Derailing a Business Sale: Beware of the Unknowns

December 17, 2015

Our client, the owner of a very successful quasi manufacturing business, accepted an offer on his business from one of several prospective buyers 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? Two things actually.

(1) 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. As a result, the seller told us that the appraisal would not come close to the represented value of the equipment package in place. Armed with this new information, we explained to the buyer that his hand-picked appraiser was refusing to place values on seven figures of custom manufactured equipment. To the buyer’s credit, he waived the equipment appraisal contingency so we were once again sailing smoothly.

(2) Fast forward to a couple of weeks from closing. At one of the regular meetings with the buyer, seller, and broker, the seller (our client) asked about “the WIP” (“work-in-process,” generally a subset of inventory). Both the buyer and 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 agreed about the inventory being included in the sale, but he again asked “what about the WIP?” We had to ask, “What WIP?” at which point the seller explained he has a “lot of WIP” on the shop floor, but not on the books. Apparently, in a major effort to push taxes out from 2015 to 2016, the seller prematurely expensed his 2015 cost of goods sold – the amount of his WIP – in essence shifting 2015 income to 2016.

So the buyer had to ask the seller about the scope of the WIP. The seller said 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 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 which 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.

Contributed by Michael Greengard, Praxis Business Brokers.

Through the Michigan Chamber’s partnership with Praxis, we can guide you through a step-by-step process of the complexities, all while maintaining complete confidentiality. To learn more about selling your business, please contact Lindsay Fulton at lfulton@michamber.com or 517-371-7691.