Buyers are expected to perform a thorough due diligence on both the business and the seller(s). However, many sellers don’t do an extensive due diligence on the buyer(s). Deals do not always close; many are aborted in the very early stages, and others tank somewhere along the way to what was hoped to be a successful closing. So, what happens that prevents a deal from closing, especially one that began with such positive signs? Obviously, in many cases, the buyer’s due diligence turns up some items that were not revealed by the seller, and others that can’t be resolved.  Some of these items probably had early-sign red flags; other red flags occurred somewhere along the way, and unfortunately, the result was that there were pre-closing red flags.

The Early-Sign Red Flags

Sellers should seriously look at who the buyer is. This may be a corporate buyer who is just looking. On the other hand, some sellers may overlook a strong individual buyer for fear that he or she may be inexperienced in the acquisition process or might be too cautious. In both cases, the seller may want to ask questions such as the following: What companies have you already looked at? How much equity are you willing to commit? What experience do you have in what my firm does?

Some sellers have that sixth sense that allows them to size up a prospective buyer. No one wants to waste time with someone who really isn’t a buyer. The deeper a seller goes into the due diligence process with a potential buyer, the more red flags may appear. If there are too many, if the ones that get raised seem too difficult to resolve, or even if they might be resolved, if that sixth sense says “no” anyway, it is probably time to move on.

Red Flags Along the Way

Once the Offering Memorandum has been given to the potential buyer, the next stage of red flags may occur. For example, if your intermediary informs you that he or she has not heard from the prospect after receiving the memorandum, it could mean that the buyer prospect is not as interested as you might have thought. Also, if the next step involves a junior member of the prospective buyer’s management rather than the CEO or COO, the red flag should go up. If the prospect, corporate or individual, refuses to provide, or delays providing, information showing their financial capability to do the deal, the red flag should be raised. One recommendation is to set up a social event, a dinner or extended lunch between you and the buyer prospect. Visiting at a social event allows the buyer and seller to get to know each other, establish a cultural understanding and build a working relationship. If this meeting goes badly, the red flag should go up, at least half-way.

Red Flags Just Prior to Closing

The Letter of Intent has been drafted and signed. One area that may cause several red flags to go up is if the buyer’s attorney is inexperienced in the deal process, is overly aggressive, or just won’t bend. This is such an important issue that if changes aren’t made, the deal is probably in serious jeopardy of collapsing.  The seller’s attorney may be able to gather some insight on this matter.

Both sides are taking some risks in any buy-sell process, but both sides should take their due diligence efforts seriously. If a deal has arrived at “a just prior to closing” status, it is certainly vital that both sides can resolve their red flag issues. It could be tragic if the deal has gone this far without serious red flags being raised.

The whole purpose of recognizing the red flags is to try to resolve them before the deal “craters”. A positive attitude by both sides is almost always the answer, and this attitude is best accomplished by the use of a professional intermediary who has been there, knows the red flags, and knows how to resolve them.

The “loose lips” tagline was a common World War II phrase and was on posters everywhere. The problem continues on the business battlefront today.  Leaks of confidential information coming from, apparently, some of the Directors of HP have been in the news everywhere. This is an ongoing story. If it can happen to HP, it can happen to anyone. Leaks of confidential data are a serious issue at any time, but are especially serious if they involve the sale of a company.  Sellers are very concerned because of the impact a leak can have on their company and their employees.

Unfortunately, confidentiality is a Catch—22 issue. On one side, the seller wants to maintain it; on the other side, the seller wants to get the highest price possible, which can mean exposing the business to numerous potential buyers. The more potential buyers contacted, the better the chance of a good price being obtained—and the greater chance of a leak.

Owners may be overly concerned about leaks of confidential data, but since this is a concern, the issue must be dealt with. The shorter the time table between going to market and a sale the less chance there is for a leak. The selling process should not drag on! This is one reason why the price, terms and deal structure should be as fair as possible from the very beginning. The longer negotiations take, the greater the chance for word to leak out. If all of the red flags are dealt with early on, the more likely there can be a quick closing. That way, if there is a leak, the deal can be concluded before any damage can be done. The only other alternative is to deal with just two or three potential buyers. This, of course, lessens the chance of getting the seller a better deal.

Sellers should make sure that all documents involving a sale or potential sale are kept under lock and key, marked “Confidential,” and only transmitted to buyers in a secure manner. Confidential information should only be emailed or faxed when one is absolutely sure it can’t get into the wrong hands. Buyers and sellers have to be cautioned about the confidentiality issue. Too many times when there is breach of confidentiality, the leak comes from the seller. The seller tells his golfing partner, mentions it to a neighbor at a cocktail party, reveals it to a relative – indeed, it is usually a case of “loose lips sinking ships.”

If there was ever a reason to use a professional business intermediary, this is it. They can be the conduit between the buyer, seller and the outside advisors. Business intermediaries are experienced in preventing breaches of confidentiality, e.g. by requiring buyers to sign strict non-disclosure agreements. What’s even more important, they are pros, knowledgeable about dealing with one if it happens. This is just another reason to use the services of a business intermediary.

