The Value of Full Disclosure

When it comes to digging businesses out of self-made trenches, there is nothing quite like an advisory board.

Here’s a tale from Doug’s book of how a team of experts helped a company.

The Value of Full Disclosure

Donny and Erica, a husband and wife team, approached us a number of years ago to sell their company. The company was not performing very well. It had an EBITDA of $300,000. After depreciation it showed a small operating loss. The company was undercapitalized. The bank loan was operating at its peak almost constantly. Book value of the company was $1 million. The bank loan was $2.5 million. The accounts receivable was $2 million. Inventory was showing at $1.5 million.

We went through a phase one Analysis and noted the industry standard for this type of business had an EBITDA of 10%. If this company was operating at 10% it would make the business worth a great deal more money than the $1.5 million at which we had set the value.

I encouraged Donny and Erica to hire a chief executive officer to help them operate the business. I explained that they would probably have to pay this person $120,000 a year plus bonuses of up to $30,000 if he or she achieved goals and objectives that were set out.

They asked me where they could find such a person. I referred them to three different headhunters.

After about five weeks, Donny called back and said, “Look, we don’t like any of these head hunters we met. And we don’t like any of the people they have sent around to see us. Erica and I would like to hire you as our CEO.”

I was honoured but explained to them that I was already the CEO of a company, one that I already owned, and I really didn’t have time to be two CEOs.

“No, no!” Donny said. “You don’t understand. You have a great team of people. Perhaps you can put together a team or committee that can help us with our problems.”

I told him I would think about it and get back to him in a couple of days. I remembered that I knew a chap, Les, from our Rotary club who had recently retired – a former vice president of one of the national banks. I respected this fellow’s ability and integrity. He had taken an early retirement.

“Les, would you be interested in a part-time assignment?” I asked him. “Maybe three days a week? The assignment may last six to eight months, maybe even a year.”

Les pondered it for a while. We agreed on terms and conditions. Next I pulled one of our accountants from Robbinex to work a day a week with the client and I spent half a day a week myself with the team.

Within thirty-five days we discovered that there were significant errors in the accounting procedures. Inventory was overstated. Receivables were overstated. Accounts payable were understated. The result? There was no book value in the company.

We pointed out to Donny and Erica that this, in effect, was fraudulent as far as their bank would be concerned. We had to talk to their bank about it.

Donny absolutely refused us permission to talk to the bank. So we quit. We didn’t feel we could carry on a charade with the bank and maintain our reputation.

“You can’t quit!” Donny said. “What do I tell the bank?”

My response was, “Have the banker call me and I will tell him why I quit.”

The air was blue with swearing for a few minutes after that. Donny reluctantly agreed that we could go in and sit down with the banker.

We met with the banker a couple of days later. The colour drained from his face when I explained the problem and

the accounting error. We assured him that the company was operating at a break-even or a small profit, and that we were in there providing consulting services on a daily basis.

We also agreed to provide a monitoring function for the bank. We reported to the bank every week on receivables, payables, inventory levels, and orders on hand.

The retired banker mercilessly whipped the company into shape. He had an MBA and he really meant business – all the time. Within six months the company was operating at an annualized EBITDA of about $600,000. Within nine months its annualized EBITDA was $1.5 million, or 15%.

Lo and behold, someone came along and offered Donny and Erica $7 million for the business. The transaction closed a couple of months later.