Buying a Machine Shop

The contents of this article are as follows:

• Intro

• Some definitions

• How to find a machine shop for sale

• The Process

• Challenges

• Conclusion

Intro

The following describes the insight I gained while searching for another machine shop to buy. As a machine shop owner, I thought it wise to expand thru acquisition to gain a return on investment. Engineering and machining are my background and I wanted to stick with what I know when spending large sums of money. It’s important to note that I never did close on a purchase, but after looking at many machine shops and businesses in other fields, I still feel there is value in sharing what I’ve learned.

My goal in a business purchase was increased profitability by using the funds I had gained over the years, rather than start from new. I loved the idea of using money to save time rather than build a business which can be slow and tedious. I focused on businesses in the lower middle market range, or <$5M purchase price. I was particularly excited about my timing, with the generation of baby boomers retiring and exiting their small businesses.

Some Definitions

Price

Businesses are valued because they generate profit, and they are priced as a multiple of that profit. If a machine shop generates $100k a year in profit your market price is probably around 2-3x earnings or a $200k-$300k purchase price. A company that generates more profit will sell for a higher multiple. Say 6x earnings for a shop that generates $1M or a $6M purchase price.

Here is a further list of multiples based on my anecdotal experience Please note that the following values do not include real estate and, as always, everything is negotiable.

Earnings               Multiple

<$150k                 2x earnings

$151-400k          3x earnings

$401-600k          4x earnings

$601-999k          5x earnings

$1M+                    6x earnings and above

Earnings defined

The most common type of earnings listed by sellers is seller discretionary earnings, or SDE. It takes the profit of the business and adds back the seller’s income and any expenses that were paid for by the business but should have been claimed personally.  Travel, auto, cell phone, are typical examples of reasonable add backs. I write more on this topic in in regards to depreciation below.

Asset or Share Sale

Companies will list themselves as either an asset sale or a share sale. In an asset sale, the buyer is purchasing the businesses’ assets (such as machinery) and starts a new company which hires the former employees and reintroduces itself to suppliers and customers. The seller keeps the ownership of the business entity in an asset sale and often the company cash and receivables while being responsible for the payables.

In a share sale, the buyer purchases the shares of the business and takes on the former liability of the company, but keeps the cash and receivables. A share sale has some tax advantages to the seller where the gain is taxed at a lower rate. Almost all companies I’ve looked into were listed as asset sales.

How to find a machine shop for sale.

Brokers

I’d like to tell you that the businesses you see in online listings such as bizbuysell.com, bizquest.com or businessforsale.com are all you need, but in reality, it’s best to contact brokers to keep you top of mind.  Brokers typically only list and market businesses once they’ve exhausted their potential buyers list. This is because they aren’t incentivized to maximize the sale price thru marketing the business to its maximum potential. They are however very incentivized to close since it’s the only mechanism that gets them paid. It’s often a safe bet that the businesses found online have already been passed on by several potential buyers. In short, get to know the brokers in your area, send them your buying criteria and be prepared to wait.

Approach directly

Approaching potential companies you want to buy directly is something I’ve done and highly recommend. It’s takes longer, as the timing of sale between the buyer and seller may not align, but you’ll relieve the seller of broker fees and eliminate a middle man in the process. I sent cold emails with my buying criteria and followed up periodically.

The Process

Once you’re introduced to a machine shop of interest, the broker will send you a non disclosure agreement, which states that you won’t use the information provided by the seller for any other purpose than to evaluate the company to purchase and you agree to not interfere with the brokers commission.  In other words, here is the company info, you need to promise not to compete with the seller and not circumvent the broker.  One problem I often ran into with NDA’s was they ask you to not contact their customers, employees, or suppliers. This creates a conflict if you’re in the same industry or a competitor.  Since you sign before you know who the customers, employers or suppliers are, you could get yourself legally locked from communication.

The broker may also ask you for proof of funds to ensure you’re not just kicking tires. I typically provided a letter from my bank which stated I met their minimum cash requirement but didn’t disclose exact amounts.

If the broker and seller agree. They’ll send you the summary of the business prepared by the broker and the financial statements of the business. The NDA mentioned above will state all the financial information needs to be evaluated and that the broker has not confirmed their accuracy, but you will have the chance to verify during diligence. Once you like what you see on paper, a meeting with the seller and viewing the shop is next on the to do list.

