Transcription
[Music] When it comes to buying businesses, buyers obsess over financial analysis and legal docs, but the landmines are in operations. In this video, Chelsea Wood breaks down how to do diligence beyond the numbers so that you don't end up with a six-figure surprise after closing.
My name is Walker Dyel. I am the Wall Street Journal, USA Today bestselling author of Buy Then Build, creator of Acquisition Lab, where Chelsea Wood and I have helped hundreds of buyers acquire almost half a billion dollars in small business transactions. If you want to avoid six-figure surprises after closing, this is a video you can't afford to miss.
Welcome everyone to this webinar on how to reduce surprises with operational diligence. I'm Will Smith, host of Acquiring Minds, the podcast. Today's session is with Chelsea Wood. Chelsea, you all already know, co-founder, managing director of Acquisition Lab. And the lab is a cohort-based education community for people serious about buying a business. Many successful lab grads have been guests on Acquiring Minds, including most recently Lucas Phillips. Great conversation and story. Go back and and look for Lucas uh if you're interested.
Chelsea's topic idea for today is such a good one because there's so much effort by searchers to diligence their their target businesses financially, which of course there should be, but that can sometimes often times overshadow other types of diligence, namely operational diligence, operational DD. And listeners of acquiring minds know that there is just as much likelihood that something operationally could bite you post-transaction as financially. So Chelsea has a great presentation for us around this type of diligence, operational diligence.
All right. So what I want to talk to you guys about today is um operational due diligence, right? And I think that operational due diligence is a topic that is often it's very nebulous, right? And I think that when people talk to me on uh strategy calls for the acquisition lab, a lot of times they're intimidated by due diligence, and everyone always talks about legal and financial, but I think what they're actually scared of is operational due diligence and they just don't know it yet. Um because it's really hard to know what to ask. And so anyone that's attended any of my sessions in the past will know that I try to be very kind of uh tactical and practical in my webinars. Um, and so I'm going to uh kind of try to dissect this in a way that helps you understand it.
Last night I was trying to think of an analogy for how I view operational due diligence. And uh, Chat GPT was my friend as I sat there and rambled to it, and what it came back with was like, "That sounds a lot like an iceberg." And I was like, "Holy hell, that does sound like an iceberg." Right? And so when you I love Chad GPT for helping me think. Um, so when you think about due diligence, you've everybody knows you have this team um of providers you're going to use. Everyone talks about QVS and financial diligence. And so when you think about diligence, it's like you're I feel like people are talking about the top of the iceberg, right? And that's just the top, right? But if you look at the full iceberg, what what's actually biggest and most impactful um is the operational due diligence. And that's where you guys are going to be at, right? Um, and so it's like financial and legal diligence gets the spotlight in all the conversations. Um, but in Chelsea's opinion, operational diligence is actually what's going to sink you.
And I couldn't have timed this presentation better because as I was finalizing it last night, lab members were talking about this episode in Slack. Um, and I was like, hey, that sounds cool. So, I was listening to it as I was finalizing the presentation and like there his number one takeaway was that thorough operational due diligence is non-negotiable, right? And you need to make sure that you really understand the operations. And part of that is um trusting the seller, right? And and and really making sure that you um trust what's being said to you. And so what I did is I put together a discussion guide. So I put together an operational diligence checklist as well as a discussion guide because I think people are often overwhelmed with figuring out how do I figure this stuff out? Like how do I know if they're um if I should trust the seller? Um, and it's a lot of the questions that you ask, the responses that you get are data points, right? Um, and so we'll talk a little bit about, you know, all of that throughout the presentation.
So, I'm going to very very briefly talk about due diligence basics. Um, and then I'm going to introduce you to the optics framework, which is what I use when I'm um looking at deals. I, um, kind of lump them operations, processes, and practice. And so I think about uh processes and practice and I use those words very specific because what's documented in your SOPs and what's actually happening are very different, and it's important for you to understand the difference. Um and then tools and technology, infrastructure load and how what the capacity is to actually sustain growth. um customer experience and then what are the surprise risks. Um I'm going to talk about what to ask in each of those categories as well as red flags to look for and then I'll do an overview of some tools and templates that um are available for you guys.
So these are the most commonly discussed components, right? And I just thought it was important that we level set, right? So you have the quality of earnings which is really looking at the financial health of the organization. This is where you're going to get your uh working capital analysis completed. um they're going to look at uh cyclicality. They're going to look at um you know validating that the financials are what the financials say. Um if you do the QV and with the lab that we've worked with partner to design it goes a little bit deeper into that um into the stuff or into the business health around like marketing and keyman risk and all that stuff, but most quality of earnings are going to look at um the financial health of the organization, and then legal diligence is really looking at um all the legal implications, right, regulatory um uh challenges, any um any like litigation risks, anything like that. Right. And of course, some of that HR stuff's going to be in that in there, too. Hopefully, make sure that someone's doing the HR side. Uh, right. But at the end of the day, the legal and financial is really just verifying what you were told was true, right? It's very backwards-looking, right? It's an analysis to ensure that historical performance is what they say it is. But to me, the reason why I think this is such a big topic is the foundation that produced those results that they're verifying and understanding and evaluating how that's going to continue under your ownership is what operational diligence is. And to me, it's extremely nebulous, especially when you're a first-time business owner or you're in an industry that you're not familiar with or you've never operated. It's a lot of um you have to really understand a lot of different business components uh that you may not. So I am a like my education is basically trains me as a consultant and so my model just tries to help you get your arms around um all the different aspects of the business.
