Buying a Small Business in the UK - A Quick Reference Guide

A fast track to understanding the process of buying a small to medium-sized business (under £20M)

Ken Gorman is a Regional Director and a Merger & Acquisition Advisor with Transworld M&A UK. Ken is a Certified Merger & Acquisitions Advisor (CM&AA) and was previously a Certified Public Accountant (CPA) at Ernst & Young. He has also completed a certificate course in business valuation.

Transworld Business Advisors is the largest Sell-Side Advisory service in the world, with over 500 brokers across 200 offices. Transworld M&A UK operates from 15 offices, with its regional headquarters located in London. The company emphasizes a culture of deeply caring about the journey that Sellers are on, as well as taking care of the people that are affected by a transaction. Clients benefit from hands-on local office support, along with high- caliber packaging, buyer search, and deal support from the head office. Transworld M&A UK is committed to aligning their interests with their clients and, as a result, does not charge upfront fees. If you are considering selling your business or need help buying a business, please don't hesitate to contact Ken Gorman. The Transworld M&A UK team of dedicated Sell-Side M&A Advisors is eager to assist you with your business sale journey. You can reach out to Ken at: Ken Gorman KGorman@transworldukmanda.com.

A Quick Reference Guide

Buying A Small Business in the UK

A Fast Track to Understanding the Process of Buying a Small to Medium Sized Business (under £20M)

No part of this book may be reproduced, distributed, or transmitted in any form or by any means, including photocopying, recording, or other electronic or mechanical methods, without the prior written permission of the publisher, except in the case of brief quotations embodied in critical reviews and certain other noncommercial uses permitted by copyright law.

Table of Contents

Preface ............................................................................................................... 1 Chapter 1 - 10 Great Reasons to Buy a Business .................................... 4 Chapter 2 - What is The Right Business to Buy? ...................................11 Chapter 3 - The Seven Deadly Sins When Buying a Business - By Jeff Lermer, Chartered Accountant................................................................... 20 Chapter 4 - Who is The Business Seller? ................................................. 29 Chapter 5 - Timescales and Statistics ....................................................... 34 Chapter 4 - Finding Business Sellers......................................................... 39 Chapter 5 - Connecting with Business Sellers........................................44 Chapter 6 - Valuing the Business............................................................... 51 Chapter 7 - Making Offers and Getting to Heads of Terms................71 Chapter 8 - The Post Heads of Terms Process ......................................82 Chapter 9 - Determining Working Capital and Excess Cash...............96 Chapter 10 - What About Commercial Property? .............................. 106 Chapter 11 - Confidentiality Matters .................................................... 109 Chapter 12 - Working with Advisors ..................................................... 113 Chapter 13 - What to Expect Post Sale ................................................ 120 Chapter 14 - The 5 Steps to Scale Up Your Acquisition – Paul Avins, The Grown Up Business Coach............................................................... 123 Chapter 15 - Basic Business Buyer Education..................................... 130 Chapter 16 - Potential Challenges During the Process ..................... 134 Chapter 17 - Next Steps ........................................................................... 144

Preface

This book is dedicated to all those brave souls who feel their calling is to buy a business but have never made it all the way through the process. I wrote this book as I saw so many good people spend months and years trying to fulfil this dream only to see failure after failure after months of hard work, often just on the brink of closing their first deal. This part is understandable…the merger and acquisitions game is hard, very hard. And beyond that, there are many misconceptions and false expectations about what it takes to get the right deal over the line. This book is designed to be a starting point for new Buyers to at least have a foundational understanding of the process and many challenges they may encounter. The book is meant to be used as a companion guide while working with Transworld M&A and letting us manage your first transaction. The book is not meant to be read and implemented as a DIY project for a new Buyer or replace comprehensive new business buyer training programs (i.e. the Business Buyers Club in the UK). There are still 100’s of twists and turns that could not be covered in any book or course and we believe we can add tremendous value in getting your first deal over the line. There are three main benefits of working with us and letting us manage the transaction from beginning to end using our Dynamic M&A Transaction Management Program (DTM): • The chance the transaction closes will be greatly increased • The time it takes to close the transaction will be greatly reduced