In many cases, the sale of a small company is “event” driven. That is, the reason for sale is health, divorce, partnership issues, even decline in business. A challenging reason is one in which the owners want to retire and live happily ever after. Here is the problem:

The owners have a very prosperous distribution business. They, unfortunately, are the embodiment of a value-enhanced business (see “12 Ways to Increase the Value of Your Company,” under Selling a Business). They each draw about $250,000 annually from the business, plus cars and other benefits. If the company sold for $2 million, after debt, taxes and closing expenses, the net proceeds would be, let’s say, $1 million. Sounds good until you realize that this sum represents only 2 years income for each (and that doesn’t include the cars, health insurance, etc.) – then what? Unfortunately, many owners of smaller companies claim they want to retire when the reality is that they just want to slow down, or eliminate the day-to-day responsibilities of running the business.

Those who want to retire, but don’t think they can afford to, may want to reconsider their decision. Perhaps they can’t afford not to sell.  These owners may have already retired, at least mentally. The owner loses focus, decides not to invest the capital necessary to continue to grow the business and ultimately loses sales and profits or loses a key manager or salesperson, etc. This lack of enthusiasm will no doubt impact their business, lowering its value to a buyer when selling becomes inevitable. In the meantime, following their decision not to sell, they could lose a major customer, a major competitor might begin to eat away at sales — and profits — or a new competitor may move into the market. All circumstances that will reduce value!

Perhaps the owners will not have the “luxury” of changing their minds and deciding not to sell. If they are eventually forced to sell the firm because it is declining, they most likely won’t receive anywhere near the $2 million they might have earlier. The time to sell is when the business is at a high point. Using the services of a professional intermediary can bring the highest price possible.   If you are thinking of selling but hesitating because “the time isn’t right,” take the step that can make all the difference. Seek expert advice, which is as close as your nearest business intermediary’s office.

A buyer was interested in a building products manufacturer that did $70 million a year in sales.  Although the business was profitable, it seemed that their margins were lower than they should have been for this industry. The buyer asked the seller how they priced their products.  As the seller was explaining his pricing strategies, he happened to mention that a price increase of 1.5 percent would not really impact sales. He failed to see that the price increase of 1.5 percent on $70 million in sales would bring $1 million in profit. A smart buyer would realize how to get an additional $1 million in bottom-line profit simply by increasing prices by 1.5 percent.

A recent book titled The Art of Pricing by Rafi Mohammed went immediately to the business best-seller list, and no wonder. The author stated: “One of the biggest fallacies in business is that a product’s price should be based on its costs.”

Here are some of the author’s suggestions:

• Restaurants: Keep the entrees priced attractively, but expect to make up the profit shortfall on drinks, desserts and extras.  McDonald’s profit on hamburgers is marginal, but it has substantial profits on French fries and soft drinks.

• Television Advertising: Sell 75-85% guaranteed slots six months in advance, then sell the balance of advertising to the spot-market with little advance notice at premiums of 50%.

• Financial Printing: Price the printing of IPO prospectuses at near break-even, and then charge exorbitant fees for last minute changes.

• Investment Banks: Quote a relatively modest accomplishment fee as a percentage of total consideration, but insert a rather substantial minimum fee.

Another notable quote from Rafi Mohammed is: “Companies should develop a culture of producing profits. Through better pricing, companies can increase profits and generate growth.  In many ways, smart pricing is like hidden profits.”

This takes us back to our first premise: Small pricing increases can greatly increase profits.

Much has been written about “fairness opinions” due to the financial manipulations among companies such as Enron, Tyco and others.  The conflict in the use of fairness opinions  was (and is) that an investment banking firm not only handled the sale of a company,  but also got paid for doing a fairness opinion.  For example, when the Bank of America decided to buy Boston’s Fleet bank, B of A paid the investment banking firm of Goldman Sachs $3 million as a retainer, $5 million for a fairness opinion, and was prepared to pay a success fee of $17 million if the deal actually was completed.

Keep in mind that a fairness opinion is prepared by one or more financial experts, or by a firm, to protect the shareholders; in other words, to assess whether or not the deal is fair to the real owners of the business.  It also protects the officers and board of directors from shareholders who feel that their company is paying too much for the business being acquired.  It is also apparent, from the example above, that the investment banking firm makes money, and a lot of money, through the entire purchase from beginning to end.  They don’t have much of an incentive to really come in with a “fair” fairness opinion.  However, regulators are looking at this obvious conflict of interest very seriously, and changes in the current regulations are almost sure to happen with full disclosure being only the first step.

So, how does all of this impact the privately held company?  It is vital that an owner of a privately held company who has minority or family shareholders should also seek a fairness opinion.  It may not have to be done by an investment banking firm and probably shouldn’t be prepared by the owner’s accounting firm, for the same reasons outlined above.  A third party evaluation should be done to insure that a minority owner doesn’t come out of the woodwork and claim that the business was sold for much less than it is worth – at least according to the dissident shareholder.

A professional intermediary can be an excellent resource in the preparation of a fairness opinion for the privately held company.  They can provide several valuation professionals and/or firms and also assist in the gathering of the necessary financial records.  Generally speaking, a fairness opinion is prepared after the selling price is agreed upon.  In the sale of a privately held company, the price may fluctuate throughout the negotiations, but a third party valuation can set the bar.  And, it’s very possible that using a business intermediary to market the business will bring a price above the valuation, pleasing everyone.