This is the meme that I saw that Brent Behore posted um and it is like the perfect representation of being a business um buyer, right? And so like the CIM looks beautiful. Um, and financial and legal diligence isn't going to uncover the mess that operational diligence is going to uncover. And so like if you just verify the information presented to you is true and you don't do a good job with due diligence, you won't know what you're actually buying, right? Um, and this just made me laugh so hard that I had to I had to use it.
Here's just a a few um high-level examples from the lab of things that were missed in diligence that came kind of to haunt the uh lab members post-close. Um some of these things I think are really important that you understand um because it's a lot of the human capital side uh that I think just kind of gets glossed over. Um, and actually most of it is, and then some of it is just, you know, equipment that is aged and and, you know, uh, you have to make sure that you're actually doing evaluations on the the assets that you're buying, right? At the end of the day, you do not want to be standing there going, "Damn it, how did I not catch this?" Right? And I do think that there's a a level of um grace that you're going to have to give yourself because no matter if you spend a million dollars on diligence, you'd still miss things because some things never show themselves, right, until you're owning it for a while and they just come up and that's okay. Um my hope is that through the process that we talk about today, um it'll at least allow you to uh get ahead of it a little bit, right? And maybe plan for some challenges so that they don't surprise you, which is what this is all about, right? Um, and so here are the categories that I talked about earlier and we're just going to go through each one. Um, but the goal is that holistically once you walk through these um, categories as well as like an industry-specific category that I don't know because I don't know the company you're buying um, you'll get a better handle on the business as a whole.
So it starts kind of figuring out who's running the show and are they going to be able to keep it up post-close, right? And that's the operations side. Um, as a small business owner, I unfortunately identify with this meme a lot. Um, because I think that most small business owners, they'll say they have work-life balance, they take vacations, it's okay, all is good. But like when they're on vacation, are they actually working? Because that's important to know. Um, and so when you're looking at operations, you really want to understand who's actually doing the work. Um, but the bigger thing is like how are decisions being made, right? Um, if I once worked with a company that was trying to exit and the seller was still involved or yeah, the seller was still involved in every decision and that was an company with hundreds of employees like 150. And so it's really important that you understand if you're inheriting an actual company or if you're uh acquiring a bunch of hands, if that makes any sense, right? like you have one brain in the company and then everybody else there is just a pair of hands so that if you take the brain away they're not going to know what to do. Um so I try to do a little bit of a discussion guide for each section so that you could understand okay so I understand what I need to like what I need to review. I understand what questions need to be answered but like how do I actually get the answers to these questions? And so questions you can ask when you're in your seller um meetings is like walk me through a typical day for you. um talk to me a little bit about um you know a a a problem right like that popped up when you had to leave right you had to be out maybe a medical leave or something um understand like help me understand if there have been any um recent uh people changes right that that have um impacted the business um the important thing here is that you understand like how the work actually gets handled, delegated, decided, um acted on. Are is everybody actually like empowered to do their job, right? uh red flags that you want to look for here especially is if there's no clear second in command like is the seller constantly answering questions like oh you know we just figure it out like oh you know um my employees are really great but he never there's never a layer of specificity that's like oh well you know Peter manages this stuff and Becky does this stuff if it's all kind of nebulous then it could be a sign that there's not actual clear delegation because if Bob handles things he's going to say Bob handles. Right. And so, um, there's risk inherently when there's a lack of specificity. And so, when we talk when, um, and I'm so sorry, I don't remember the gentleman's name from the earlier, uh, podcast that just launched, but, um, when they mentioned how why, like, how do I know if I should trust the seller, that lack of specificity when you're trying to diligence operations is should be kind of a data point for you to consider, right, of like, oh, it kind of felt a little squirrely. I couldn't get him to really land on anything. And if you're getting like that, my word of advice, guys, is that you should have a list of employees, right? If there's if you're getting no clarity as to how operations actually run, go through the list. What's Becky do? What's Susan do? Like, talk me through like what decisions has Susan made in the last 12 months, right? And really start to get specific.