Buyer and seller chemistry

The chemistry between the buyer and seller are important, mostly due to trust. You’re both entering  into one of the biggest transactions of your lives, with many details to work out. It’s a lot of work, so you want to trust each other to limit the amount of diligence required on both sides. In the beginning of the relationship, trust is low and skepticism is high, and the process of building trust is built on small leaps of faith that prove true.

During the meetings, I tried my best to be as forthcoming and honest as possible to allow the seller to feel comfortable. Likewise, the seller needs to understand and be empathetic towards the buyer. It only takes one or two questionable actions to lose trust and kill the deal.

I would often ask and answer the question, what do you want and what are you afraid of? I found this question to be extremely helpful and efficient in determining a good fit. For example, the seller may want a fair price but they’re afraid that they’ll waste time or give out their company information to a stranger or worse, a competitor. As the buyer, you want to be able to duplicate or improve the operations of the seller and are afraid that pertinent information will be kept from you. It’s a really good idea that you both lay your cards on the table to move forward in the cleanest way possible.

The Shop Tour

The shop tour is extremely useful to gain an understanding of the business you’re potentially acquiring. Profitable machine shops are efficient, which typically means clean and organized with a lack of clutter. If the shop you’re interested in is already orderly then it’s important to note there may not be a lot of value in improvement on such a situation. However, if the shop you’re looking at has plenty of gains to be made in organization, waste and efficiency, then a corresponding discount in purchase price may pay off. Either shop condition could work.

Letter of Intent

Once the review of financials and meeting with the owner(s) are complete, both the broker and seller will expect a letter of intent (LOI). A LOI is a statement from the buyer to the seller stating the price and other terms and conditions of the sale. Its purpose is to demonstrate intent in writing on the part of the buyer and acceptance of the offer from the seller. It is non-binding, meaning the buyer and the seller both have the right to walk away from the purchase at any time. Its purpose is to provide a guideline for the rest of the sale process while being flexible to be changed. There is often a deposit included form the buyer into an escrow account to add further meaning to the process. The terms and conditions in the LOI may include a certain amount of time for diligence, the amount of training required from the buyer, any holdbacks of funds, a non compete clause for the buyer and  a exclusivity period where the seller may not market the business for sale to someone else. It’s best to contact a lawyer to advise you and create the LOI.

Due Diligence

After both parties agree to the LOI, the diligence period begins, where the buyer starts sharing in depth information about the business on a confidential basis. During due diligence the company is often no longer marketed for sale to other buyers and is often listed as pending. The due diligence inspection may include the following:

• An audit of the financial statements by piecing together revenue, expenses and profit according to available records for certain time periods

• An introduction and getting to know employees, suppliers and customers

• Review of written process and undocumented tribal knowledge

• Inspection of assets

• Legal risks

I write “may include” above because the extent and timeframe of diligence is really a negotiation between the buyer and seller. There are no preset rules.

Closing

After the diligence period, both the buyer and the seller need to decide if they’re prepared to close and under what terms. I have very little to say on this topic as I’ve yet to reach it, as previously mentioned.

Challenges

Purchasing a business isn’t without its challenges and I personally found some to be deal breakers. The following describe what I found to be the most common issues.

Depreciation

A very common add back is depreciation. Defined as the yearly decline in price of assets. This figure is often accelerated on tax statements as a incentive for manufacturers and is not a real-world figure as per market factors.  Unfortunately, most financial statements prepared by the seller, will add back the full accelerated value they can write off to the tax man, which is higher than the real world value. This creates an issue because depreciation is a real expense. If a shop purchases a machine tool for $500,000 and a year later the market dictates that machine is now worth $450,000, the cost of depreciation is $50,000. Worse, the statement will often list the accelerated value, say $100,000 all of which is commonly removed from the costs of doing business and falsely increases profitability.  

If a buyer accepts the often-listed depreciation value, you’ll pay for it when you have to purchase a new machine tool to replace the current one.  As Warren Buffet explains, “Does management think the tooth fairy pays for capital expenditures?”

