Due Diligence Analysis: The Iron Works Story

How much error can a buyer expect from a seller’s financial reports? A due diligence investigation will help you discover all you need to know.

The subject company of this analysis is a fabricated steel manufacturer. They manufacture I-beams, and act as subcontractors for general contractors building commercial buildings and high-rise office buildings. In this business they get almost all of their contracts from having a sharp pencil when bidding jobs. Making friends with general contractors helps but bid must be competitive or contractors won’t hesitate to go elsewhere.

The company I was reviewing for a buyer had a very good-looking financial statement, because sales had been going up every year since 2009. The building crash was in 2007-2008 and everyone took big hits in sales. The profit was $500,000 split between two working owners; the equipment was worth $200,000; the accounts receivables were $200,000. The asking price was $1 million, with the accounts receivables not being included. That meant that the buyer had to pay $1.2 million to get buy this company.

Using Due Diligence to Find Out How Much is a Business Actually Worth

Because of the nature of this business—bidding for potential jobs, Tom West the author of Business Brokerage Press©, a publication of “Rules of Thumbs,” of which I am a contributor, says the rule of thumb needs to be the value of the assets only. In this case the assets are $200,000 in equipment and $200,000 in accounts receivable. Therefore one should only pay $400,000 as a total value for this particular business.

The reason the value is so low is that there really is no goodwill. This is because bidding is how you get all your customers. You may have some repeat orders from general contractors you have a good working relationship with, but you cannot maintain 100% of the contractor’s business without bidding every single job.

Calculation a Business’s Value

When we calculate the Seller’s Discretionary Earnings (SDE) for any small business we only include the labor of one working owner, who is always the owner.  A fair market wage for a second owner must be deducted from profit, in the case of multiple working owners.

In the above case study, we will assume that in this industry a non-owner manager can be hired for $75,000 a year. This brings the profit down to $425,000 from the original $500,000 mentioned above. The accounts receivable are still $200,000.

I have a different way of looking at this company. It is an operating company, with valuable trained employees in place. It has repeat customers even if they demand the lowest price possible. There is cash flow taking place, and business in the works. I would value it at the one-year’s SDE income figure of $425,000 plus the accounts receivables of $200,000; the equipment is included because the income stream can’t be produced without it.

When looking at this business, one must consider these facts: Would you pay $1.2 million knowing you must continue to bid every job and if you raise the price even a little you could lose all your business? This kind of a business requires a short payback period since the real estate construction market place is so volatile.  That is why it is only worth $400,000 or $625,000 depending on which number makes the most sense to the buyer.