Um, the next piece is really around processes, right? And so you want to understand if they're actually solid or if they're just if they're solid processes that are practiced or if it's just habit. Um habit is institutional knowledge that will walk out the door. Right? So you don't want that. Um I had my I threw my husband um a birthday party this weekend and this meme gets shared across in-laws like consistently at least once a year with me around if I do a job in 30 minutes it's because I spent 10 years doing it blah blah blah. And I think that every time I see it, and this weekend was no exception, I always think of sellers when we look at listings and they're like, I only work for four hours in this job, right? But they've had it for 30 years. It's like, are they actually only working four hours a month because or four hours a week because you'll be able to do that because they have processes in place or do they have are they doing it because they've been there 30 years and now they can do it based on their own kind of um function but not necessarily because of the function of the business. And so when you're analyzing the processes in practice um you want to understand not just how it's written but how it's actually done. Um you need to understand if there are um known deltas for lack of a better word like is there are there known uh deviations from the processes and then why like is there any repercussions for deviating from the processes? Um all of that gives you data points about how the company is run, right? And whether or not it needs operational cleanup or if you're buying something that's operationally sound. Like we always talk at the lab about how um every deal is a good deal for the right structure and you know not every deal is a good deal for the wrong buyer, right? And so if you're looking at a business and it's got really messy operations but you are an operational efficiency person like you love nothing more than doing cleanup and and process work, that's a good business for you. If that is if you're allergic to that, then you do not want to buy a business that needs cleanup. You will be lost. You will be overwhelmed and you won't be able to put order to the organization. And so it's just really important that you get your arms around knowing if the hair on the business is the right shade for you or not. Like if the if the issues with the business are appropriate for the the the value you're going to bring as a buyer. And I know this topic is really really big and I like I'm laying in bed last night thinking about all the things I didn't include in here. Um and so hopefully this will give you a starting point at least. Um, but here you want to ask about uh, you know, what's the most recent um, updated SOPs? Look at the like actually get the files. Um, if they're paper files and they're dusty and and the last date on them is in the '9s, that's, you know, probably not still practiced that way, my guess. Um, but you also want to know um, in this like ask like um, walk me through the process when somebody new joins the team. Right. Walk me through how you train someone on the process. Right. Walk me through how are there audits to make sure that you know how does it how does the process change over time? It's really important to recognize that small businesses a lot of these answers are going to be no, right? Because small businesses often are cobbled together over time, right? And so these aren't necessarily like deal breakers, right? The whole point is that you go into this eyes wide open and you just know what you're buying because at the end of the day, if you don't know this stuff, then you don't know you need to fix it, right? You don't know that there's inherent risk. So, you're going into this with assumptions that like, oh, you know, they said they had SOPs, so we're fine. And then people leave and you realize that the SOPs aren't actually how the work gets done, and you have a hard time now replacing talent. And so, everything I'm sharing with you guys today isn't like a, oh I have to end this deal. It's no, it's just about being prepared, right? This is about this is why I like the optit framework is it's about eyes wide open, right? It's like going into this and understanding what you're what you're moving into so you can plan accordingly.
Um Chelsea, can can I interrupt real quick just because we had Oh, please. Yes. We're getting questions and and I had the same question. you just answered it, but I think it's worth highlighting that, you know, isn't isn't this lack of process a big a big reason a big way to professionalize these businesses? This is where the searcher adds value. Uh so so so anyway, so that you just answered it. The answer is yes. It's not we're not trying to identify places where there isn't process to therefore say that's a red flag and the business should not be acquired. It's just to educate yourself as much pre-transaction as you can so you know know what you're getting into.
Yes, these often are it is precisely this where opportunity lies introducing the processes professionalizing the business. Exactly. But if you are a buyer that's buying a business with a sales background and you're like I'm going to come in and I'm going to execute on a sales strategy. You don't want to buy a company that doesn't have clean operations because that's not your area of expertise. And so I think it's really important that you understand your value as a buyer. It's why we still do the intensive. I it's not because I feel like sitting through 53 more sess 53 more cohorts, right? It's because it's absolutely critical because the there's no bad business, right? There's bad deal structures. There's bad buyer uh business fits. It's just about eyes wide open, right? That's all this is ever about to be honest.
Chelsea, I'm going to invi invite you to just elaborate. You said that's why we still have the intensive for people who don't know what that is. What did you mean by that and why is it relevant to this piece right here to what you just said does buyer fit?
So for the lab everybody always asks well what differentiates you from others and like my answer is I don't know I'm not in other people's programs but I can tell you our approach that we built and the reason I was so comfortable throwing my career away to build the lab was because Walker anchors I know right um I'm so glad I did it everybody. Um, so Walker anchors and making sure you understand who you are and what you should be buying because that's the key to doing this successfully. In all of my years of doing M&A and being an industrial organizational psychologist, I also agreed that not enough attention was paid to fit right buyer fit. And so it just made sense. And so our intensive that we still require uh which is like a 4-week onboarding into the lab which is a lifetime access to advisory services but like the beginner part of it is based on figuring out who you are, what you should be buying, how to position yourself to the market so that people will understand you're the right buyer um of that business. And so all of our intensives um are live still and we force you to go through um exercises um through Zoom um with your you know cohort members so that you can actually identify um where you're going to add value to a business so that you'll know like should I buy a business with no SOPs? No, no, maybe you shouldn't. Or yes, maybe you should, right? Um there's a clear distinction of like type of person that's buying businesses and this is a
Great one for specific types, right? Um, it's a really bad one for others, right? Um, and so I just think that's really important.
Okay, so are the tools actually helping, or is everything held together with duct tape? One of the biggest challenges with small businesses is capital restrictions. And so sometimes they don't invest in the technology and the equipment that supports the business. And so it's really important that you understand what you're buying, um, from both technology as well as equipment perspectives. Um, and so you want to find out if there are things that are helping the business. Um, are there like things that keep coming up as being barriers to your employees or the workforce being able to get the work done? Um, you want to find out if there, god forbid, are safety shortcuts, right, that are actually safety risks. Um, and that can be pretty impactful in some of the more blue-collared type of industries or manufacturing where there are known shortcuts because of a failure to maintain equipment. Um, and then that's a lot of risk and all kinds of different due diligence categories, right?
Um, and so when you're doing these conversations with the seller, you want to ask about: Is there a specific tool or specific instrument or equipment that's frustrating to your team? Uh, what happens when systems go down? Is there a process in place? Um, and how is that handled? Um, you want to find out if there are mechanisms in place and if they're actually tracking downtime, if they're tracking service histories, maintenance records, things like that. Um, because that'll all help you figure out exactly what you are buying and the health of the assets that you're buying. Um, which will also help you understand potential future capital outlays, right?
