How to recognize a poorly managed business?

[phlgirl]

If the goal is to purchase a business which is up and running but not yet at optimum performance, what key factors would one look for, as indicators?

I am hoping we can brainstorm a list of measurable characteristics which might point to weak management or a potential for growth in a business.

The goal is to buy a good business and make it great.

Any thoughts?

 

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[Allthingznew]

I assume you would look at the financials, but even before asking to see them you might decide it's whether it's a potentially good investment.

Any business in particular?

I have to default to the restaurant business because I spent many years managing there. Maybe some of it will translate.

I can tell if a restaurant is well managed or poorly managed by looking at a few things. Is it clean? How clean is it? Those are actually two different questions. Is the management visible? What do the employees look like? How do they act? What does the store look like at night? Are there lights out? Does it run well on Sunday? (Typically the managers day off)

I walked into a Subway last night to see one employee cleaning the chair legs in the seating area and the other ready to wait on me. It was very clean. Didn't matter that I didn't see a management person per say, I saw the fruit of their training.

Factors outside the business control can be key too. What kind of area is the business located in? (Growing, stagnant, or declining) Evidence of crime? (May or not be a negative)

Obviously a B&M approach. Summary, look at condition of business "assets", people involved, and location. Sorry if this is jumbled, I need to get some sleep. Maybe others can offer more and/or I can do better tomorrow. Hope this made sense enough for now.

 

[David]

We'll on a Sunday I manage this corner store which is basicly over priced compared to even some of the most expensive stores and is located roughly 50m away from a shopping centre with a supermarket.

Anyways what makes us different is that we make sure the customers are served with the best level of service which is being fast, simple and clean. Running a business isnt about what you want but your customers wants. Find out what you can offer for your business thats better than others and most important is what you can offer your customers, because in the end they are the one making your business work.

 

[White8]

The financials of course are key. Ideally a business should be showing at least some increase in sales each year as opposed to stagnation or decrease. I also like to see profits increase at a greater rate than expenses as a company grows which indicates an increase in efficiency. There is not as much benefit to owning a growing company whose sales to profit ratio always remain the same unless you enjoy the headache of more employees to deal with as well as a larger payroll.

Another important aspect is to locate where more money is allocated than needs to be or even should be. For example, right now I am looking at a local service oriented business with 15 employees. Last year this business spend $7k on telephone and $23k on vehicle maintenance. To me, this is an example of a business on auto pilot. The phone bill could be cut in half by utilizing a cell provider with in calling and VOIP for the office. The price of vehicle maintenance could significantly be reduced by hiring someone from the local car dealership to work an Saturday.

Employee retention is also a good indicator of management. Happy employees will give good customer service with a good attitude. Conversely, unhappy employees give poor customer service with a poor attitude and tend to only stay until they find a new job.

One final point on growth. Businesses have three stages in their life cycle: growth, plateau, and decline. Of course it's ideal to purchase in the growth stage and OK in the plateau stage. That determination is one you'll have to make. Can you force a plateaued company to grow? Yes, but only at a greater expense. The product placement ladder once established is pretty well set unless a competitor makes a drastic mistake. Take for example Home Depot and Lowe's. HD is the largest in any given market. Lowe's can throw millions in advertising, coupons etc. and maybe take a 1-2% bite out of HD for a period of time and then it will shift back. The way these companies grow is by expanding into new markets which is the same for a small businesses once they reach the plateau stage.

 

[phlgirl]

Thank you all very much for your input!

White - this is exactly what I was looking for.....at this stage, I am just trying to filter the potential candidates out there. I am requesting the financials/business summary and hoping to do some analysis based on the numbers first. I should have been more clear in my question.

For example, I know that in a business with inventory, if the business is holding a high level of inventory (relative to sales), this can be a sign of costs which could be better managed. Your example of the phone/auto expenses in the service industry are perfect. I will keep an eye out for that. I also really like the employee retention factor - will have to ask for that info.

