War Story: Add It ALL Back
My client was looking at a labor recruiting company. The business sourced talent particularly in the online marketing vertical. It would then sell this talent primarily to B2B companies who were hoping to get in front of customer leads and more effectively market.
While doing the Quality of Earnings, we discovered that the $400k in SDE only checked out if you believed a spreadsheet of add-backs. When we analyzed the sheet, we saw that the broker added back 100% of expenses outside of the cost of goods sold—meaning all of the operating expenses were added back. Come on!
I've heard some incredible stories in my time as a deal guy, but I have never heard of anything this outrageous. They were trying to tell us that on a million dollars of revenue—of which $400k drops to the bottom in profit/SDE—that all of that profit came from adding back every single cost. It was hogwash.
My client and I went to the broker to ask about it. The broker said that the sellers used some unorthodox tax strategy that they could explain on a phone call. I had not laughed that hard in years. We got on the phone anyway. We had to hear it, right?
When we got on a phone call, the sellers vaguely mention this tax plan. They didn’t sound confident or clear on it. To us, it felt like they knew it was a lie. We almost quit there.
I sat with my client. We thought maybe it could still work. We realized the only way to move forward was to rebuild the profit and loss statement based on the expenses my client expected to incur as part of running this business. Instead of depending on the information the sellers offered us, we based our calculations on the knowledge of my client. He had some understanding of how the business operated and how to run it.
We ended up with a number that we thought was a true SDE. At that SDE level, the purchase price still made sense. Both for my client and for the SBA.
There are basically two things to learn from this story.
First, well-known brokerage firms will add back 100% of the expenses and not think twice about justifying it. It’s a scare strategy. If you're not smart enough to see through it, you can very easily buy a business that is marketed as doing $400k of SDE and is really doing $50k of SDE.
The second lesson here is to not look past false information. Oftentimes, buyers throw the baby out with the bath water, walking away too soon. You may want to alternatively consider, like we did, that if you were to rebuild the profit and loss statement to calculate your own SDE. The deal may or may not still make sense. If not, go ahead and walk away. However, the deal might still make sense as is or it might make sense if you take the price down 80%. Try this strategy, and you may live to negotiate another day.
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