• The Buyer and Seller will be on a good footing for a good post-sale relationship One of the commonly understood statistics is that somewhere around 75% of small business transactions do not make it from Heads of Terms (where the Buyer and Seller agree on the commercials) to the closing table. Following that, 50% of the deals that do close don't deliver the value expected 2 years on which can mean everything from not exceeding expectations to liquidation. The cost of these failures in terms of time and money can be significant for the Buyer. Another misconception is that once a Seller is found, a transaction can be completed in a short time scale like a month or two. For people who are inexperienced, this is wishful thinking…there are so many moving parts to the process and just the legal side can drag on for months if not properly managed. To put the cost of this delay in context, if you are buying a business with say £520K in after-tax profit…this would mean that every week a transaction is delayed costs you £10K in lost income! Many people don't understand this and try to cut costs by not getting good advisors and the right systems, only to have this turned upside down with delays running into months. However, buying a small business can also be very rewarding when it works. There is no better (legal) return on investment when the model is working. Also, owning a business gives a new Buyer a channel for expression and a vehicle for serving the community…as well as building wealth for them and their family. So in most cases, it is well worth the effort and both Buyer and Seller win I have spent over 10,000 hours running transactions and closed over 50 deals and been involved with over 100. Or, the way it feels is 10,000 hours of mistakes and learning from those mistakes. So I know deals can be closed and we can run a process that is

successful most of the time. Although challenges can often seem infinite, most of the dozens of issues that arise during the process do repeat themselves in some form and have had solutions previously, so experience matters. Transworld M&A is over 40 years old with 250+ offices globally (15 in the UK) and we sell over $1.5B worth of business annually. Being a Transworld M&A advisor requires extensive training and often advisors have advanced certifications and years of business experience. But most of all, a successful advisor has learned from 1000s of hours of field experience through both successes and failures and used our proven Dynamic Transaction Management Program to make sure everything stays on time and transitions close as quickly as possible. The details of how to buy a business and the school of hard knocks are not something someone buying a business once every few years should have to go through…there is help! We can use our experience to make your business buying experience easier, faster and have a much greater chance of getting over the line. This book is about providing a reasonable foundation to engage with us in the process, not to encourage you to learn whatever is not in the book the hard way…save that for the lessons your new business will teach you! So, we hope you get value from the book and please let us know when you are ready to engage your first business sale project and we will be happy to help. Please feel free to contact me and my team if you have an acquisition you need help with. Ken Gorman Managing Director Transworld M&A UK LSW KGorman@transworldukmanda.com

Chapter 1 - 10 Great Reasons to Buy a Business

There are many great reasons to buy a business and in fact, you should expect it is one of the most exciting, life-changing things that you ever do! Next to getting married and having children, the act of buying or selling a business can be the biggest life event for many people. It is to this that we dedicate our work as M&A Advisors, to helping people embark on this very important life transaction. I personally consider it a privilege to work with the business Buyers and Sellers that have been my clients and my vocation to make sure they get the right transaction for them, in a timely manner and that they have a chance of sleeping at night during the process. We thought we would start this book off in a positive way with a list of 10 good reasons to buy a business, although there are probably many more: 1. Freedom - Running your own business gives most people freedom. Freedom to express themselves, freedom to serve the community in their way, freedom from supervisors and being fired, freedom of creativity, time freedom and hopefully, financial freedom. In most cases, there is also the freedom of when to work and where to work. Of course, this is all subject to the demands of the customers and the operational demands of the business. One of the goals of most entrepreneurs is to move in the direction of operator to owner to investor. At each stage the Seller is needed less

and less in the business and with each stage comes more freedom. It also makes the business easier to sell as the Seller is not integral to the operations and so does not create a key person issue. This can take years to accomplish, but with diligent effort and understanding that this level of freedom is one of the objectives of the business, it can be achieved in most cases (often with the help of a business scaling coach). There is one caveat to the pursuit of freedom for its own sake. We have seen some new business owners be so successful that they feel they have lost their freedom to HR issues, VAT reports, legal issues, doing everything for 60 hours+ a week, etc. and come to us and feel the solution is to sell their business to get their freedom back. We always counsel that generally there is a better way than selling as a successful business producing yearly cash flow is a great thing to have and hard to replicate. The solution often is simply to change the way of working to get their freedom back, although this is very difficult to do without help. Fortunately, help is at hand. There are great business scaling coaches that can help with structuring your business to delegate more and get your freedom back while still enjoying the fruits of your business. One of them has written a guest chapter later in this book. 2. Financial Return - Making a Good Living - It goes without saying that if you own a business, you control the bank account and can pay yourself what you want within the limits of the profits, business plan and good tax advice. This is different from having a salary that you have, a 3rd party owner or a boss that you need to negotiate with every year. If the business does well, this allows you to extract a good living. For some of our clients, a very good 7-figure living! How you pay yourself is a matter for you and your tax advisor. Usually, a minimal amount is PAYE and dividends make up quite a big portion, but these can be paid to family members who have a small shareholder to minimise tax. So there are many opportunities

