War Story: Under The Table: Reducing Staff to Boost EBITDA
My clients, a married couple, were hoping to buy a company and leave their corporate jobs behind. They found a business close to their home, and they happened to share some commonalities with the current owner. The deal seemed promising. The cash flow was high enough for both of them to earn wages and neither would have to work anymore. From a high level, the deal made a lot of sense.
The business seemed normal with 20% SDE margins. It had certainly been impacted by COVID, but not so much so that the fundamental business value had been eroded. On a 2020, 2021, and trailing 12-month basis, the business looked fine. When we started peeling it back, a more careful financial analysis brought some key things to light.
Revenue on a trailing 12-month basis was approaching 2019 revenue. However, the labor costs in 2019 were around $400k higher than the labor costs in the trailing 12-month period. When we asked the broker, he just said the company had reduced staff and become leaner.
Business owners generally won’t spend excessively on labor if they don’t need it. If they needed that extra $400k in labor in 2019, then they would likely still need that in the current moment to achieve a similar level of revenue. The only way this would be the case was if the owners had stepped in and taken over four jobs instead of two. Or if another hunch I had was correct…
On one of the calls halfway through our Quality of Earnings process, the seller mentioned that he had a small number of cash payments that he paid to contractors from time to time. It was one of those statements that seems benign until you realize that cash payments are near impossible to track through a business. Once the owner started paying in cash, we couldn’t be sure if the payments were $1, $1,000, or $100,000.
Essentially, the seller had let go of employees and continued to pay them in cash under the table to deliver on the work the business needed. By lowering the traceable labor costs, the EBITDA appeared higher than it might actually be with these cash payments going out. We had no way of verifying how much that extra labor costs might amount to.
This was the first deal my clients were looking at, and they did not want to believe this was happening in the business. They made every excuse for why the staff and labor costs had gone down. At the end of the day, the seller offered no commentary about what efficiencies had been achieved to reduce labor costs. The buyers weren’t even given the chance to go sit with the sellers for a day to see what their work entailed.
If my hunch was right, the seller's discretionary earnings from the business would 100% be eaten up by these extra labor costs. My buyers would be buying a company with no cash flow.
My clients discussed at length. They were looking for an opportunity that would allow them both to retire. If this was that opportunity, they didn't want to give it up.
The seller remained elusive, unable to explain this change in the business. Eventually, the lender also found this discrepancy concerning. The reduction in costs and cash payments were never adequately explained.
Ultimately, the deal did not go through. My clients were off to search for a deal that would actually make sense for them. That's one of the most important benefits of due diligence. It can save you from making a huge mistake on the wrong deal which would prevent you from finding the one that's a perfect fit.
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