Most of what we are looking at, so far, seems to be service based. For example, we have looked at a Health Club, Car Washes, Limo Services, Dry Cleaning, etc.

I have lots and lots of reading to do...... very exciting. I love new projects!

Again, thanks to everyone for the feeback. Keep the ideas coming!

 

[kimberland]

Am I assuming that since you WILL be management
(if you're buying a controlling interest),
you're looking for a strong brand or proposition with weak management?

'Cause if you have a strong brand, a strong proposition and strong management,
you'll likely be overpaying.
Plus you should wonder why, with all that, management wants to sell.

That said,
look at what you really want to buy (the brand, the vendor arrangement, etc)
and ensure that this will be locked in upon sale.

I did some clean up on an acquisition
where the new owners thought they were buying sales revenue.
Turns out all the clients were buddies with the old owners.
When he left, they walked and the new owners were left with nothing.

 

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[kimberland]

Sorry.
I should have asked this before I went "off."

What size company are you looking at?
Are you looking at multiple locations?
Will you have a controlling interest?

BTW... in each industry,
there is usually a defining stat or stats that you should look at.
For example:
In blog, it could be unique visitors.
In grocery, it is turns.
In cable, it is subscribers.
In restaurant, average check and average guest count,
etc.
That stat is usually the quick and dirty on the health of the business.
(Any analyst report on a company within the industry will mention this stat)

 

[White8]

You are exactly right in your example of businesses with inventory. Another aspect is perishable inventory or inventory that can become dated that will sit until it's dumped. Always specify marketable inventory a dealer cost or below.

There is a definite advantage to service based industries as you should never have $100k of widgets in the warehouse tying up your working capital. Typically service based industries should be priced around 3 times SDE excluding real estate.

If health clubs in PHL are like they are in Salem, OR the health club business model is excellent. Subscriptions are always good. The only difficult aspect is the majority of new members join in the first quarter to make good on New Year's resolutions so marketing has to be hard and fast. Car washes have some pretty specialized and expensive equipment. I don't know the lifespan of the equipment or what maintenance runs so I would definitely check it out.

In your analysis, look for sales anomalies. For example, when I owned my John Deere dealership, one year we sold the city $70k worth of equipment. It certainly made the sales for the year look good but it was a one time sale.

Be sure the seller or broker will share at least a performa with you before you make an offer. Some brokers like to get your offer first and according to my broker it's a sneaky way to operate and wastes a lot of the buyer's time. There are plenty of fish in the sea.

Have Fun!

 

[White8]

Plus you should wonder why, with all that, management wants to sell

Excellent point. I look for retirement situations with people who are truly old enough to want to retire. Most 40 year olds who "want to retire" are wanting to get out for some reason.

 

[phlgirl]

Kimber -

Yes, we will be the new management.

As far as business size - so far we have set a guideline of a minimum of 300k in cash flow. This seems to translate to a purchase price of 1M and upwards.

Yes, we will own 100% of the business.

Currently, we are thinking one location, to start. The thought is that we will learn, strengthen and grow the existing business and then, if possible, replicate the operation.

I think you summed it up well.....we would like to buy a strong brand or proposition, which is currently under-managed. Ideally, I am thinking of someone who is just asleep at the wheel..... the business generates income but perhaps they are burnt out and really not maximizing the true potential. I recognize that this might not be the easiest thing to find..... but I do enjoy a challenge.

Excellent point about why they are selling. It is one of my first questions but I fear the answer is not always honest. As White mentioned, it seems a large portion claim 'retirement' but the picture tells a different story.

You are right about the industry stats as well. I am not sure if I got the link from you or ATW but that BizStats site is definitely one of my favorites lately. Great information!

Thanks so much for your feedback!

 

[jganz]

I think you need to know a guideline of each business on which specifics are important to look at..

for example.. I own a few restaurant franchises...

the only numbers i need to know on acquiring one are the gross sales and the rent..

all other numbers mean nothing to me.. since I know what I will make them..