to not only make a good living but to minimise tax which are not available if you are an employee of someone else's company. 3. Financial Return - Building Wealth - As the business and profits grow, so does the value of the business if you decide to sell. So not only are you receiving the profits in a given year, but the level of profit is simultaneously increasing the value of the business so a sort of double bubble. From an investment perspective, the leverage factor is staggering if the business does well based on a small investment from the Buyer. Let’s run through an example: Enterprise Value - Your target company has EBITDA of £600K (and after-tax income of £500K), in this example you decide to purchase this company for £1.8M (3x). Offer - You offer the Seller a closing payment of £1M which comprises £300K of your money (your total investment is £400K as you need to cover £100K in acquisition costs) and £700K from a bank cash flow loan over 5 years plus £800K deferred payments to the Seller (£1.8M - £1M) over 4 years or £200K per year. Debt - This means total debt payments are £200K for the deferred and about £200K for the bank loan leaving you £100K excess each year. Growth - Over the 5 years you increase the EBITDA by 10% a year so at the end of 5 years, EBITDA is up to £1M. Exit - After 5 years, all the loans are paid off and you sell the business for a 4x multiple (as EBITDA is higher) * £1M in EBITDA or £5M in sale value. Return of Investment - Your return on your £400K investment is a staggering 1250 %! (12x+).

Profit Along the Way - Additionally, you have collected the extra profit along the way which you may have put into a SASS pension, further reducing tax and building wealth (another conversation with your wealth manager). This is a somewhat simplistic example, but it makes the point of how leveraged owning a business is when it goes according to plan. 4. Community Impact - Many people care deeply about making an impact in the community. For many, this is as important as making money and brings them even more joy. By definition, most businesses are supplying some service that the community needs to function or bring more ease and happiness to the people in the community. Doing a good job with your product or service makes people's lives easier and contributes to the well-being of the community. In fact, when we step out of our homes, almost all the services we are using beyond the government supplied services and those nature provides fall into this category. So owning a business that does a good job at a reasonable price is a tremendous way to be of service to the community. 5. Family Legacy - Many people don't just want to earn money for themselves but want other family members to benefit as well as be able to leave wealth for future generations. A business is a multi- dimensional vehicle for achieving just this. While you are in the business, the wealth being generated can be used to benefit the whole family. Family members can come into the business to learn certain skills, get their first jobs or just earn pocket money. A business is a great vehicle to sponsor programs and events that other family members may be involved in. You may also be able to help family members abroad who want to come to the UK with things like work permits. So there are many possibilities to benefit the family while you own the business.

Retirement planning and wealth transfer to children is also very multifaceted. Shares can be transferred at low tax rates and many inheritance taxes don't apply. Family SASS pensions are also a great way to invest profits from the business with all the family members in one program. Please speak with your wealth manager who will specialise in this area. 6. Personal Growth - Running a business can be one of life's great challenges. Small businesses are very much a function of the growth of the owner in being able to expand their own thinking and navigate the business through a changing business landscape and also growth. Many business owners seek out coaching programs to help them grow personally and constantly develop ever better, more effective business strategies and personal strategies…something they might never do just as an employee. There is no shortage of challenges from financial, staff motivation, leadership, customers, and products…and finding personal balance in the middle of all of it can be daunting. This process can also be very rewarding as challenges are overcome and real change happens…or debilitating if the person is not really made for this kind of experience. The type of person that thrives on these challenges we call an X-Factor leader which is covered in a later chapter. 7. Being Part of the Business Community - There are some amazing people running businesses in the community who have a unique perspective that someone that is an employee would not necessarily have. These people often belong to specialised networking, political and social groups. Being a business owner often qualifies you to be part of these groups in a way that might not otherwise be possible. 8. Starting a Business From Scratch is Much Harder - The general statistic that is discussed is that only 20% of businesses are even still trading after 5 years and only 10% after 10 years. Of the ones that are still trading, the vast majority never make it over £1M in turnover.

People often point to the IT sector, which is largely funded by Venture Capital (VC). In the VC model, they will invest in something like 5 companies expecting 3 to not make it, one to break even and one to be the star that pays for the rest…not great odds if you are betting on your family's future! It is very difficult to start from scratch, figure out customer demand, build the systems and hire the right people…to get the formula just right so to speak. Once a business gets the formula right after 1000s of tweaks and the right team, it often takes off and is very scalable. So in buying a business, you are buying a proven formula…if the business has been around more the 5 years the chances it will survive another 5 are very high…and 10 years even better. 9. A Creative Outlet - Many people want a creative outlet for their efforts in life, sort of a life's work so to speak. The right kind of business can offer this while simultaneously being of great service to the community. Owning a business gives you the opportunity to try things and see what works. In fact, this process is essential for success. There are endless challenges to overcome that test creativity and ingenuity. The best business owners we encounter are very proud of their companies. From the service they deliver that has been perfect through many years of improvements, to their branding and websites, their culture, their investment strategies, etc. A successful business is often the result of a prolonged creative process by the owner and those close to him/her that has tangible results that can be very rewarding. 10. Having Fun! - When you add all of these up, for many people running a business is just fun. It can also be a lot of hard work, but often the activities that are the most fun in life are like that. But it should be fun and rewarding. Knowing this from the onset will cause a new buyer to veer towards businesses they will enjoy running. We

think it is a fallacy that enjoying the business you run has to be sacrificed for maximum financial gain. Our experience is that one drives the other. The most successful businesses we encounter tend to be with owners who really enjoy running those businesses. We also wanted to mention that even though a certain business may not have an exciting product or be considered to be in a ‘fun’ sector, it can still be fun to run. The ability to execute well, build a rewarding culture, have satisfied customers, watch people grow, make money, etc. can be fun in itself!

