Derailing a business sale: Beware of the Unknowns

A true story: when – 4th quarter 2015; where – Oakland County, MI; what – read on

Our client, the owner of a very successful quasi manufacturing business, accepted an offer on his business from one of several prospective buyers whom we brought to the table. It looked like a (relatively) easy deal to close with minimal banking and lots of buyer cash. And as seller cash, A/R, and all liabilities were excluded assets from the sale, the deal price was essentially fixed assets, inventory, and goodwill. What could go wrong? Read on…

Due diligence started out poorly when the buyer’s equipment appraiser showed up and said he could not give any kind of value to the custom designed and built machines so prevalent on the seller’s shop floor. The seller quickly told us that the appraisal would not come close to the represented value in place of the equipment package, so the seller requested our help. We explained to the buyer about his handpicked appraiser categorically refusing to place values on literally seven figures of custom manufactured equipment. To the buyer’s credit, the equipment appraisal contingency was waived by him so we were once again sailing smoothly.

We are now just a couple of weeks from closing. What else could go wrong now? Read on… At one of the regular meetings with buyer, seller, and broker, the seller (our client) asked about “the WIP” (“work-in-process,” generally a subset of inventory). Both the buyer and the broker reminded the seller that the $600,000 of inventory on the balance sheet is included in the sale price, and the seller was shown the exact verbiage in the signed letter of intent. The seller of course agreed about the inventory being included in the sale, but he again asked “what about the WIP?” We retorted, “What WIP?” The seller then calmly explained that he has a “lot of WIP” on the shop floor, but not on the books. In his major effort to push taxes out from 2015 to 2016, the seller prematurely expensed as 2015 cost of goods sold the amount of his WIP, in essence shifting 2015 income to 2016.

The buyer correctly asked the seller about the scope of the WIP. The seller responded he didn’t know, but “guessed” it was between $200,000 and $800,000. Our hearts sunk as we felt deal tremors before a possible explosion as, if the WIP amount turned out to be meaningful (it was – $523,000 to be exact), the seller would want some additional compensation especially in light of the fact that the business was doing better than advertised because the additional, “hidden” 2015 profit was unknown to all but him.

The seller did ask for an additional $523,000 cash at closing while the buyer declined, not wanting to pay any additional amount. It took a couple weeks of negotiating how much and through what financial instruments a satisfactory settlement amount could be agreed upon, and while being neither fun nor easy, it did get done, and the deal eventually closed. The moral of this story is that a solid business transaction between a willing buyer and a willing seller came so close to being derailed on two separate occasions because the seller did not take stock of what unique and unexpected financial aspects of his business should have been explained on day one to brokers and buyers. We are fond of saying that it is so much easier to handle bizarre news on the front end of a deal than by often acrimonious negotiations just prior to closing. Please trust me on this. I have been there before.

Contributed by Michael Greengard, Praxis Business Brokers.