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Selling a Business – Avoiding an own goal in due diligence – Part 4

By Peter Kroeger

How secure are your forecast gross margins?

In the last blog I dealt with the question of Employee claims.

Another hard lot of questions you will have to answer will be to do with your historical and forecast gross margins.

This is based upon an actual case. The Company in question sold products all over the world – 90% of sales were to overseas customers. It had grown and now turned over £5m and made a gross margin, after deducting costs of sales, and direct costs of carriage, freight, insurance and agent’s commissions (all of which varied from territory to territory) of around 30% overall fairly consistently year on year. The price for each customer was negotiated annually in advance and took into account these varying direct costs.

Internally, the gross profit was really only accurately reported after a stock count which was performed every 6 months. The accounting system used did not have a dynamic stock and cost of sales program and sales were analysed by country. Yet every year end after calculating for the actual physical stock on hand the gross profit was quite consistent.

The Acquirer was being advised by a large firm of Accountants who performed the Due Diligence on the forecast Sales and Cost of Sales. In this case the Vendor presented a forecast showing a consistent level of sales growth and the same gross profit percentage of 30%. The investigating accountants were not at all impressed. They wanted to see the actual sales, cost of sales and direct costs by customer by month for the last 3 years and a 4 year month by month, customer by customer forecast.

As it happens it was possible to reconstruct the history from the sales and purchase invoices and standard costing for the materials used in cost of sales. This meant creating a spreadsheet and keying in nearly 1000 invoices and all their detail and working it out. And then the forecasts had to be prepared showing expectation of sales and gross profits by customer and by territory for the next 4 years.

This resulted in the following questions:
– why did the gross profit for customer 123 in territory 10 drop by 3% in a 6 months the financial year ending 20xx?
– why have you forecast a less revenue for customer 456 in territory 9 for next year
and so on, almost ad infinitum

Due diligence took 3 months before the Investigating Accountants were able to say that the forecast Gross Margin was reasonably likely to be achieved. The upside was that, due to this higher level of certainty, a better valuation and payment terms for the deal were achieved, so it was worth it but at one point the owner nearly invited the Acquirer to withdraw.

The lesson is, long before you start a sale process, do consider what you are going to say regarding your forecasts and start to collate the information that you think will be necessary.

I will deal with more such sticky issues in future blogs.

For a no-obligation chat about your future business sale, please feel free to get in touch with Peter Kroeger.

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