Chapter 2 - What is The Right Business to Buy?

What really matters is what is the best business for you, the individual Buyer. As everyone is different with different backgrounds, skills and desires, this is specific for each individual Buyer. So it is worth considering who you are and what type of situation would work for you. Notice that we are not going straight to some kind of discussion on verticals, financials or growth sectors (although they are very important and we will get there later) as we believe that ‘cultural fit’ and the nature of the people really make transactions successful so this needs to be discussed/understood in the first instance. We estimate over 90% of people that try to buy a business never will successfully close for many reasons. Of those that do, over half will struggle to run it successfully. So who are the Buyers that are in the 10% that will be successful? This is an important question as getting it right can save an enormous amount of time and money. Firstly, it is worth considering why the person who owns and built the business you are trying to Buy has been successful. We believe much of this success can often be summed up in a blanket term we call X- Factor Leadership . This differs from management, which involves the day-to-day running of the business. This is actually the aspect that has guided and provided inspiration for the business to get where it is today. An X-Factor leader also navigated the business through the ups

and downs that are inevitable in running any business over a number of years to the point where it is profitable and sellable as an ongoing concern today. We mention ‘leadership’ specifically, as generally there are very good ‘managers’ in the business but leadership is a different concept. A manager is a different type of person that is excellent at their day-to- day job but they are generally working under an X-Factor Leader that has provided the context for their role. Most often, X-Factor type leaders will not work under other X-Factor leaders (not for very long anyway) so the fact managers have been in place for a significant period often demonstrates they are not this type of personality. Often, the current managers could be mentored into X-Factor leadership type people, but this would require a process and people from outside the company over a period of time and for the right type of person. It is not just something that just automatically happens any more than someone becoming a star football striker just because they have played on the team for a few years when the star striker leaves. As an example, during the Covid period, a manager who was well trained in how to run the business in a certain way might have come to a standstill when the regular customer activity dried up. However, X-Factor leaders were often able to completely pivot their company to survive or even take advantage of the situation the pandemic caused. Many did this effortlessly and came out the other side stronger. Many businesses that did not have an X-Factor leader continued operating and managing as they were and slowly shrunk out of existence. This debunks the idea a good ‘management team’ alone can somehow drive and grow a business long-term just by doing the same things. It takes an X-Factor leader to drive constant change, adaptation and growth.

However, in a business sale, very often this X-Factor leader is leaving (as generally, their leaving is the purpose of a business sale in the first place). But who is going to fill the ‘leadership void’ that is created? Is it one of the current management team? Very often managers are not X-Factor leaders, they only work for them. Usually, an X-Factor leader will not work for another X-Factor leader for long, they will leave to start their own project. So when you have good managers that have been in place for a long time, generally they are just that…good managers. In our observation, the important point is simply to recognise that this potential ‘leadership void’ (versus management) that may occur when the Seller leaves exists and needs to be addressed as an integral part of the deal structure. And also to avoid the pitfall of thinking that the day-to-day operating managers will be able to ‘lead’ the business without this leadership void being addressed in some way. But this void must be filled somehow and often this is the catalyst of why they want to sell the business. Their time has come to leave and they need someone else to come in and continue and grow their legacy. So very often this is one of the main criteria for being a good Buyer is being able to fill the leadership void with one or more strategies. Filling the X - Factor Leadership Void There are several ways in which we have observed this leadership void being addressed that can work (in fact being in denial that this is an issue is the biggest problem in our experience). The Private Equity Approach - Private Equity companies generally ‘do not run businesses, or so they say. The Private Equity firms are very good at identifying existing management team members who have potential and then surrounding them with an experienced, generally non-exec, leadership team. This will typically mean a chairman who is

