are concerned when it comes to buying distressed businesses, if assessed and transacted appropriately, significant upside can be obtained through purchasing a business with an uncertain future.
1. Look for Good Bones
Regardless of a business’ situation (downward trending, archaic and disorganized records, etc.) you will want to look for a strong foundation. In most cases, this foundation comes in the form of a strong, diverse, and (most importantly), loyal customer base.
Ensuring the business has a happy, robust customer base is your first sign of life. If any single customer accounts for more than 30 percent of the company’s total revenue, that’s a red flag. Lose that customer and your revenue (and business) will suffer greatly.
Another foundational item to look for is the quality of the team. Are the employees fleeing in droves? What is the turnover rate? Ultimately, if you are going to turn this business into a positive, you need people to stick around.
2. Do Your Due Diligence
One important myth to put to rest is the notion that the purchase of a troubled business is a bargain. The old saying that "if something appears too good to be true, it usually is" certainly applies here.
When investigating the merits of purchasing a business, it is critical to develop a comprehensive due diligence program that addresses the key financial and legal risks involved; this is particularly true with purchasing distressed business. Given that prospective buyers will likely be faced with limited information and a short period of time to achieve a sale, having a plan and executing that plan can make all the difference in your search for a hidden gem.
If the business isn’t prospering, figure out why! Your goal should be to turn over every stone. Doing this takes time. It's therefore crucial to agree on a reasonable period of due diligence to give you the time to adjust your offer downwards as problems come to light. There is no business worth saving if it is a complete fire sale.
Start by checking the basics: legal standing, outstanding payroll or taxes, liens against the company, and so on. A thorough review of the company’s financials is another must. It’s not enough to simply scan through Profit & Loss statements. It is imperative to do a deep dive into the business’ accounting software, and to cross reference your findings with company tax returns and bank statements to make sure that there are no misrepresentations. The worst thing that can happen is to find out that there is a major leak in the boat after you’ve launched from the dock.
If a negative issue arises, look for a cause. Many times, issues can be justified. If that’s the case, then make a note of it and keep pushing forward. If, however, there is little to no link between the issue and a reasonable justification, walk away. Only buy businesses where you fully understand why the business is currently in the position it’s in.
3. Buy Assets, Not stock (Equity)
It is very important to mitigate the danger of any hidden liabilities through careful structuring of the deal. In most cases, it will be advantageous for the acquirer to consider purchasing the assets of a company rather than equity (stock).
The problem with purchasing the stock is that the company (and the buyer/new owner) will retain all past, current, future and contingent liabilities - including any tax liabilities.
On the other hand, an asset sale usually means that the liabilities remain with the company’s seller and will not transfer to the buyer. Furthermore, the buyer can be selective in which assets they take on.
Each situation is different and it comes down to smart negotiation and attentive deal structuring.
We recommend seeking professional, independent legal advice on this.
4. Have Funding Readily Available
Restrictions on traditional funding may apply. You are unlikely to acquire bank or SBA financing to buy a struggling business. This means that you will need to be creative.
Whichever path you end up taking, it is smart to get funding in place before you embark on this journey and make an offer. This will dramatically help your credibility on the market. All sellers, regardless of their company’s wellbeing, like to know that they are dealing with someone who is serious and capable of transacting- and not someone who is simply sniffing around.
Inform and prove to the seller that you have financing available and that it is simply a matter of finding the right opportunity. This will make you progressively stronger as you begin your negotiation and give you a leg up on the competition.
Related: What is Seller Financing?
5. Push for Your Terms
If the business is truly distressed, you as the buyer will want to push for your terms. This means that you will want to set the deal’s terms in a way that protects your investment and ensures that the business will live on. There are several ways to do this; escrow holdback, seller financing, and earn-outs, to name a few.
An escrow holdback is when a portion of the purchase price is not paid at the closing date. The amount is negotiable and is usually held in a third party escrow account until a future condition is performed.
Seller financing is when the seller actually lends the buyer a percentage of the asking price (with interest). This deal structure is a normal part of the selling process for most small businesses and makes for an attractive funding alternative for the buying party.
Earn-out scenarios are a little different in that they are tied to future performance and therefore include variable payments. The seller faces the chance of discounted payments should the business under-perform on an agreed-upon threshold. This truly incentivizes the seller to work with the buyer throughout the transitionary period and beyond to make sure that the deal is truly what it claims to be.
Whatever the terms may be, it is important to protect yourself and the investment you make.
6. Remember Why You’re Doing This
Remember, a distressed company is an opportunity for you. It presents you with a depressed price and a chance to map out a new future. One of the main reasons that entrepreneurs buy businesses they plan to operate is that they believe that they will be able to run the business better. This means that a buyer needs to be sure that they have what it takes to achieve this.
The business may have been run poorly for a plethora of reasons. Consider how you can run the business differently and what additional resources you have within your reach that would be advantageous to the company in discussion.
You should, however, never lose sight of the risks. Be objective and realistic about risk and calculate how to minimize your downside exposure. There is always a chance that it will be impossible to turn around the distressed business. Each business has a life cycle in which, at some point, it will die. As a purchaser, it is your responsibility to determine whether it is dead or if it is in hibernation.
With all of this said, it is possible to find the needle in the haystack if you are willing to look. Recognize viable opportunities but be careful not to get seduced by low prices. It is crucial to take a 360 degree view in terms of vetting the opportunity and setting the boundaries and terms for life after closing.