The plumbing and heating industry is not unlike many other mature industries experiencing large scale consolidation. Individual companies competing in mature, highly fragmented industries have limited opportunities for growth. Their growth is limited to either the growth of the existing customer base or to the growth of the overall economy.

Meanwhile, consolidators such as American Residential Services, Service Experts, Comfort Systems USA and GroupMac see enormous opportunities to enhance their market position as leading providers by growing through acquisition and implementing a national operating strategy that enhances internal revenue growth and profitability.

Consolidators are in the business of acquiring privately held companies. They are acquisition machines that are very effective at purchasing companies at favorable prices.

My company, JD Ford & Co., has been involved with several consolidators in numerous different industries. During the last 12 months, we have represented several service-oriented businesses — including plumbing and heating companies, drain cleaning companies, travel agencies and contract manufacturers, all of whom have sold to a “consolidator.”

If a consolidator calls, it may be an opportunity for a business owner to gain liquidity for his company and gain personal financial independence. Based on JD Ford & Co.’s experience, when the consolidator calls there are several steps business owners must execute in order to ensure they receive the highest possible purchase price for their company, and increase the opportunity for successfully closing a sale.

Contact Professional Advisors — Before a confidentiality agreement is signed, the seller of a business should organize a team of advisors. We recommend that you contact your attorney, CPA and an investment banker. Professional advisors will play a critical role in protecting the business owner’s interest during the sale of his business. Your attorney will be crucial to prepare and review transaction documents, such as the purchase agreement, lease agreements (if necessary) and employment agreements. Your CPA will play a critical role in the financial due diligence that will be performed by a potential purchaser, and advise you on the tax implications of a transaction.

An investment banker is a professional advisor who can guide you through the selling process. An owner who is contemplating selling to a consolidator must realize that consolidators are professional acquirers. They buy hundreds of companies each year, and they are very skilled at negotiating the value of a business. Given the skill of the buyer, it is to your advantage to hire a professional to represent you on equal footing. An investment banker will advise you in the negotiating process, determine a reasonable market value for their business and will position your company to receive the highest possible purchase price. Obtain A Signed Confidentiality Agreement — A confidentiality agreement should be signed by the consolidator before any information is exchanged. The confidentiality agreement will protect you from the buyer disclosing confidential information about your business, or from disclosing that your business is for sale. Keep in mind that if a consolidator does not acquire your business, there is a good chance that it will acquire one or more of your local competitors. Also, be sure to have your attorney review any changes made to your confidentiality agreement by the buyer. Provisions may be added to the agreement that will prevent you from negotiating with any other parties. Understand The Buyer’s Valuation Method — Most consolidators are publicly traded companies and are generally able to pay a higher price for your business. However, they will be unwilling to pay a price that would be “dilutive” to earnings per share. If you are to receive the highest possible price for your company, it is important that you understand the valuation formulas that are used by consolidators in your industry.

In addition, you should also take note of how the buyer will account for the transaction. There are two accounting methods that apply to mergers and acquisitions — “pooling of interests” and “purchase accounting.” It is important to understand which accounting treatment is being used. The treatment will have a significant impact of the valuation of your company. Recast Financial Information — Many small business owners prepare their financial statements on a cash basis with a desire to reduce their tax liabilities. As such the net income on a company’s financial statements may be substantially understated. Common areas that are understated and that may not reflect the economic reality of the company are as follows:

Inventory: Usually, small business owners immediately expense a large portion of all inventory. If that is the case, inventory on the balance sheet will be understated and cost of goods sold will be overstated. The result is a lower net income and likely a lower valuation.

Prepaid Expenses: In addition, small business owners immediately expense any prepaid items such as insurance premiums. This would have the effect of decreasing net income and would likely lower a company’s valuation. Excess Owner’s Compensation: Many small business owners have the luxury of taking salaries in excess of normal compensation. If an owner sells his business to a consolidator, the owner’s salary will likely be adjusted to reflect a normal compensation level. As such the differential must be recast into the financial statements in order to get a true picture of the financial condition of the company.

These are just a few examples of possible areas of a company’s financial statements that may need to be recast. An investment banker would need to work with your accountant to gain a further understanding of your operations to fully adjust the financial statement to reflect economic reality. Keep in mind, every dollar increase in your company’s earnings that is a result of recasting your financial statements could possibly increase the purchase price by a multiple effect. For example, if there are adjustments that increase earnings by $20,000, the resulting increase in purchase price could be anywhere from $60,000 to $120,000. Do not rely on the consolidator to help you identify all of the potential add backs.

  • Assess Strategic And Financial Fit — It is important to access the strategic fit your company offers the consolidator. If your company is one of the leaders in your industry or your region, your company may demand a premium price. It is your investment banker’s responsibility to identify the strategic reason why your company should command a premium price. It is also important to demonstrate the unique benefits that your company can bring to the consolidator’s operation and the financial rewards of owning your business.
  • Prepare Due Diligence — If your company is purchased by a consolidator, it is likely that your operations and financial records will be under a great deal of scrutiny during the due diligence period. We recommend that the due diligence process be coordinated by your investment banker. This will allow the investment banker to control the document exchange process and maintain control over the flow of information.

    The consolidators are usually public companies and as such are under careful review by the Security and Exchange Commission. Therefore, it is essential that all of your records are in good condition before the due diligence period begins. Your investment banker should work with your accountant and your attorney to review all of the accounting and corporate records before the buyer begins his due diligence. The review of these documents will allow your advisors to discover and resolve any issues that may be of concern to a potential buyer before the documents are actually reviewed by the buyer.

  • Your Management Role Going Forward — Be prepared to remain active in the business for an extended period of time after the sale is complete. Your management talent is critical to the success of the consolidator’s strategy. If you are not willing to continue to operate your business, don’t expect the consolidator to be interested in buying your company.
  • Don’t Run Off With The First Call — There are usually several different companies that are actively consolidating an industry. The first consolidator to call may not offer you the highest price or the ideal transaction structure.