from the industry, a CFO and other advisors on the board who can support the specific type of business. Starting during due diligence, they meticulously work with the new CFO and management team to develop 5 year plans with specific metrics they will use for managing the business. The management team that takes this journey will typically be incentivised with significant Sweet Equity shares that will often allow them to retire should the business hit the 5 year goals they have set out. In our experience, the Private Equity directors are still very involved after the sale at a Board Level to support and guide the business. Trade Buyers - A trade Buyer has the advantage of often understanding the Seller’s business and in fact, they may be a direct competitor. They may simply be able to leverage their existing leadership team (which is probably headed up by an X-Factor Leader). Very often, they can cross-pollinate management over to the business they are buying. Sometimes they will simply be buying customers or staff and the business does not need to keep running in the current form. Operator Buyers - An operator Buyer is most often an X-Factor Leader in their own right with previous industry experience and track record running a business generally related to the sector they are looking at. They may already understand and have run a business similar to the one they are considering buying. Occasionally, they will be buying a business in a new sector and can make an agreement with the new owner to mentor them for an extended period (like 1 year +). But the one commonality is that the Operator Buyer understands that they need to be actively involved in the ‘leadership’ (versus day-to-day management) of the company. For example, they will need to spend a year to 18 months actively involved in running the business to understand it and maintain a board level leadership role afterwards.

Team Member - In this model, the individual recognises that they are not an X-Factor leader and will need to be on a team with someone who is. They may have finance skills, for example, and be a team member with another X-Factor leader who is going to take the role of filling the leadership void. Investor Buyer - Our observation is that the idea someone can just buy a business they don't have a background and are unwilling to become an operator with the idea of just relying on the existing day- to-day managers does not work well in most cases and a flawed model. If someone is not an X-Factor leader and/or not prepared to fill the leadership void, they will need to be on a team or investing in someone that is to lead the business post-sale. We realise that many people in the community and some Buyer programs may advocate for this ‘investor only’ model. We are simply being true to our observations that this does not work in practice in most cases. It is important to understand that the due diligence period and contracts phase could take 3-6 months. During this time a Seller is going to get to know a Buyer pretty well. They will need to be confident that a Buyer can take over and run their business or they are likely to pull out of the deal. In the first instance, they will want confidence that their legacy will be maintained. In the second, they will want to be confident that they will get paid any monies due after closing. So it makes sense, to be honest about whether a Buyer is the right fit early on to save both sides time and money. What Type of Business Should I Buy? This is a multidimensional question that is different for everyone. This topic is also covered in many other books, so we won't go into it much here. However, below are some thoughts and guidelines you might find helpful:

A Sector That You Understand - Warren Buffett is famous for saying that he would not buy a business he doesn't understand. We agree and in fact, believe that if you are going to fill the X-Factor leader role you really need to have some kind of background in the sector you are buying into or be prepared for an extended mentoring process by the existing owner (maybe years). A Sector That You Like - This goes with the previous point, if you like a sector you are going to want to learn more about it, leading to understanding that sector well. Also, this ties into every point on why to buy a business…if you are inspired by a sector you are likely to be more creative, offer a better service to the community, work harder, be more committed, want to get people involved, etc…all of these generally lead to good financial results. A Company That Inspires You - Liking the sector is important, but to be truly successful you will probably need vision. To have vision you need to be inspired by the market you are surviving and whatever it is you are offering them. This inspiration is infectious and can turn the business into more than just a job for the employees with significant productivity and service level results. Geography Matters - You are going to need to spend time at the business, with the people and with the customers, at the very least. Although much of business can be done remotely, there is no substitute for meeting people and there are generally many people beyond just employees and customers that benefit from face time. Due to this, being close enough to attend the area where these people are is very important. The idea you can buy a business and be 200 miles away from most of the people and not cause a massive headache is unrealistic in most cases. A Business You Can Afford - As will be discussed in the chapters on valuation and deal structuring, there is a certain amount of your own capital that will be needed for costs and also a closing payment in most

cases. You want to make sure the amount you have to put in mirrors the business you are looking at and that you do not overstretch yourself. The idea you can just get as much debt as you want is generally not accurate. For one thing, the banks won't just lend with significant scrutiny. Also, the cash flow has to be sufficient to pay the debt back. So it is prudent to understand what Enterprise Value range and terms are going to work for you. Recurring/Repeating Revenue - The value of recurring/repeat revenue is talked about a lot and is, of course, true. In the end, you are buying a future cash flow and the less risk there is around this actually coming in, the better. Sometimes repeating revenue is the best kind to have as the customers will just keep their contracts running indefinitely as long as there is no friction. This can even be better than long-term contracts, which may have an endpoint or a ‘cliff’. But in both cases, the customers are baked in and the business does not need to find new customers for the bulk of the revenue which lowers risk. However, this is a general concept that must be evaluated in detail for all types of businesses on a case-by-case basis. There are many nuances and some businesses that rely on a new customer or new contracts on a regular basis are great businesses. Room for Lots of Growth - In theory, the leverage buy-out model can work ok with flat revenue (when the debt is paid in 5 years and the business can be sold again for the same price, mathematically the return is still very good for the original investment). However, it is commonly understood that businesses are either growing are dying so this is not a great strategy. Also, business is in a constant state of flux with the loss of some customers and markets and others added, so a business owner generally wants somewhere to grow into. One of the main features of buying a small business is to be able to improve and scale the model, so there needs to be a market to scale into. Growth is exciting and just