So, I shared on the earlier slide like, um, and one of the engines in one of our members' trucks blew up in like the first month, and now thankfully he had a really good relationship with the seller. So, like it was all good. They worked it out. Um, the guy actually just gave him his truck, um, which was a new truck, which was cool. But you won't always have that kind of relationship or opportunity, right? And so it's really important that you have equipment evaluated, which might mean that there's a third-party person that needs to come on-site, like, uh, let's say you're buying some kind of company that has equipment, big equipment; you might need to have the service provider come out and do an inspection, right, to actually look at the equipment and make sure that it's well-maintained, make sure that the useful life is accurate, um, right, which will help you with depreciation and all of that stuff as well.
Um, I just really love memes. I was on a call with somebody yesterday that was like, "Oh, I was listening to your office hours and I was sharing this meme that you shared." And I was embarrassed because I was like, "I wonder what meme that is. I use so many." But he seemed to find it entertaining. And then I saw this one and I came out of very large companies, right? So we went from three billion to six billion through transactions. And I often did capital planning, and one piece of equipment had been around since the 70s. It was literally duct-taped together. Um, and that in big companies, right? And so it's the same way in small companies. And so it's just really important that you understand what the actual environment is that you're buying. Um, because again, it's a data point, right? If a business owner didn't maintain the equipment, then they probably—it's a symptom of a bigger issue, right? Where they may not have maintained the business. Um, and so it's just kind of a risk factor for you to evaluate, right?
Um, another thing is like it's very, very, very common in these businesses for them to operate on Excel and not use software; if that's another common upgrade, right, for for AEES is I'm going to buy a business and I'm going to put systems in place. My only point of note for you guys is to make sure that if that's the case, if a lot of things are outdated and you want to come in and optimize that, you are including the cost of optimization as well as the impact on productivity of the change efforts in your financial forecasting, right? So the cost of all the execution of whatever technology you're implementing as well as the potential—you're forecasting a drop in productivity because that always happens through change processes.
Super solid strategy. So, I don't want anyone on the call to think that I'm telling you not to go buy businesses like that. But again, this is about preventing surprises post-close through thorough operational due diligence. And so, it's okay if you find these things. You just need to make sure that it translates into your plans post-close. How close are they to breaking?
So, this is when I think about capacity for growth plans. Everybody in the lab buys a company with the intent to grow it, potentially through acquisition, but like definitely grow, right? Right? If you're not growing, then you're dying as a business. And so in this category, it's really getting your arms around how much growth can the business actually handle before it's maxed out. Right? So, we were just looking at a deal um for somebody in the lab, and all of the locations—it was location-specific. I can't remember what it was, maybe dog grooming or something, but whatever. The locations were all at max capacity. And um, they were at max capacity, but then they had shut down other locations in the past like recently. So I don't know what that was all about, but the whole point to the analysis is like, okay, so you can't grow it because it's pretty much at capacity, which means the only growth plan you're going to have is opening new locations, and they've opened new locations and shut them down. So like, what was that all about, right? And so you need to make sure that you understand the feasibility and the potential impact of any growth plans that you have for the business. And so you want to think about how—what are the people and the resource and the capital restrictions or costs associated with your growth strategies, right? And so understanding how the business has been able to perform is really, really helpful, right? And so understanding—like you can say things like, you know, "Tell me about a time when you guys, I don't know, experienced a peak in orders and how you managed that situation," or like, "I'd like to understand why sellers haven't grown," if sometimes—again, growth can be costly, and some sellers don't necessarily have the capital to invest in growth—but actually asking what are the current limitations? Right? Like, do you think that—a lot of times you'll hear things about actual physical space constraints, or—we do hear this a lot—like the phone's ringing; we just don't answer it, uh, because they're—they have a staffing—you know, they don't have enough staff. That should be a—let's go to—red flags; should be a little bit of a red flag for you guys uh when they have—I know that lab members love that answer—when a seller's like, "Well, I've got all these calls. We're just not taking the work." Typically, there's a reason, right? It's not just because the seller is lazy or tired. It's typically because they don't want to hire someone. And so, you need to dig in a little bit deeper into why they don't—they haven't hired people. Um, because it is possible um that that business has some talent issues, right? So, like we have a lot—this is the same as like HVAC acquisitions, right? Or any of these service-based ones that you hear about on social media all the time; they have a really hard time staffing anything that—anything in that space or anything with skilled labor is hard to find staffing, skilled staffing that stays for long periods of time, right? And so you need to understand if you're buying a business with a really shallow pipeline for talent, because I think that's another surprise that people um are getting when they're buying in certain industries that they're really having a hard time staffing. Um, and so if they're not growing, you need to make sure it's not because they—they can't find staff, right? Or they can't keep them. Another member was just looking at a deal, and they're—I was like, "Well, when's the last time they hired anyone?" And they're like, "Well, 10 years pretty much." But they have hired a couple of people, but they didn't stay. Well, that's—should be something to click into, right? And figure out, okay, so why can't they retain new people, right? Is that an issue where you have existing employees that aren't necessarily supportive of new people? Do you not have somebody that knows how to train, so you're just going to continue churning talent? Um, so all of these things are just things to kind of click into, but you won't know it until you ask the questions.
