Post-Close Unexpected SMB Costs
August 16, 2023 | Issue #88
Big Deal Small Business: Post-Close Unexpected SMB Costs
August 16, 2023 | Issue #88
If you are a new reader / new searcher, I recommend starting with the New Searcher Reader Guide.
Talk to most searchers-turned-operators — most ran into costs shortly after closing that they didn’t see coming.
I’m not talking about costs required to generate new growth. These are costs that the former owners just weren’t incurring for one of a few reasons:
Owner Self-Performed: They handled certain tasks themselves and you can’t.
Missing Costs Altogether: They didn’t do certain tasks (often related to legal / admin) that you intend to do.
Off the Books / Gray Areas: They paid for certain services/tasks under the table or out of their own pocket, and now you have to actually pay for those. Or they just didn’t do them, and they really should have.
This list is my best attempt to create a comprehensive list of potential unexpected costs searchers may face, so that it may serve as a diligence checklist of sorts for searchers pre-close.
That said, I anticipate there are plenty of costs I haven’t considered — if you see something missing, just reply to this newsletter and I’ll keep updating the post with new ideas I see. I’ve also got a Twitter thread running with tons of great replies from other folks (some of which are incorporated here).
But first, a quick sponsored plug:
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Okay — here we go. Non-exhaustive, but I threw out everything I could think of!
One quick comment though — due diligence is about turning over stones, primarily by asking questions or requesting documents/records.
You can’t help it if the seller outright lies in their responses to you. You protect against fraud & lies in the transaction documents using reps & warranties & indemnities.
But it’s on you if you just fail to ask the question and hope the seller proactively tells you. Lying by omission tends to come with the territory in business acquisitions (whatever you may think of that ethically).
Further, in many cases (especially the “owner self-performed” bucket), the owner isn’t actually lying by omission when they fail to mention a missing cost proactively. They’ve just been doing it for so long that it doesn’t even occur to them that it may be a notable detail to you — unless you ask.
Owner Self-Performed
Service Provision:
Maybe too obvious to put on the list, but if the owner is actually providing services to clients or involved in production of goods for sale, you will have to replace her.
Important: If the owner only does a little bit of service provision, it’s likely the highest-value / highest-margin work that is hardest to replace.
Sales & Marketing: Similar to above, if the owner directly owns client relationships, you have several problems.
You need to hire a salesperson to take over these relationships (or do it yourself).
You introduce elevated client retention risk, which can lead to meaningful revenue loss.
The owner usually owns the highest margin accounts, so you are risking a higher % of EBITDA than immediately apparent if you only look at % of revenue.
A similar but related concept to help you think creatively — what if the seller is directly managing the Google Ads account (rather than using an agency), and that is the primary lead generation source? This is a real problem to solve where you will have both new costs (from the agency) and lower ad spend efficiency (as they’ll be worse than the prior owner, most likely).
Mechanic Costs:
Very common for owners to self-repair their trucks, specialized equipment, and other small equipment. Unless you’re handy as hell, good luck.
The sticky issue with this cost is that it may not just be a function of money — depending on the equipment, you may not even be able to find a halfway decent technician to work on it in a timely manner. So now you’re facing downtime, which can lead to real revenue losses.
Bookkeeping: Very common for the primary business owner’s spouse to be managing the books & filing taxes (in an unpaid capacity). Depending on your ability to take on parts of this role, this could easily stack up to a $50-100K annual cost the day after close.
Admin / Scheduling / General Office Management: Similar to bookkeeping, this is very often unpaid labor done by the owner’s spouse. Some items to ask about:
Who files sales tax monthly?
Who files quarterly / annual B&O tax filings with each city?
Who manages quarterly / annual IRS filings and tax payments?
Who manages city & state license renewals?
Who manages vehicle registration renewals?
Who manages sending COIs or contracts to clients?
Who pulls permits if you’re looking at a contractor business?
(I do most of these in my business, hence the specificity…I’m sure there’s tons of other stuff too.)
More generally — if it’s a larger family-owned business, there may be a number of small tasks handled by family members at no cost, such as delivery runs of supplies, borrowing a Sprinter van that cousin Jimmy owns for his restaurant business, etc.
Rent:
Fairly common for owners to use their home or personally-owned property for the business. They may not be charging the business any rent (or market-rate rent), which is an adjustment you need to make.
One detail that tripped me up — I decided to rent a new facility for my business to replace some of the “home business” elements. My diligence nailed the per-square-foot rental costs of a new facility. What I missed, however, was that I could not find a facility as small as I needed. I ended up having to rent more square feet than I really wanted.
Replacement Friction:
Even for the tasks that you intend to take over for the owner (say, Accounts Receivable management), you need to factor in that you will be slower at the job and less effective, at least for a while.
You can make up for that in pure hours worked by you, or by hiring more staff to help offset the inefficiencies created by you attempting to replace the owner. Either way, that’s a real cost.