a small amount of growth each year, like 10%, can double the ROI over 5 years. Be Careful of Capital Equipment Refresh - Businesses that are capital intensive need to have this capital equipment refreshed on a regular basis. Often when a sale comes up, the owners have put this off and been ‘sweating’ the assets. This leaves a new buyer needing to use cash to implement a refresh program. If this was not understood at the time of purchase, it can cause a lot of problems. If this is understood, it can be managed and modelled and is usually not a problem. Good Systems - Most businesses are about the people that deliver the service which is true. But these people need to be organised through good systems. The people should have figured out 1000s of details about how to optimise their service to the customer and this should be understood, repeatable and documented so new people can be trained and KPIs monitored. When you are buying a business, a big part of what you are buying is these systems. If they are not well documented and sloppy, when the owner leaves, it could cause serious disruption to the operations of the company. A company with good, well-documented systems is much easier to take over and absorb the loss of any staff. This goes hand in hand with good books and records. Understanding business performance metrics is critical to managing any business (if you can't measure it, you can't manage it is the old axiom). Poor books and records cast doubt on whether the business results are accurate at all and whether the products and services being delivered are profitable. Not understanding that can lead to the wrong decisions and weaknesses in managing cash flow, which is one of the leading causes of businesses going out of business. People You Like - The leading cause of business sales not getting to the closing table or not delivering after the sale, even if it does can usually be traced back to what we call ‘poor cultural fit’. We use the

term ‘cultural fit’ as it encompasses people with similar values, a similar vibe, and people that like each other and are able to formulate a common objective and have fun with it. We find that almost always the deals that make it to the closing table are when the Buyer and Seller take an instant liking to each other in the first meeting. In fact, this is one of the main things we look for early on, call it chemistry. You might wonder why this matters if the owner is leaving? The reason is that the owner generally reflects the culture of the company as a whole. This is not always the case and sometimes it is the number 2 person that is staying in the business if the owner has been out of the business for a significant period but then the same goes for the chemistry with this number 2 person. At some point, a Buyer should feel that he really likes these people and is looking forward to working with them and vice versa. These are the transactions that survive the rest of the process and delivery after closing as a general rule.

Chapter 3 - The Seven Deadly Sins When Buying a Business - By Jeff Lermer, Chartered Accountant

I very much appreciate being asked to prepare this guest chapter in a very important publication, because this publication is the beginning of your journey to buying a business. As a Chartered Accountancy Practice, we help businesses in many ways and I’m gonna look at a number of sections as I have described as the seven deadly sins of buying a business. The seven deadly sins are as follows: 1. Not defining what you are buying 2. Using the wrong entity for buying a business 3. Not doing proper due diligence 4. Not knowing the value / agreeing on the price – paying for potential, understanding goodwill 5. Not budgeting cash flow, or understanding what you are buying 6. Not knowing what you don’t know 7. Not understanding tax

1. Not Defining What You Are Buying You may have an idea of what you’re buying, and the target may have an idea of what they are selling, but as you can imagine, too young and inexperienced lovers (apologies for the terrible analogy), trying to model something without actually knowing what they are doing is a recipe for disaster. There are a number of areas of misunderstanding, are you buying the shares in the company or are you just buying the assets? Are you buying some of the assets or all of them and are you taking on the liabilities? If you are buying the shares, what will be left on the balance sheet and how much would be taken out? How much of the Target company to treat as a distribution prior to the sale? In order to avoid these problems, you need to be completely clear about what you are buying. If you are buying the asset, and if you find a company you need to define exactly what the balance sheet would look like post sale. As an accountant, I like numbers, and it is clear to me if you have defined exactly what you were buying. Many vendors believe the cash in the company is theirs, while the acquirer might think that money will be used to finance the business going forward. These are genuine misunderstandings that need to be sorted out. 2. Using The Wrong Entity For Buying A Business You must first decide if you are buying the assets or the shares. Also, if you are buying the assets personally or in a limited company as the taxes are very different. If there are deferred payments, how does this work and what are the specific guarantees being given? I am normally a fan of acquiring assets, not shares. If you acquire the shares, you also acquire potential liabilities that are within that company. For example, if the previous owner has made mistakes on VAT, or PAYE, or has disagreements with the amount of what they are owed or owe, you take on all those obligations.