Um, another thing in this space is really getting your arms around cash conversion cycle. Um, typically that is calculated in financial due diligence in a QV, but you need to make sure if you're doing like any kind of light package that they're still calculating that for you. Um, if not, then you need to calculate it for yourself. Um, cash flow management is probably the biggest point of failure post-close. And so you need to understand if growth um and just the health of the business was actually limited because of the cash conversion cycle for the business. Um, and again, not telling you not to do it if—as long as you have a strategy for how to fix that if that's the problem. Um, but this is all about identifying—that's what due diligence is—but identifying challenges so that you can plan for them post-close so that they don't sneak up on you and cost you money.
Okay. So, um, the next category is really the customer, right, and you need to understand what customers are expecting and what could go wrong with you trying to deliver on that promise. Um, so this is really, really important as we go back to that staffing challenge. If typically if there are operational issues, they're going to show up in customer complaints. And so I—this is what I was thinking about when I was in bed uh last night trying to sleep—was like you have financial due diligence and you have legal due diligence and you have operational due diligence, but under all of that is preliminary due diligence, which I don't have time to talk about here. Um, and so there's a certain layer of stuff that I'm assuming you've already done in these slides, right? And one of those things, and I'm saying it now just in case you don't know to go do it, is you should be shopping the customer cycle for the company you're acquiring as well as competitors if that's reasonable. Um, so that you can get a feel for the customer experience as well as the competitor's experience. Right? That's just a data point. That's a basic diligence item. Um, and that includes looking at reviews and searching, you know, for people talking smack about it on Facebook and in Reddit and stuff like that, right? Um, that's free publicly available information. So, that's going to be part of your preliminary diligence as you're evaluating the listing typically.
Um, all of understanding what mechanisms of customer feedback um is available is really important. Um, but when you're talking to the seller and you're trying to get your arms around the business, understanding like is there any common theme that comes up in feedback um about the business. So like the lab—the only negative feedback I get ever is that there's too many systems in place, right? And so they should have something, right? Not every—every company should have at least one thing that customers complain about. Again, silence is a sign of a lack of disclosure, right? And something that you need to click into. I'm sure there's something that people have complained about. And then, um, understanding—like looking at service level agreements and understanding exactly what you're committing to is really important. Um, I can't tell you that enough actually. It's really important that you understand what you're communicating. And for some reason, I think that those get taken for granted for some reason. And like I've had clients not even realize that things were listed there. Um, and so make sure you're reading the service agreements um with your clients. Um, make sure that there's a clear understanding of how customer issues are even brought forward um and how that's handled.
Um, as you're—as you're processing the customer side, um, you need to make sure that there is a strong brand. If there isn't, which is okay again, um, as long as you have an understanding and an ideally experience rebuilding a brand, um, but I would be very reticent to buy a business that has a really—a really troubled brand. Uh, because it can be really hard to come back from psychologically if it's publicly available, right? So, like we get this sometimes where a member will look at a listing and the Yelp review is like a 1.8. A 1.8 is going to take a lot of data points to come back from. Um, and it can be done. Uh, but you need to understand that that is going to be a deterrent, right, for people doing business with you. Um, and so again, this is about not getting surprised post-close. Um, it's okay if you want to try to take action on that, but make sure that you're diligencing the cost of doing so and that you are ensuring that you have planned for that in the valuation, right? uh, because that's something that's going to—not tank—but it'll negatively impact a valuation.
Um, you want to look at um kind of refunds, complaints, um, any um like service—I'm trying to think of the different industries—any kind of service records, warranty claims if it's a type of company that's warrantied. um, because at the end of the day, um, those are going to be highlighting potential operational challenges that you need to be thinking about.
The last category is really just trying to figure out where the real risk is going to be hiding, right? So what are the surprises that might come your way? Like, at the end of the day, uh, you do not want to be standing there going, "Oh, like I—I didn't—I didn't think of any of these things, right?" Um, and so this is where you kind of put on your sky-is-falling hat and go into the—into the space of like, okay, so in the event that all goes sideways, you know, what are all the ways that can happen so that again you can plan for it. Um, nothing that I say here means the deal shouldn't get done. It just means you need to put mitigation strategies in place, right? And so in this one, it might be key person risk, right? We talk about that a lot. Um, and everybody wants to talk to the employees, all the employees before closing. Uh, which sometimes, just to be clear, you can, uh, right before closing, typically after the APA is signed or at least after it's been like in its final form. Uh, but you don't—you also don't want to necessarily alert the employees because that can cause a lot of risk, for lack of better words, right? A lot of psychological—for whatever reason, I can't think of the word. I'm going to say trauma, but I don't mean that, but like your workforce will then get kind of jostled, right, in their security. Um, thinking about like, oh, the company's for sale, and they'll start looking for jobs because they don't know you yet and they don't know how it's going to go. And so, it—it's just one of those kind of like setting off a bomb. We had a member who—the—went for a seller visit, and when he got there, the seller walked around and introduced him as the new buyer to all the employees, and I was like, "Oh, that sucks. I hope they liked you."
Um, so at the end of the day, you're really just looking for um any kind of um—I like, you know, to think of this as like the shadow culture. And so what is happening that—that isn't necessarily coming out in file reviews, um, in site walkthroughs, in asset, you know, evaluation. And so, um, asking some of those kind of pointed questions to the seller that are kind of like the—I don't want to say put him on his toes, but like getting a little bit morose, for lack of better words, right? Like, okay, so what happens if this person disappears, this vendor disappears, or what happens if, um, uh, there's a safety violation? Um, what's the last like close call that happened, right? Um, and then what happened? How did that—how did that get handled? Um, and just asking like, "Hey, is there anything that you can think of? I understand that we've seen X, Y, and Z that's been documented. Is there anything that you know offhand is not documented that I need to make sure I get squared away right away?"
