Imagine that you’ve made it through all four quarters of the game and you’re on the 1-yard line in selling your business. Then, out of nowhere, the opposing team’s defensive lineman hits you in the gut taking you down, while the rest of their team piles on top of you. You were so close. You didn’t even see them coming. How did this happen (and probably, ouch)?!
The scenario above is similar to what usually happens to most Managed IT Services Providers (MSPs) at some point during the process of selling their business. And it’s brutal.
However, after working with tech firms in the M&A space for over 20 years, I can share with you the top three reasons why 95% of IT business owners get “tackled” when trying to sell and how to prevent it. These top three are working capital, deferred revenue, and misrepresentation.
It’s a struggle to manage cash flow efficiently on a daily basis. As an MSP business owner, your time is limited, and you’re being pulled in a million different directions. The last thing on your mind is calculating working capital. Nonetheless, you must know your company’s working capital as it’s the lifeblood of your business.
When selling your business avoid being undercapitalized or overcapitalized.
Your business is undercapitalized if the working capital required to run your daily operations is less than your company’s expenses upon the sale of your business. For example, if you bill a customer on January 15th but won’t be fulfilling their services until February. This revenue, earned before services are rendered, is known as “deferred” or “unearned” revenue. The consequence of being undercapitalized is that buyers can request a discount on the asking price for your company. The reason being that the buyer will be responsible for your outstanding expenses upon the sale of the business. An easy fix to this is to bill all expenses on the 1st of the month, for the upcoming month. Being undercapitalized while trying to sell your business will create unsavory consequences in similar ways to being overcapitalized.
Your business is overcapitalized if you have a surplus of working capital upon the sale of your business. This happens if you overestimate your company expenses prior to the sale of your business. The result is that you’re giving money away for free to the buyer. Usually, this happens because you neglected to take out a line of credit and opted instead to just leave the cash in
Before you begin the process of selling your business, you should assess whether you’re under or overcapitalized to avoid losing money. If you want to find out your working capital until after your buyer has seen your financials, the damage is already done and cannot be undone.
However, this hasn’t stopped some owners from trying to “fix” their overcapitalization by moving the surplus money out of their accounts. It’s really hard to leave all that extra cash there once you know better. But, again, it’s too late. The buyer has seen your financials and will view your business as unstable and inquire about the major fluctuations in large cash withdrawals. In a mere second, you can torpedo a multi-million-dollar deal for the chump change you think you’re saving today.
How do you assess if you’re under or overcapitalized?
You need to talk with your Certified Public Accountant (CPA) about your working capital requirements. Your ultimate goal is to have zero excess capital once you’ve deducted your liabilities and 30 days of operating expenses from your current assets.
Once you’ve double-checked and addressed any issues with your working capital, it’s time to attend to any additional costs you need to report or pay prior to selling your business.
Here are costs most that most sellers forget to report prior to a sale:
- PTO (Paid Time Off) time for employees: This is a liability charge. You pay your employees in cash for their vacation time, or you pay the buyer, so they can pay your employees.
- Book backlog (or “deferred revenue”): If a customer bought an x number of services in advance, but you haven’t provided those services yet, that revenue belongs to the buyer.
- Accrued and prepaid expenses: If you’ve prepaid expenses well past the dates the buyer is responsible for, the buyer needs to pay for the difference. For example, let’s say you paid all your storage fees for 2022, but you ended up selling your business in June of that same year. Then, your financial obligation only lasts until June. Once July hits, it’s the buyer’s responsibility to take over.
- Work in progress: If you’ve worked on a project but haven’t yet invoiced the customer for your it yet, that’s considered unbilled time you need to invoice for. This is processed as an adjustment, which is tied into your working capital calculation, and the 90-day true-up report.
The 90-day true-up report is completed 90 days after the transaction has closed. The buyer and seller collaborate on addressing outstanding expenses or revenue due to either party.
Deferred Revenue (or “unearned revenue”)
Again, this is a payment that your business receives prior to the delivery of the products or services. This is a valuable accounting entry that will impact your company’s cash flow.
How can deferred revenue impact the financials for my MSP business?
It’s easy to assume that even if you haven’t delivered a product or service for which you received payment, you can still count that money towards your revenue before you sell your business. Cash is cash is cash, right? Unfortunately, it’s not. The Generally Accepted Accounting Principles (GAAP) standards mandate that you ONLY recognize revenue in the month you DELIVER the product. The revenue does not count prior to that time.
Deferred revenue can lead to significant cash losses for you.
Let’s say you’ve collected $500K in advance and you’ve only provided $100K in services at the sale of your business. The $400K difference will be removed from your Accounts Receivables or Cash ledger and put into a deferred revenue account for the new buyer.
The buyer of the business is now responsible for delivering the product you received payment for. So, the buyer needs to cover all the expenses required to pay your team for the work in delivering the product to your former customer.
If you’ve followed GAAP standards, this will be displayed on your balance sheet as deferred or unearned revenue.
Misrepresentation is basically a false statement of a material fact made by one party to another to influence the contract outcome. Misrepresenting your business during a sale can lead to negative consequences. Usually, sellers aren’t trying to blatantly lie to a buyer about their company, they just want to do everything they can to make it look good.
However, the biggest reason deals fall apart is a misrepresentation.
It’s more common than you might think because little white lies are harmless, right?
When it comes to money, don’t lie, ever, especially when it’s about selling your business. For example, resist the temptation to suggest that a mass exodus of C-Suite officers left, hoping to project a higher, but unrealistic, future revenue.
Instead, tell the whole truth and nothing but the truth. At the end of the day, the buyer’s going to find out anyway
Being transparent will help the sale of your business in the long run. The person who buys won’t have grounds to back out or sue you later due to undisclosed details. Your M&A advisors can create a plan to mitigate whatever risks you’re attempting to hide, etc. Selling a business requires full disclosure.
More often than not, owner misrepresentation is an accident. However, this won’t prevent or excuse you from suffering the consequences. It’s your business, it’s your job to know your financials and to accurately represent them during a sale. If you’d like help steering clear of any potential misrepresentation, it’s time to engage an M&A advisor.
Investing in an advisor will help you throughout the selling process by helping you avoid the following mistakes:
- Representing yourself in an M&A transaction and not asking the right questions. Mind you decide to represent yourself, it’s important to remember that sellers and buyers commonly present only the good sides of things and not the ugly. However, the problem is that once you sign and send a letter of intent (LOI) to the prospective buyer, there is no longer any room for negotiating a higher price.
- Failure to effectively address a buyer’s concerns over newly discovered risk factors. If you’re the seller, it will be extremely hard to negotiate from that position. However, an M&A advisor can provide facts, reassurance, and trust to a heightened situation.
- Trying to negotiate deals with experienced, serial business buyers. They have a lot more experience than you probably do, especially if you’re a first-time seller.
Having an advisor could really help you level the playing level. Are you ready to determine your MSP company’s value so you can make the best decision for the next stage of your life? Click here to learn how we might be able to help you.