Yes, it is true that you can cover these with tax warranties, but it’s far easier to avoid this with an asset sale. The majority of very small acquisitions are carried out as asset sales in the transactions that we work on because they are simpler and cheaper. Notwithstanding this, the reason that share sales are popular is the tax treatment from the vendor's point of view. In a simple way, they simply exit the business. The vendors agree on a price for the shares. They resign and you take over removing what is agreed. The normal process, if you are buying the shares or all the assets, is that you use a special-purpose vehicle and potentially a holding company. A special-purpose vehicle (SPV) is just a new company formed for acquiring the assets and liabilities on the sale, all the shares in a share sale. The reason I will advocate using an SPV is to manage the risk if all goes wrong. The liabilities for the acquisition will be held in the SPV and if you have bought a complete disaster, and unfortunately that is more common than you might think, you can limit your liability via the company. I’m sure if you have reviewed the chapters in this book, the term deferred consideration is mentioned. That is a position where you pay for the assets, or the shares, over a period of time in the future. The term vendor finance is also used. This is particularly common and useful, especially when you cannot agree on the share price. I will give you one very true life example: Typically, in the construction industry, small construction companies are worth, in my opinion, very little. The vendor believes there will be a whole stream of work coming to that company, but contractually all the acquirer gets is the contract that is signed on the date of the sale. There is a massive gap in expectations and to breach that gap you might agree to some sort of deferred consideration that is contingent

on future activity. This may be a percentage of turnover or a percentage of profits. I’m probably a fan of a percentage of turnover on the basis that this number is significantly easier to calculate and agree on, while profit is extremely subjective. Above the SPV, you may decide to use a holding company. The benefit of a holding company is really if you plan to acquire more than one business, and you wish to separate these businesses. Please see the diagram below:

You will also see a little bubble on the left-hand side of the diagram which says employee shareholders. This is not essential, but it’s sometimes useful to offer some shares to existing share in existing employees as they may be key to this acquisition being successful for you. Caution should be taken here, as your rights need to be protected, and you need the ability to buy back those shares at an agreed price at some stage in the future, but it may be a good way of bringing in loyalty, support, and the right help you need at this stage. 3. Not Doing Proper Due Diligence Anyone considering acquiring a business needs to check all the assumptions that are being made in the deal.

Financial due diligence provides peace of mind to you by analysing and validating all the financial, commercial, operating and strategic assumptions that you have made in buying the business. In my opinion, it will give you significant and necessary confirmation. Just getting into the business, looking around, checking emails, reviewing information like the complaints log, and chatting to the team about what’s going on will give you a really good feel for the business. Also, looking at the numbers, the VAT returns, and any mistakes made will indicate how well the business is run. If you are not buying the business, it may seem like you are looking a gift horse in the mouth, but it may not be such a gift. I’m not a fan of using Latin, but the phrase caveat emptor is completely relevant here, which means Buyer, beware. It is up to you to check what you are buying. The themes to look at our as follows: Administration Financial Human resources Assets Taxes Intellectual property Legal matters Customers 4. Not Knowing The Value / Agreeing The Price – Paying For Potential, Understanding Goodwill The fourth big mistake, people make is not knowing or agreeing the value of what they are buying, and paying for potential and not understanding what goodwill is. This may seem to seem obvious, but how do we know if the business we are being offered is being offered to us at the right price? The

correct price is what you were prepared to pay and what the Seller is prepared to receive, based on the full information. The goodwill would be defined as the difference between the assets and the future profits that will be generated from the assets. How much would you pay now for the expectation of these profits? There should be a maximum price, although other items matter too, especially with no money down. The value today of any business, in theory anyway, is the discounted sum of the future cash flows being generated. But a big mistake is paying for the potential that you are adding. It’s very easy to run away and to overvalue potential. Even if you’re putting little or no money down, you don’t want to just buy a job; you want to buy a business that will grow, thrive and give you a return at the end. Especially if you’re investing in fashionable technologies, you may get overexcited about the potential, ignoring the hard work that you will have to do to make that potential happen. A great client of mine once described an ideal business to buy and I completely agree with his summary. He said if it’s a sort of business where you are sitting at a dinner party boasting about, feeling amazing about, thinking you rule the world because it’s so up-to-date and fashionable yet it’s probably a business that is not making much money. The businesses that really succeed are the ones nobody really talks about, the ones that just produce a good sustainable growing profit each year in an unexciting market. I think this advice is liquid gold. Goodwill does exist and this may be based on things like the value of a company’s brand name, its solid customer base, its good customer relations, good employee relations, and proprietary technology which allows it to make more profits than its competitors, or provide things that these competitors cannot provide.