Um, some red flags to look for is if um if there's no service plans for equipment, um, which sometimes they just—they're very poorly maintained depending on the operator. If you've got somebody that's very sales-focused, right, the owner is very sales-focused. They're just there and they're not a detailed person, and there's not a right-hand man. A lot of times this stuff just happens, right? And again, it's fine if that is you and you're going to come in there and take care of it, but um, having somebody say like, "Oh, it's never been an issue before," um, is a red flag because if it's never been an issue before and that's actually true, it's going to become an issue for you probably right away because that means that aged equipment is fine for now, and then that means you need a budget for potentially needing a heavy capital outlay in the first couple of years, right? Um, if there's no plans in place for like outages with equipment or some kind of inventory restrictions or something like—if there's just no plans in place. Um, that's—that's a concern. A really good question to ask, and I have this in the—in the notes in the guide, is like actually asking like how did this business perform during the last economic recession or like how—and actually diving into analyzing the data to see how the business has performed over time is really, really, really helpful in this category.
And so as you think about how to actually execute on this, um, I—my intention is that you'll use the discussion guide like in person, right? You can use it as a question tool as you're going through. Um, the checklist is more of a—here's all the files you need to review and the questions you need to answer over time, but not necessarily like sitting down and like checking it all off in a meeting with the seller. It's more like holistically directional. This is what needs to get addressed under this lens. The discussion guides are meant to be more of a conversational tool, right, that you could actually take with you. At the end of the day, none of you are experts typically in the industry you're buying. In my experience, um, very rarely does somebody come up and say, "I want to buy a business in this industry." My experience is most people want out of the industry they're in. Um, and that's okay, right? The goal is that you understand what questions to ask to make sure that you're getting your arms around the business. And there are going to be a ton of industry-specific questions um that aren't in this, right, that you're going to need to potentially tap into somebody that's in the industry so that they can help you understand what questions you might need to ask. Um, but at the end of the day, this is used in tandem with your diligence teams. Um, I know that there were like questions around me giving you guys such detailed resources and whether it was hurting our business, but like at the end of the day, my goal for starting the lab was to try to minimize the impact that these transactions have on communities because unfortunately, very rarely do they go well. Um, and so I'm hoping um that they help you guys, but it is just a part—like step one is asking the questions. The really hard part comes from figuring out what to do with all the information you get back, right? Like what's something that you just need to plan for and what's something that you would need to maybe renegotiate your purchase price, right? Or what's something that you need to ask them to take care of before closing. Um, and that's honestly—
Why we do lifetime access is because it gives our members the ability to just keep coming back, right? Even post-close. And so again, if you want a copy of the checklist that I've been kind of hinting at throughout the presentation, just email me: chelsea@bythebill.com. Um, and you can get the checklist and the um, discussion guide.
We always say at the lab, the goal is buying a business, but not at the expense of making a mistake. And that's what this is all about, right? Like none of this is a deal killer. It's just things that you need to be mindful of, um, as you evaluate the listings.
Great, Chelsea. Very thorough. Thank you so much. Um, such important. I mean, any any one of those many kind of um weaknesses or oversights that you talked about can can be life-changing to the negative for somebody. So, while there was there's so much there, each and every one of those is is really something you want to diligence if you can.
A lot of good questions today. So, let let's get to those. Um, let's just start with this one: Shopping the business that you're you're targeting. Would you advocate pretending to be a customer or having a friend pretend or even hiring them as part of an evaluation? I mean, if you could hire them, that'd be stellar. Um, because you'd have firsthand experience then. Um, I am a weird human who can't lie. Uh, and so I don't know that I could feel comfortable. It's whatever the heck you're comfortable with. So, like I would have to be me and be honest. Um, but if you feel comfortable having a friend do it or you're comfortable, however you're comfortable, go do it. Um, I would probably just be a customer if I could. Um, because that feels the most honest to me. Um, yeah. And it is something people do. Um, absolutely. Yeah. It's it's common at all. I just I've heard it done in ways that is a little questionable to my ethics as a human, but like I'm not here to judge, right? You do whatever you need to do. Um, but this isn't about like corporate espionage or anything, right? This is just understanding the market. It's market research. You can actually pay firms to do that for you, too. I don't know if anyone's made a money and they just want to hire more providers, but there are marketing agencies that will actually do market research for you. Uh, and compare and contrast the experience and stuff that can be really helpful. Actually, you can I mean, it's not I think we've got providers that do it for like five grand, right? And I could imagine that would be pretty useful information.
One little litmus test you might apply to this question is, um, if the seller were to find out later that you did this, would you feel like you like they would be pissed off or were treated unethically by you? Or would they get it? Would they be like, "That's fine. You were just doing diligence"? Could be a good way to think about it. And maybe you should assume that in fact the seller will somehow figure it out.
Correct. Correct. And I wouldn't hide it, right? Like, um, most sellers will understand that you want to experience the customer journey and it's probably the easiest way. You don't necessarily want to experience it as a buyer. Um, as far as competitors go, there's really not it's just common practice honestly. Like I can tell you half the competitors we have in this space went through our funnels because I have their names right in our applications. And so it's pretty common practice. I wouldn't worry too much about it. I would I would as a human I would discourage anything being dishonest about it because that could come back to bite you in the in the rear end later when you're in the industry.
