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Buying small businesses: 7 pitfalls to avoid

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For large corporates and big banks the process of buying and selling businesses, or “M&A”, is part of daily life. But for small business owners and entrepreneurs this is a major event. It’s vital to get it right. And so easy to get it wrong.

Forgetting the tax implications

A buyer needs to consider the tax position of the company or group after acquisition and its plans for the future. Is there a chance that the new business may be re-sold in the future? Are there tax losses anywhere in the group? Have you considered that having an additional company in the group will reduce the threshold at which you become a large company for corporation tax purposes?

Not considering all the options and potential outcomes fully in advance can lead to painful tax consequences further down the line.

Assumptions around cross-selling

There’s a massive bonus in putting two businesses together. Each business will suddenly have access to the other’s customer base and hence sales in both companies will show a significant boost. Right?

Wrong. Assumptions around cross-selling are often over-egged. Just because a customer buys product A from you does not mean you will be an automatic choice for service B. Products may need tailoring for different markets. Sales staff may need training in both product sets. The sales approach, sales cycle, and the customer contacts, may all be different. Sales staff from the acquired business may be reluctant to let your salespeople talk to “their” key contacts, and vice versa.

Cross-selling can be a major advantage, but it does require an obvious fit between the products and customer base, and careful planning. Don’t just assume it will happen.

Over-promising to investors

It’s an exciting time. Your business is going well and your proposed acquisition has significant potential. You’re both experiencing sales growth and there are obvious synergies from consolidating back-office functions. You need to sell the deal to investors – banks, VCs, EIS business angels. It’s easy to get carried away.

There will be unforeseen changes and unexpected delays. Not everything will go to plan. Investors will understand this, and will give you credit now for identifying these risks and building them into a cautious forecast. They won’t thank you for using them as excuses later when you don’t quite meet your optimistic plans. Even if you’re not far off the forecast.

Give yourself every opportunity to exceed your forecast and under-promise, over deliver.

Poorly conceived earn-out

Earn-outs create natural tension between the buyer and seller. Don’t let a poorly structured earn-out exaggerate this tension. Particularly if the seller is remaining part of your enlarged business going forward.

If profits in the remainder of the current year are important to you, make sure the earn-out targets reflect that. Basing the earn-out on the next full year alone creates an unnecessary conflict of interest.  If the seller’s business is highly dependent on the sellers remaining in the business, make sure the earn-out keeps them locked in for as long as you need to ensure a proper transition of knowledge and relationships.

Insufficient restrictive covenants

In owner managed businesses the seller is often a vital part of the business. It is one thing to persuade them to stay on after the acquisition. What’s to stop them leaving you after a year or so and setting up in competition – or worse, taking staff and customers of the business you bought?

Under normal employment law, the ability to prevent a former employee competing with you is heavily restricted under restraint of trade rules. However restrictive covenants agreed as part of a business sale, can be far stronger. Make sure you take advantage of this.

Poor integration

80% of acquisitions fail to achieve the benefits intended and fail to create value for shareholders. Where they fall down is in the execution.

The right pace and strategy for integration is key. Impose your systems and processes from Day 1 and you lose any potential benefits of the target company systems. Staff have to learn new systems quickly, possibly unnecessarily, and goodwill can be lost. Integrate too slowly and you don’t get the synergies or control that you need, and you lose the all too short window when both your new and existing staff expect things to change.

Communication is vital. Even top performing staff can get paranoid about non-existent plans that affect their role if you don’t communicate your plans. However benevolent your plans, staff will often fear the worst. And what is the seller saying to their former employees – either in the business or down the pub?

Limiting due diligence to the financials

Of course, proper due diligence is needed. You have to assure yourself that there are no hidden liabilities, that the seller’s financials represent a true and fair view and that the projections are realistic. Good legal and financial due diligence is essential for most acquisitions.

But in smaller and medium sized companies, it can be the softer less tangible areas that cause problems for your enlarged company further down the line. How well do you know the management team? Are their values and aims truly aligned with yours? Have they bought in to your strategy or are they just paying lip service? What is the history and culture behind the business? What is the role of and relationship with any non-management shareholders?

Miss something here and your new acquisition could turn out to be an expensive mistake.

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