Missing Costs Altogether
Promised (or Delayed) Raises:
This is a challenge to diligence, but I would ask for an employee census that shows their current pay, as well as some historical info to see when folks last got raises. If you see someone at $24/hour for 3 years, odds are high you will be asked for a raise shortly after closing.
Ask directly if the owner has promised raises or bonuses to any of her employees recently — but I would also suggest making this a rep/warranty in your transaction documents to the extent your lawyer agrees.
Benefits: This can potentially be delayed depending on how bad it is, but it’s fairly common for thrifty small business owners to be way too lean on benefits, sick leave, PTO, etc. You may want to beef that up shortly after closing (also a way to win some employee goodwill out the gate).
One-Time Vehicle Transfer: This doesn’t impact EBITDA on an ongoing basis, but depending on your state, you may need to pay sales tax and other registration charges at the time of acquisition for all the value allocated to vehicles.
If you buy a business with $500K of truck value, and a sales tax rate of 8%, you’re talking $40K+ due to the licensing department within the first 30-60 days of closing. Be prepared for that.
Bonus Tip: Your lender should be able to include these one-time costs as transaction costs and finance them for you as part of the overall deal. It’s still a real cost, but won’t impact your liquidity out the gate at least.
Delayed Maintenance / Capex: You may find equipment & trucks in poor condition, especially if the business has been on the market for a couple years. The former owner may have really started penny pinching as they prepared for retirement.
Personal Vehicle: It’s common for owners to add back their personal vehicle as part of the transaction — but that only makes sense if they actually don’t use the vehicle in their business.
“Basic” Software:
Obviously “basic” is subjective, but if the former owner ran their books on paper or purely with an outsourced bookkeeper from the 1970s, you will need to subscribe to QuickBooks at a minimum.
Domain name & email addresses (to the extent the business uses gmail/yahoo to conduct business).
You may want to add in new IT controls, such as 2FA, upgraded website to be ADA-compliant, etc.
You may need to upgrade internet speeds, refresh computing devices, etc.
Insufficient Insurance Costs:
It would not be uncommon for small businesses to be underinsured in terms of their policy limits or coverages, especially if they’ve grown recently and never re-visited their policies.
Potential gaps include Employment Practices, Cyber, and D&O (important if you have investors / board).
If they added a new service vertical in the past couple years, they literally may not have coverage for it even though they think they do. They may also have customer contracts that come with insurance requirements that no one actually bothered to check.
Work with a firm like Oberle Risk (who I used for my deal, not a sponsored referral) during the diligence process to assess the current policy and what additional coverages you may want to have.
Safety & Training: If you’re buying a business that has meaningful labor injury risk, you may need to beef up your safety & training program to be both OSHA-compliant and for your own ethics/peace-of-mind. This creates downtime for your team that has a real cost.
Off The Books / Gray Areas
Cash-Paid / Undocumented Labor:
This is incredibly tricky to diligence or tease out. But if the business relies on undocumented labor in any way, you’ll have to make a personal decision about how to handle that going forward.
If you’re looking at a services business, take the time to work out revenue per labor hour worked (by getting payroll data). If the effectively hourly revenue is multiples above industry norms, you can guess that something is off.
Suffice to say, off-the-books payments to labor are real expenses that will not show up in business books or tax returns, but will show up the day after you close.
Inaccurate Workers Comp: Owners may cut costs by misallocating employee hours under their workers’ compensation insurance policies. I would ask them to show you how they do payroll & workers comp hours and just do your best to assess if something feels off.
State/Local Filing Fees & Records:
Very common for SMBs to be missing basic practices around staying current with various federal, state, and local regulations.
One example — service contractor that is licensed in its major metro, but not in all the small suburbs surrounding that metro. You could get hit with licensing fees, B&O taxes, time it takes to file those forms, etc. for each of those little towns.
You may actually find a liability here from past records being unfiled — these liabilities can sometimes chase you through a transaction, even if you did an asset deal, given the government dynamic. It’s worth trying to box these in your transaction docs (reps & warranties & indemnities), in addition to diligence.
Conclusion
That’s what I got! As I mentioned up top, there’s an ongoing Twitter thread with more responses you can check out. And I’ll update this post from time to time based on new costs I hear from folks, so please hit reply to this email if you think I missed anthing.
For thoughts or feedback, just hit reply to this email or post/DM me on Twitter.
Thanks,
Guesswork Investing
P.S. I run a local building maintenance contractor in Seattle, WA that focuses on single family residential & commercial properties. To the extent you know folks in the RE industry in Seattle (both homeowners & property managers), I’d always appreciate intros.
Great article. Can you share what areas of your diligence you did yourself vs. outsourced, if any? Assuming you hired someone for QOE, but I'm curious about the legal, regulatory, HR, tech, etc.
Just outstanding. Thanks so much for a highly reference-able post.