Yep. On the topics going back a number of slides now, on the topic of owners not wanting to hire people. You know, the the phone is ringing and no one picks it up, which searchers love in theory. But so the question is, even though demand exists, um, is one way to explain that to yourself to get comfortable with that situation as a buyer that's simply the seller's content with the cash flow is good enough and they just don't want to deal with hiring somebody else. They just don't want to deal with more business because that that is a pattern that we see a lot so often in fact it's like why isn't if it were so easy to grow in x, y, or z way, why isn't the seller doing it? And the answer and I think a realistic answer is often, look, I'm 60 and don't feel like it and I already have a lot of cash in the bank. I think that is part of it for sure and hiring typically it depends on the business um but introduces a whole level of complexity. I think my challenge is with that if it's a big enough business where they already have employees, it shouldn't be a burden to them to hire someone because they shouldn't be the ones hiring. Uh, that means they're doing too much and they're not delegating. So like I have just again it's not a reason not to buy the business. It just is it's a data point to me, right? Where I would want to say like, well, isn't there someone else on the team that could hire people? Uh, cuz the business needs right like growth otherwise it's dying. Um, and so I think the the lack of activity on it is just I don't know. It's interesting to me, right? Like, well, I guess if the business is really small and it's you probably already know that, you as a buyer probably already know that. So if it's a 10-person business, the seller is probably just doing all the hiring. And um and the answer is simply because it's a small business, a very small business, and you already know that. And so it's not necessarily it's just more to me it strikes me as more of an indication of size of business. Is there a management layer or not? I think that it's still a sign of a lack of delegation. 10 people, you should have somebody else hiring with 10 people like that the seller shouldn't be doing everything when you have 10 people. It's just it's the health like there un- especially if they're making enough money like it's a better use of your money to go and hire somebody so that it frees up your time. But it it to me again from a psychology perspective, it just tells me more I think about the buyer, I mean about the seller and the personality of the seller potentially. Um, and it would just be something I'd want to click on, right? And figure out like is this is this a controlling person, right? Where it's more of a like nobody else can do it correctly and so I'm not delegating it to anyone else. I still feel like it has to be me because that's I mean you could hire some you could have somebody hire somebody with two people, right? 10 people is a pretty big team. Um, to have still have all the decision-making on your like on your own. You know what I mean?
Yep. How would you think about valuation? Discounting the valuation, discounting your offer price for a business that's super reliant on the owner for the day-to-day. um, asking because as the new owner, I would likely need me and another person to do to do what the owner does day-to-day.
No, I think I think they're thinking about it correctly. Correct. And we just had this conversation, me and another lab member, like no one's going to work as hard as a founder or an owner. Like a founder or owner is going to probably do five times more work because it's their business, right? And so you do have to be realistic about how hard it is going to be to replace them. And so ideally transferability is the biggest value lever that there is period in small business buying. And so if a business isn't transferable and you're going to need two people to replace the seller, then you have to deduct Chelsea's opinion. This is not I'm not saying this is truth. This is my approach. Is that you would need to deduct the cost of replacement from the add-back of their salary. Um, because they cannot be replaced with one person. And so as a result, they they can't add back their full compensation because they're not accounting for this other person that has to be replaced. Um, and so I would adjust the SDE to reflect the replacement cost. And then I would probably uh ratchet if you watched my valuation webinar, I would decrease the multiple uh based on that transferability being a risk. Um, and so I don't know where I'd end up because I'd have to look at it holistically, but it would become a negative factor in how I would value the company.
Yeah, you should you should just be you should be thinking you and you can make the argument probably unless they're really stubborn pretty convincingly to the seller. Look, seller, you know, in my hands, this business actually needs two people to do what you do. So, so I I I'm not buying this based on the earnings that you're enjoying because you work 80 hours a week and you work at twi, you know, twice the efficiency because you know the business and built it for 20 years. I need to be evaluating the earnings that it will have under my ownership. And that they should understand that. That's not too um no abstract and it's facts and logic, right? It's math. You literally, especially if you're buying it with debt, um the way that I always tell lab members to explain it, and when they do explain it this way, it typically always goes okay, right? Which is I care about the longevity of this business. I want to continue your legacy. You care about the longevity of this business. I can't afford to operate it in a healthy way without adjusting the earnings, right? Like I have to now replace you and I have to pay down debt, right? which means this is the amount of money that I can now buy the business for. Um, now they can take it or leave it, right? But there's often much much less resistance, right? I have seen an owner say, "Okay, well, I'll hold it for two years. I'll make the changes and then I'll come back to market." And that's fine, right? That's their prerogative.
Yep. I liked what you said earlier, Chelsea, about how um much more efficiently a seller will do things because they have all this institutional knowledge and they've done it a bajillion times and built the process likely. You know, it's like I I'm tempted to I was thinking about like dog years versus human years. We should think about things in seller hours. So, if you know it's 40 seller hours a week, it's likely 80 normal hours. um, just because they work they'll do things so much more efficiently.
That's true. Can you share more on timing for these kinds of questions? They're great questions, but they're really detailed. So, I'm curious if Chelsea recommends this level of detail right as you get the the LOI counter-signed.