If I know sales are 60k per month... and the rent is 8k

my cogs will be at 30% and payroll at 20%..

if the sales are higher.. cogs the same.. payroll as a percent lower..

if i were to try and buy a different type business.. i think i would take a job there for a few months so i could do a breakdown of the costs on my own.. (due diligence)

good luck

 

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[Allthingznew]

I think you need to know a guideline of each business on which specifics are important to look at..

for example.. I own a few restaurant franchises...

the only numbers i need to know on acquiring one are the gross sales and the rent..

all other numbers mean nothing to me.. since I know what I will make them..

If I know sales are 60k per month... and the rent is 8k

my cogs will be at 30% and payroll at 20%..

if the sales are higher.. cogs the same.. payroll as a percent lower..

if i were to try and buy a different type business.. i think i would take a job there for a few months so i could do a breakdown of the costs on my own.. (due diligence)

good luck

Your number don't make sense to me. Could be a different restaurant venue is why, but I find your percentages hard to fathom.

Please define "cogs".

I'd say 30% is not an unreasonable number for a food and packaging number. You must not be open full hours or something to have a 20% labor. Is that with production and management or just production? I could see it just production.

My numbers are dated, but in the fast food industry in the early nineties I ran a 27.5% food cost with 4% pkg and 21.5% combined labor with a net sales average of $85k a month and was at the top of the company with these numbers. Stores that did the sales you mention then had food cost of 28%-29%, pkg 5%, and labor 23% combined.

Since then labor costs have gone up along with other costs and of course prices too, but I look at your numbers and go tilt when comparing to what I know. From what I've seen, if you walk away with 10% of your net sales, after ALL is said and done, you're doing great.

 

[Yankees338]

One thing I'd consider would be the source of growth. Ideally, you're going to want to find a growing business. However, the source of the growth could reveal something else. If it's effective advertising, it will help to know what works when you assume control of the business. If it's just because it's a growing industry, you should know what to expect.

I've obviously never bought a business before, but if I was going to, this is something I'd consider.

I also agree with jax's idea to get a job in at least something in that industry beforehand. Perhaps you could work out a deal to work for the current owner for a month or so?

Great advice from the rest of you, btw!

 

[jganz]

good questions..

'cogs' in my definition would be food and paper...

i sell salad so my 'cogs' would be lower than other food establishments (not much meat)
in my experience.. the only thing with lower food would be pizza..

payroll runs right about 20%.. i am in mall foodcourts.. so I run mall hours..

1 store manager with a decent salary.(30-35k).....all the rest hourly..

payroll is never over 6.5k.. every 2 weeks..

john

 

[Allthingznew]

Ok, your 'cogs' make sense. You also don't have the labor demands due to location and venue. Thanks for helping me get my mind around the numbers.

 

[yveskleinsky]

Typically service based industries should be priced around 3 times SDE excluding real estate.

What does SDE stand for?

++rep White- great comments!

 

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[White8]

SDE stands for Seller's Discretionary Earnings which is basically what the profit would be if the owner didn't spend or shift profits for the sake of reducing tax liability or to essentially steal from his own business. A prime example would be leasing a new Hummer for his wife to drive as a "company vehicle"

 

[phlgirl]

Ok, so I think I found one sure fire way to recognize a poorly managed business.

Terrible financial records.

I have requested financials for at least 20 businesses over the course of the past 2 weeks or so and I am amazed at what I have seen.

Yesterday, I got an email which contained 3 attachments. First doc had 12-24 months of scanned electric, water & gas bills - ranging from 2006 to present. I took the time to do a cross reference - to try and build my own financials.... and there were only 2 MONTHS of full data, for the any given time period. The second document was an excel spreadsheet, which was supposed to be a record of what the weekly take had been for the past 12 months. The 3rd doc? An excel spreadsheet of the weekly take for another business (same owner but completely unrelated).

LOL

The scariest part was that when I spoke with the broker, she told me that she was going to send me what she had 'rough' since this was a brand new lising and she had not yet had an opportunity to put the financials 'together'. So, I am assuming, had I called a week later, I would have gotten a made up pro-forma, based on the mismatched data.

