Relative to buying a large business with hundreds or thousands of employees, one might think that buying a small business is a piece of cake by comparison. But that’s definitely not the case.
I’ve spent the last five and a half years advising buyers and sellers of businesses of all sizes: from $1 million all the way up to $1+ billion. What I’ve learned from those varying experiences is that the smaller transactions are the hardest. The reason for that is the lack of experience that small business operators have with M&A. At large businesses, there are teams of people under the CFO or in Corporate Development that were likely hired in part to execute M&A deals. At small businesses, the finance team is miniscule - there’s definitely no one focused on Corporate Development and there may not even be a CFO. If there is a CFO, chances are they’ve never done any M&A. It’s likely that no one at the small business has ever done any M&A.
If the documentation process were commensurate with the size of the transaction (the smaller the deal, the less documentation required), things might be different. However, there are certain areas of diligence (Legal, Insurance, and HR) that are the same regardless of the size of the business. No matter the size, every seller needs to provide their incorporation and organizational documents like by-laws and capitalization table. No matter the size, every seller needs to provide documentation related to insurance coverages. No matter the size, every seller needs to provide information related to employee pay and benefits.
Due to the seller’s small team and lack of experience, gathering all of the required documentation puts an incredible amount of strain on the business. To compensate, it requires efficiency and additional support by the buyer. I’m in the middle of a deal right now - by far the most difficult transaction I’ve been a part of as a buyer - and below are the most important things I’ve learned thus far to make the process go as smoothly as possible.
As I mentioned, the only way the deal gets done is if the buyer shares their experience with the seller by walking them through the more complicated parts of the transaction. Normally, a sellside investment banker would do this but because of the size of the deal the seller likely won’t hire one due to the cost. So it’s up to the buyer to give some of that same advice. But it’s a very fine line the buyer has to walk because some of the advice they could give would hurt their position as a buyer, for example, regarding valuation. Therefore it’s very important that the buyer maintain independence when advising the seller and not influence the seller’s decisions. The buyer can present the facts and the considerations, but the seller should make all final decisions using their own judgment.
With that in mind, below are the things that a buyer can help with:
- Shorten the due diligence request list: this isn't as easy as it sounds because you don't want to leave out anything important. But there are some things that may not apply to the business. You still want to ask for it and let the seller say it either "doesn't apply" or they "don't have it". Receiving those types of responses are important and may even be incorporated into the purchase agreement. What you should do to shorten the list is walk through the list at the very beginning of the transaction specifically asking for the seller to identify things that don't apply or they don't have. Have them ignore requests (for now) that do apply to them and that they'll have documentation responses for. The side effect of this approach is it relaxes the seller going forward because the request list isn't as daunting because it's shorter.
- Clarify priorities: if you're trying to close the transaction on a certain timeline, there may come a time when you say it's okay for the seller to not provide something even though in a perfect world you had it. This is one reason why it's important to prioritize. Another reason is to get responses that will require extensive review by the buyer or buyer's counsel first so that those don't become a bottleneck.
- Be available to answer questions: because the seller doesn't have the experience, they will have lots of very simple questions that if they're left to figure out themselves will unnecessarily slow down the process. Email and phone aren't always sufficient - if possible, you should spend time on-site at the seller's office so that questions can be asked as soon as they come up. It's not ideal from a buyer efficiency perspective, but it's incredibly helpful to the seller and so if they're the bottleneck then it may be worth it.
- Encourage the seller to hire an additional accounting resource: the quality of earnings process is like going through an audit. The finance teams at small businesses are grossly inadequate for this process. The seller should consider hiring an accounting resource to assist - ideally it would be a former big four auditor or transaction advisory professional. This whole process may seem overkill to the seller. If that's the case, position it as a first step in the integration process as opposed to a condition to completing the M&A transaction. If the buyer is on GAAP, the acquired entity will have to convert eventually anyway.
- Take over mindless tasks like scanning files: the seller likely has filing cabinets filled with files that the buyer needs to review. Chances are the files will satisfy the majority of the items on a diligence request list. Rather than let one of the seller's employees scan the files - which is such a basic task even a monkey could do it - have someone from the buyer do it on their behalf. The important thing to remember here is that the buyer needs to maintain their independence, and so they shouldn't be deciding what to scan and what not to - just scan everything.
- Reduce scope of due diligence requests: this again involves leaning on the buyer to put in extra work. If the seller's files are all scanned, then the buyer can review and organize them and then ask the seller to simply review them for completion. For example, the buyer can organize all the customer contracts and then ask the buyer to confirm that they don't have any more. If every document in their filing cabinet and server was shared with the buyer, then this should be easy to do. The scope is reduced from "please find all customer contracts" to "please find missing customer contracts."
If you find yourself buying a small business, I hope these tips come in handy.