Buying a Distressed Business

Many businesses have suffered financial losses due to the COVID-19 crisis. Some may even be on the verge of bankruptcy or otherwise looking for an exit strategy.

Fortunately, there's an upside: Adverse market conditions can create opportunities for investors with excess cash and access to capital to acquire and then turn around distressed businesses. Here's some guidance on this strategy, including how a business valuation professional can help avoid potential pitfalls.  

Costs vs. Benefits

Arrow that is half red and half white pointed towards a target

Turnaround acquisitions can yield significant long-term rewards. But acquiring a troubled target can also pose greater risks than buying a financially sound business. The keys are choosing a company with fixable problems — and having a detailed plan to address them.

When seeking a turnaround opportunity, look for a company with hidden value, such as:

It's important to assess whether these opportunities exceed acquisition risks and potentially provide ample financial benefits.

Due Diligence

Successful turnaround acquisitions start by understanding the target company's core business — specifically, its profit drivers and roadblocks. Without a clear understanding, you may misread the company's financial statements, misjudge its financial condition and, ultimately, devise an ineffective course of rehabilitative action. This is why many successful turnarounds are conducted by corporate buyers in the same industry as the sellers or by investors (such as private equity funds) that specialize in a particular sector.

During the due diligence phase, you'll need to pinpoint the source of your target's distress (such as excessive fixed costs, decreased demand for products and services, or overwhelming debt) to determine what, if any, corrective measures can be taken. Be prepared to find hidden liabilities — such as pending legal actions or deferred tax liabilities — beyond those you already know about.

It's also possible to unearth potential sources of value, such as tax breaks or proprietary technologies. Benchmarking the company's performance with its industry peers' can help reveal where the potential for profit lies.

Cash Flow Management

Before completing a transaction, determine what products drive revenue growth and which costs hinder profitability. Does it make sense to divest the business of unprofitable products, services, subsidiaries, divisions or real estate? Should you cut staff?

Implementing a longer-term cash-management plan and developing a forecast based on receipts and disbursements is also critical. Cost-saving and revenue-generating opportunities, such as excessive overtime pay, high utility bills and unbilled services, can be achieved with a strong cash-management plan and a thorough evaluation of accounting controls and procedures.

Reliable due diligence hinges on whether the target company's accounting and reporting systems can produce the appropriate data. If these systems don't accurately capture all transactions and list all assets and liabilities, a potential buyer won't be able to track progress and fully pursue growth opportunities or respond to potential problems.

One troubled manufacturing company, for example, wasn't tracking future purchase commitments. After the company was acquired, the new owner prepared and circulated among managers a comprehensive commitment and contingency report that helped senior management renegotiate terms of the customer agreements. This step dramatically improved profitability and helped ensure a successful turnaround.

Outside Expertise

Turning around a financially distressed company can be a tall order, especially in uncertain market conditions. A business valuation professional can help develop a strategic plan that provides a map toward revenue growth and improved cash flow.

Deal Structure Counts

When buying a business, the parties can structure the deal as a sale of either assets or stock. Buyers generally prefer asset deals, which allow them to select the most desirable items from the company's balance sheet. Plus, asset sales offer a fresh start: The buyer receives a step-up in basis on the acquired assets, which lowers future tax obligations. And the buyer negotiates new contracts, licenses, titles and permits.

In an asset sale, the seller pays capital gains on assets sold. If the seller is a C corporation, its shareholders also will pay tax personally when the company liquidates.

On the other hand, sellers typically prefer to sell stock, not assets. Why? Selling stock simplifies the deal and tax obligations are usually lower for the seller.

However, stock sales may be riskier for buyers because the business continues to operate, uninterrupted, and the buyer takes on all debts and legal obligations. In a stock sale, the buyer also inherits the seller's existing depreciation schedules and tax basis in the company's assets.

Before closing, discuss these issues with your tax and valuation advisors. They can advise on the optimal structure for your situation.

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