I knew the numbers were often weak but I have to say this was eye opening for me.

So the question is this: Is there ever a case where you would even consider further pursuing such a business? My initial reaction is absoluetly NOT. I told the broker that unless I could see tax returns, completed financials, etc., that I would have no interest in discussing this business further.

I have to say though..... if ever I saw a sign of a poorly managed business, this would have to be it. If this is how they manage money, just imagine the other areas, where they are likely dropping the ball as well.

As I said, my initial reaction is No way.... walk away....move on. I just want to make sure that I am not missing something here and making a rookie mistake. I am pretty sure I would not ever be comfortable without good numbers.....but that is just me. Perhaps, there is a way to structure the deal such that it is based on future performance, etc.? How do people like this ever sell their business?

Thoughts?

 

[White8]

There are two reasons for a business seller to have that "level" of financials they are either incompetent when it comes to the financial side of their business or they are hiding something. I've seen those types of financials too, including no monthly reports, just the annual report from H&R Block.

I would be suspicious of the accuracy of a pro-forma as the broker will be trying to make sense out of a mess and she isn't a CPA.

Personally, I would let this one simmer for a while. With the lack of good financials, they are going to have a VERY difficult time selling the business. Banks wouldn't touch it with a long stick without reliable financials. Given some time and frustration on the seller's part the seller may reach the point where they will dump it and that is the time to take a serious look at it from the standpoint of buying used equipment and maybe a little something for the name if its reputation is acceptable.

From what I have read, most small businesses don't sell, they fade away or are liquidated outright. An even bigger question to me is how can someone run a business and have absolutely no idea what it is doing on the financial side? I like monthly reports and a computerized sales/inventory system that can tell me how many of each item I sold each month and to whom.

 

[phlgirl]

My husband and I had a very interesting meeting today with a business broker who has been in the business almost 20 years. I thought I would share some of what I learned.

I expressed my concern regarding the quality of the financial records. She told me this will often be the case – particularly in the service businesses. Not only will I see really awful or non existant books but I will also see what might appear to be really good books – which , at times, can be even worse (the deception is even more difficult to find).

I was given an entire page of items a buyer should require – 3 years tax returns, utility bills, daily tickets, deposit records, etc…… and then she told me that if I expect to get each and every one of them, it is going to be a long, long time before I actually buy a business.

One point she made is that sometimes you need to work backwards. During the due diligence process, you get inside the business and watch the operations/cash register for days, if not weeks. This way, you should be able to confirm some portions of financials.

For example, she told me that by looking at a water bill for a car wash, you can determine approximately how many cars have been serviced in that given period. You can actually call the manufacturer of the car wash machinery and find out how many gallons are used per wash. So if one car washing = one gallon of water usage and the water bill for that week says 250 gallons used BUT the seller is claiming to be servicing 350 cars per week, you know you have a problem.

Likewise, in a coin operated Laundromat, each type of washer has a specific water usage per wash cycle. If your water consumption does not match what the financial records are claiming, there is an issue.

In a cash (service) business, it is frequent that the owners do not declare all of the cash intake on their tax returns. This not only causes a problem for you, in attempting to determine the value of the business but also, for the banks, when you attempt to get financing. If the business shows no income, there will be no business loan. She told us that for this reason, it is almost always a seller financing situation.

No conclusions today…. just some new information. A very interesting process….learning a lot. Took me back to my audit classes from college!!

 

[White8]

Good Post!

Working backwards makes a lot of sense both if the financials are lacking and just to get a better feel for the business. I've also been a fan of going in before talking with the owner as a "customer" and trying the service to see how the business operates from a customer standpoint. It's also interesting to see how it is handled if you are an "angry customer".

Something else you can learn from the financials or working backwards is seasonality. I owned a John Deere dealership in Western Oregon so we had rain but no snow. The business bled red ink from November until roughly the middle of February therefore I wouldn't buy one in the slow time of year. I'm guessing a car wash in Philly would be similar.