5. Not Bothering With Looking At The Budget And Future Cash Flow, Or Understanding What You Are Buying It’s important to produce a cash, flow analysis, and budget, including factoring in tax, and the management time that you will need to put into the business. If you do not produce a budget, how are you going to know you are going to make a profit from this business? Relying on vendor assurances is something you must never do. I cannot emphasise how important it is to produce a budget prior to acquiring the business, so you know you could afford to run it, pay the vendors if there is deferred consideration, pay the tax, pay the employees, replace machinery that needs to be replaced, etc. And it's a harsh reality to say, but if the budget says no, you just say No! 6. Not Knowing What You Do Not Know There are a number of things to consider here, and these are as follows: Working with people like Ken Gorman at Transworld M&A, and using the skills that they have because buying a business is not necessarily just intuitive, there are lots of tricks, shortcuts, pitfalls to avoid, and he knows what items to look for. Having someone experienced at your side makes all the difference. There may be specific terms that are used in a transaction. You just don’t understand them because you’ve not come across them in normal life. For example, the word whitewash may mean a number of things. I’m choosing this to mean an acquisition using the assets of the target Company in order to acquire the shares from the vendor via a loan to the SPV. Financing and personal guarantees are something you should take specific advice on and use experts. It is possible to search the Internet

and find these things but working with your “power team” and having good inroads into raising finance, and even producing something called personal guarantee insurance may be really useful for this acquisition. You also may not have considered your future exit, structuring now can make a massive difference. 7. Not Understanding Tax Tax can be looked at in many ways, but if you just treat it as a cost, it just becomes something that should be minimised. Just as an example of how simple structural changes make a huge example see the example below: - Say Fred is buying Wilma Limited for £800k over 5 years that makes £250k per annum. - Without a holding company , Fred buys the company personally and he has the obligation to pay the £160,000 pa. in deferred payments to the Seller. - Wilma Limited makes £250,000 and pays say 25% tax so gives out a dividend to Fred of £187,500. - The dividend is taxable and gives Fred a personal tax liability of £63,281 (or more!!, could be £737,781). so he has only £124,218 after tax yet still has to pay the £160K deferred to the Seller. - With a holding company, Fred Limited buys Wilma LTD and he has the obligation to pay the £160,000 pa. deferred to the Seller as before. - Wilma Limited makes £250,000, pays say 25% tax so gives out a dividend of £187,500 to Fred Limited.

- The dividend is not taxable in Fred Limited as no tax on dividends between UK companies, so Fred Limited has £187,500 to pay the £160,000 to the Seller. Conclusion I hope you have found this useful. The purpose of this chapter is to simply reflect on the importance of structure and planning when you acquire a business.

Chapter 4 - Who is The Business Seller?

The first thing to know is that most of these heroes have worked all hours and weathered the ups and downs of the business cycle to get to a point in their life where they can see the light at the end of the tunnel, a time when they can take a well-deserved break and think about retirement. And so begins the business exit process. We have found that working with the individuals that start, run and navigate the growth of successful companies are generally simply amazing people! For most people selling a business is a HUGE life event. It can be as significant as getting married or having children and is often more emotionally complex. The process of selling a business most often arises due to a desire to retire, which is one of life's major transitions. Often a business is the most valuable asset a person owns and the sale will fund this retirement. So, in addition to the emotional side, selling their business may be the most important financial transaction of their lives. Something like only 20% of companies make it to 5 years and 10% to 10 years and still are trading. For the ones that do make it, the vast majority never exceed £1M turnover. So our clients are normally in a very small, elite percentage of people that can buck the statistics and navigate companies through the ups and downs and over a long period of time to create successful companies that someone else would want to buy (the topic of this book).

These people deserve our respect. They have beat the odds to build a business that the community demonstrates is important by continuing to buy their products and services, taking care of their employees and generally providing a good living for the families. So these X-Factor leaders generally deserve our respect and admiration as a starting point for a relationship. In fact, being willing to consider buying someone's business for millions of pounds is in itself a great demonstration of respect, which is a great starting point. Why Do Business Owners Sell? The Retiree - In the small business space, generally the answer to this is…because it is time to leave. The best way to describe what we have observed is that there is a switch in the heart that goes off and says it's time to go. Sometimes, people are aware that this switch is coming and have a 3-5 year runway. Often they have ignored this and now the switch is a very acute feeling and they feel life pulling them in another direction. Most often, this is due to retirement and a business sale not only becomes monetary but also buying time to do the things they want while they still have time. Functional Exits - Another reason people want to sell their business is they have what we call a mechanical reason. For example, they are moving to another geography, they have a health issue that no longer allows them to run the business or a major life circumstance change. These are very straightforward situations and they just need to find a Buyer that can take over and get what they can monetarily. The Young Overwhelmed Entrepreneur Syndrome - Sometimes you will get younger people with successful businesses that think they want to sell. Upon enquiry, what has happened is that they became an entrepreneur to get freedom (the most common motivation). Now that they have a successful business…there are staff issues, reporting requirements, legal issues and lots of problems to overcome and they

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