No, that's a good question. No. Um, so, I always forget you guys don't have all the context here, so I apologize. So like we our members have a road map to follow. Typically you're doing your preliminary diligence that I mentioned and then you're doing financial and legal diligence and then once all of that gets the you know check of approval then you'll go in and start doing your operational due diligence. It's typically the most robust. Um, and some of it will happen concurrently to be honest just because of the timing of it all. Um, but your operational due diligence typically takes the longest. Um, it's a series of conversations over time. It's site visits, it's inspections, there's a lot to it. Um, but you're typically going to launch your financial and legal diligence first. Um, at least to get the big big um, swings out of the way so that if it's a no-go, you can get there really quickly and not spend a ton of money. Um, and then once you get that, you get your preliminary diligence, which is like any concerns you had that you couldn't answer before you got the, um, LOI signed, um, you're going to go in and kind of check off these key things that you were concerned about and decide like yes or no, I'm not I'm before you pay other people. And then you'll pay other people to start. And then they'll say like surface level, we're looking pretty good. Then you'll start your your diligence um on your own. And it will span the entirety because again this is operational due diligence but it also starts to curve into planning right of like transition planning right and so yeah it is very detailed uh conversations.
What role can having the seller involved post-sale through owner through seller financing, what role can uh that play in transitioning through poor operational due diligence? So I guess if the if if the Oh, no, no, excuse me. Poor operational diligence assessment. So lots of I guess this the questioner is asking lots of flags in the diligence assessment, the operational diligence assessment, but sellers going to stick around uh for a while because we have um seller financing or a note. So how do those two play together?
Well, in an ideal world, your diligence is going to translate into your transition plan. And so, if things are red flags and diligence, then you will have built a transition plan with the seller to address them post. And so, if the seller's hanging around for a while, ideally, their focus is shifting, right? And they're going to start addressing whatever these big red flags are. I don't know what your red flags might be. Um, but let's just say that there are missing policies or outdated equipment inspections or whatever like you then yes that becomes a priority for them. I think that's what you're asking. Um, is like could the seller become a pair of hands for you to start addressing some of the shortfalls from diligence? I think is what that Yeah. my answer to that question is. Yeah. Yeah. I think it was.
Okay. What about um Okay. What how do you deal with companies that have had a lot of growth over the last four years? Um, how do you account for that in terms of multiple? This is not really an operational question; it's about valuation, but it's it's a it's a common one for a growth business. How do we treat how do we what earnings do we base our multiple against?
Yeah. So we talked about this actually in the valuation um office hour. So if you haven't done it uh go watch that one. Um, so it depends. Uh, you're stuck between, uh, broker valuations, which are typically listed on the highest year of growth, which is whatever the most recent one is. The banks are likely going to do a three-year straight average. Um, and then you're somewhere in the middle. And we do a whole workshop about this in the intensive for this reason. Uh, what I see most commonly with lab members when they're trying to decide what uh, valuations to or what uh, earnings to base their valuations on is that you're using a weighted average. Like you want to give some credit to the seller for the growth. Um, but at the same time, you don't know if it's a stabilized growth or not. Um, and so you will wait like the most recent year heavier and you'll wait the past two less. So that might look like you're giving uh when you're doing the calculation like 50% for the most recent performance period, 30% to the the one behind it, and then 20% to the one behind that. Um, if you're feeling very generous and the valuation would support it, you could do 70, 20, 10. Um, but at the end of the day, just understand that the broker is always almost going to, unless it's a really great broker, uh, they won't do this, but most brokers are going to value it based on the most recent highest year. Most lenders are going to do a straight three-year average, and you'll be somewhere in the middle. Hope that's clear as mud.
Are there specific questions to ask businesses that have been declining? Yeah. So like kind of maybe related to a business where the revenue is coasting or the revenue is flat or maybe even declining because the seller is just coasting disengaged. Um, how to what kind of questions can you ask to try to understand the story there of why the decline?
So some of it you'll understand just by looking at customer records, right? So you can look at customer spend by year to just see if it's pretty stat flat, which is fine, right? Flat's fine. Even like a little bit of a decline is fine. Like right where it's basically just looks like this. Um, if it's actually declining though, um, you can ask pretty pointed questions, right? Like walk me through, you know, what, and you could actually go from the high side of like, "Walk me through what um what the business looked like in 2021. How were you getting leads? How were you um converting them?" you know, uh, what did the organization look like back then to support that level of performance? And then you can say, now, you know, take me to today, you know, can you walk me through what's changed? That can sometimes be really helpful. Um, but a lot of it could also, I mean, some of this stuff you can actually just I mean, I'm an analyst, so maybe I'm a nerd and I like to dig into stuff, but um, you can actually get in and look to see if like ad spend changed or, you know, staffing levels changed or um, whatever. It just depends on what level of information they're giving you and if you have historical information or not. Whatever you don't have access to, then yeah, you just ask questions um and probe into their answers. Sometimes they'll say things like, "Oh, well, I had a health scare um and so, you know, I lost focus on the business." That's just a data point for you to poke into, right? That means they're pretty the business is pretty dependent on them if it declined when they had to step away, which is okay, very common in these businesses, right? But something you need to take into account when it comes to transferability, right? Understand what role they're providing and how you're going to pivot.
One of my favorite um stories was a member that bought a consulting company um and she's a beautiful human, but she bought a company and the they had the best transition plan I've ever heard where they're both subject matter experts in this industry. Uh, she came out of corporate and he had his own firm obviously and they're co-writing a book um to smooth the transition. Um, and so anything you can do uh to um kind of smooth that transition is awesome. Um, but I I just love that story because I've never heard that before.
Great, Chelsea. Excellent presentation. Thank you so much. This concludes the webinar. Bye.