Everyone loves a bargain, especially entrepreneurs.
The entrepreneurial DNA demands that at least once in your career you’ll be tempted by the prospect of buying a business down on its luck, giving it the kiss of life and taking the plaudits and profi ts when it returns to good health.
More frequently and less egotistically, you’ll see a business struggling that you think needn’t be, and view it as an acquisition opportunity. But while it’s perfectly possible to benefi t from someone else’s misfortune, the harsh reality is that it’s rarely as straightforward as it looks. There’s no escaping that while the price tag might be small and the potential return great, you’re actually making an extremely high-risk investment – so how do you decide if a failed business is worth a punt?
It never costs a pound
It’s fairly obvious the reason entrepreneurs buy failed businesses is they’re usually going cheap. The press loves reporting the token sum a business exchanges hands for and entrepreneurs yearn to boast, ‘I only paid a pound for it’. But let’s get one thing absolutely clear, buying a failed business and making it work, will not, under any circumstances, cost you as little as a pound.
You’ll either be buying a business on the verge of collapse with so many debts it has very little actual value to the seller, or you’ll be buying out of administration where you are picking up the assets, although without the liabilities, once it’s all gone publicly wrong. Either way, you’re buying damaged goods. The cost to put right that damage is where most turnarounds fall down – and where people seeking a quick-return end up losing a lot of money.
George Moore, an expert in turnaround acquisitions, says: “It’s mostly fools’ gold – business recovery is very hard and you almost always have to be prepared to put a lot of capital in to make it work.”
Recognising turnaround potential
Even in the hands of the most capable turnaround expert, some businesses will be beyond saving. Recognising a business has no turnaround potential is just as important as identifying one with it – and in the long-run will probably make you more money.
Rob Donaldson, a partner at Baker Tilly, says: “If the fundamentals are poor you can’t do it. If it’s manufacturing and it can be done cheaper in China then you won’t be able to do a lot with it. However, if it’s just been poorly managed, then that’s a green light to look further.”
“It’s all about risk versus reward,” says Nick Hood partner at Begbies Traynor. “Your first question needs to be ‘how bad is it?’ then it should be ‘what is the cash requirement?’ – and I’ve never seen a failing business that doesn’t have one.”
You must price everything from the worst possible scenario, advises Hood. “Plan for sales falling, new equipment, expensive sales people, marketing costs and then work out how long it’ll be before it’ll be profi table. If you’ve got to increase turnover by 50% then you have to consider if that’s an impossibility.”
If the business has a strong product and willing consumer it must be failing elsewhere. Perhaps it’s been managed poorly, needs investment in technology to make it more effi cient, has marketed itself expensively or perhaps it’s struggled to cope with debt. If it’s one of these, it may be turnaround-able.
Consider if you could improve effi ciency or increase yield through:
➧ economies of scale;
➧ access to wider distribution;
➧ reducing overheads through synergy;
➧ overseas labour or production markets;
➧ applying your superior brand
Restaurant chain Loch Fyne decided in 2003 it wanted to take on another brand and identifi ed Le Petit Blanc as a potential acquisition. It had fallen into administration despite enjoying high visitor levels. It was this that convinced Loch Fyne co-founder and MD Mark Derry that it could be turned around.
“It had a proven formula and customer acceptance with excellent sales, yet the business was failing,” says Derry. “It was taking a lot of money but spending a lot too so it was clear the problem was in the administration and we thought we could change that.”
For Hood, the high profile acquisition from administration of Red Letter Days by Theo Paphitis and Peter Jones, is another example of “a classic good idea, run badly, being bought for turnaround potential”. However, Hood insists the partnership still faces a signifi cant challenge. “They’ve bought a brand and not much else. It appears a very reasonable punt – but it’s still a risk.”
Risk is the element you should be looking to reduce throughout the whole process. At every stage, it’s essential to think, ‘is this still a good idea?’. If it’s not, move on. If it is, continue digging.
Due Dilgence
In a fi nance deal, as anyone who has raised VC funds will vouch, no stone goes unturned during due diligence. When you’re buying a business, particularly one that’s in a mess, it’s a case of snatching glances under as many stones as you can. You’ll never get the full picture, but every snippet of information you uncover will reduce that risk factor. “You’ll be under intense time pressure,” warns Donaldson.
Tony Edwards, a partner in corporate fi nance for law firm Stephenson Harwood, says: “There will be all sorts of problems you’ll need to get to the bottom of. You want to know if supplier contracts have clauses that can be triggered and if you can renegotiate them. You need to know if there are any outstanding claims, disputes or issues with real estate or environmental issues. You need to know what is going on with pensions; if there is a scheme with defi ned benefi ts and if it’s under-funded.”
For Derry it was a case of finding out where and why money was flying out of the business. “We got to see the sales books and profi t and loss account, which showed the labour costs were far too high. They had marketing managers for each of their four sites, there were too many chefs and the food was costing a lot to produce.”
In Derry’s experience, the management were very open to the assets being explored. However, Hood’s cynicism that generally you should take the vendor’s word on the true state of assets “with several pinches of salt” is shared by most. The overriding advice is to dig as deep as you can and talk to as many people – staff, suppliers, creditors, debtors, landlords – as possible, whether or not you’re given permission.
“Quite simply you need to ensure the assets you’re paying for exist,” says Moore. “But you need more than that. Talk to creditors and see what their attitude is. If there’s a debtors book fi nd out how much is likely to come back.”
In addition to an experienced accountant and lawyer, it could be wise to use the services of an independent assessor or insolvency practitioner. “They will look at the situation without emotion,” says Hood, “and ask all the ‘yes, but what ifs’ and ‘I don’t believe thats’ in the right place.”
Sometimes, however, the information won’t be accessible. This should set off warning bells. James Grenfell, a corporate fi nancier partner for corporate recovery experts Kroll, says: “If you can’t access the right people then you quite simply can’t do a deal. You should expect to walk away from one in 10 deals.”