You are exactly right in that owners who do not declare all of their income create a problem for themselves, buyers, and lenders. It is tempting to do but I've always been told not to do it for that reason. On the plus side, there can be benefits to seller financing if you can determine what the business really makes.

Something else your broker may or may not have mentioned are asset sales and stock sales. With an asset sale, on the date of the ownership transition, the business essentially closes and reopens with the new owner. Liabilities go with the old ownership and depreciation resets. Under a stock sale, the buyer purchases some or all of the shares and the company continues as normal. The depreciation remains the same and any liabilities that the previous owner incurred remain.

It's an interesting process that both thrills and makes you nervous at the same time.

 

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[phlgirl]

Great point about the Asset vs Stock sale. We did not discuss that today.

It seems like there are so many different ways to structure the deal.....very cool.

Can you think of advantages/disatvantages of both? I really like the idea of the depreciation reset - particularly since everything we have looked at, so far, includes some heavy duty equipment (although in some cases the equipment is leased with a buyout on the back end).

Any reason the seller would care either way? Does it impact their tax?

 

[White8]

There are several ways to structure the deal. There shouldn't be any tax advantage for the seller either way for an asset or stock sale but there is a definite advantage if the seller will carry the contract unless they intend to 1031 the funds. I'm not currently looking for real estate but when I do, I plan to have my CPA do a tax comparison based on an average income showing the tax liability of a cash sale and a seller financed sale so I can show the seller the benefit of financing the purchase.

As far as advantages and disadvantages of asset and stock sales, the biggest advantage I see to an asset sale is the fact that the business resets so to speak. The disadvantage is that your personal finances will play a greater role in acquiring any sort of financing for the business. The greatest advantage of a stock sale is you acquire in business in a continuing form with its cash in the bank. The disadvantages are the fact that depreciation continues as it has been and you inherit any debt or liability the business has incurred. The debt and liability can me mitigated but the depreciation is a factor unless there is no equipment value anyway.

In regards to leased equipment- if the equipment lease is held by a leasing company, not a manufacturer who refurbishes and resells, you can line up new or used equipment, and you are feeling bold, call their bluff at the end of the lease. My computer hardware was leased through GE Capital. As the end of the lease neared they wanted $3000 for the buyout. I knew that I could replace the hardware with new hardware for around the same price and told them that I would be returning everything when the lease expired. A couple of weeks before the lease ended, they sent a letter stating that they would take $150 which I accepted. Leasing companies are money people, they are not equipment people and unless they have someone lined up who will pay a good price for equipment, it's not worth their time and expense to deal with it. By my estimation of my lease, they paid for the equipment in the first year and made pure profit for the next four years. I no longer lease.

 

[kimberland]

phlgirl,

That's how I do competitive research
(that should be done also, of course).
When I was in the quick service restaurant biz,
I'd hang out in the restaurants, count customers, and watch orders.
I'd also talk to people (employees, customers, etc).
Get a real feel for it.

Nothing beats getting out there and doing it.

 

[phlgirl]

I plan to have my CPA do a tax comparison based on an average income showing the tax liability of a cash sale and a seller financed sale so I can show the seller the benefit of financing the purchase.

I think this is a fantastic idea. Going to have to use that one! ++++

Interesting information about the leasing as well. I definitely have a lot to learn here. I have never leased anything (that I can think of) and certainly have not ever assumed a lease from a 3rd party.

Today, we looked at a collection of 4 dry cleaning sites (one plant and 3 drop offs). I have to say, I was pretty impressed. We followed your (and Kimber)'s advice - after meeting with the broker we dropped off some items to be cleaned at each of the four sites. We also scouted the area for competition, potential commercial contracts, signs of growth, etc.

The list price is too high and the terms too short but I do think it would be a very interesting negotiation. Plenty of additional analysis to be done any many other listings to see but great to see potentially viable candidates.