The most common reason I’ve heard to justify the depreciation addback is that it’s a non cash expense and it’s part of another common earnings definition: earnings before interest, taxes, depreciation and amortization (EBITDA). However common EBITDA is, you should not ignore depreciation and accept the newly created profit value. The best thing to do is to use the real world depreciation of the machine tool as an expense and not the higher value of depreciation allowed by the government for tax purposes. Examine comparables for sale and estimate the market value, but do not ignore the depreciation add back, especially in machine shops, which are asset heavy.

Concentrated Owner Involvement

The owner is the business. One of my first questions I’d often ask is how much time the owner(s) spends at the business. If hours per week are above expectations, I would walk away. It’s best to assume the current owner is an expert in running his or her company and that you are unlikely to spend less time in the short term. If there are multiple partners spending 40hrs per week and you’re a single person buyer and operator, I’d suggest running away rather than walking. I’d often hear that I would only need to hire another person to replace one of the operating partners which will be easy. My personal experience taught me that I’d need to hire at least two people and I need to go thru several rounds of trial and error before I found someone who’s dependable, efficient and trustworthy. This turns into hiring and training six people before I found two suitable to replace an owner.  If it was so easy to replace an owner, they’d probably have done it themselves. Having non owner management in place is a reasonable expectation for a larger businesses generating $1M a year in profit, but it’s unlikely for a small shop with $100k yearly profit.

Owner will stay on

Another common refrain I heard, was that the seller will stay to help the new owner after the sale. Sounds great, as the buyer will likely feel less pressured and the seller can continue working in their field of expertise. However, there is no real mechanism to ensure the seller stays with the company. After the purchase closes, the new owner will simply be an employee who is free to leave at any time. It’s best to take this promise with a grain of salt. If it works out great, but don’t rely on the seller being there.

Earnout refusal

An earnout is where the seller receives payment for the business after some milestones have been achieved over time. An example, would be the seller paying for half the business up front, with the remaining amount “earned out” if the company performs over some time period. An earnout incentivizes the seller for a successful transition whereas payment in advance incentivizes the seller to close despite underlying threats to the business. It reduces risk to the buyer, but adds risk to the seller since anything could happen beyond the sellers control: market fluctuations, employee departures or buyer mismanagement. I personally believe some amount of earnout is necessary and should be negotiated into the deal. It aligns the interests of both parties and if a seller doesn’t believe the right buyer can sustain the profit of a business, then it shouldn’t be for sale.

Most Companies Don’t Sell

This is just a rumor, but I’ve heard it stated several times that 80% of companies don’t sell, which I do believe. Anecdotally, I’ve seen most of the business for sale come and go from the marketplace without ownership changing hands. I’m not aware of any central place that tracks listings versus transactions of businesses for sale, such as with real estate, so the true history of transactions is unknown. If transactions are low, it’s likely the amount of companies you’ll need to look at will be high.

Carrying Costs

As initially stated, ROI is the reason I wanted to purchase another machine shop. There are several factors the affect the return such as purchase price, future profitability, financing terms and capital requirements. When calculating my return on a potential acquisition, it was capital requirements that surprised me, specifically the carrying cost of customer payment terms. Most machine shops I looked at were asset sales, meaning the buyer purchases the equipment on paper and the seller keeps the cash on hand and the revenue earned before the company changes hands. Since, as we’ll see, there are months of revenue unaccounted for in cash or receivables, the amount of carrying costs are higher than expected.

All of this initially sounded completely fine until I realized how much more money I would have to come up with on top of the purchase price. For example, let’s use the following payment terms, order value and costs:

• Order lead time: 3 months

• Customer payment terms : 3 months

• Material payment terms: 2 months

• Monthly Revenue: $100,000

• Monthly Material Costs: $30,000

• Monthly Overhead/Salary Costs: $55,000

• Monthly Profit: $15,000

In this case, it would take 31.3 months (2.6 years!) to get your money back and you’d need to come up with an additional $395,000 on top of the purchase price to operate. Considering the purchase price would likely fall into the 3x earnings category for a price of $540,000, another $395,000 is substantial. You will get these funds back once you sell (and then some), but it’s still an unexpected capital requirement in the beginning.

Let’s dig into this situation a little more. Let’s use the above payment terms but also add a few other assumptions:

• Overhead and salary costs are paid at the end of every month. These would be all the other costs other than material: rent, insurance, employee salary costs, tooling, etc.

• Orders are placed at the beginning of every month at which time naterial is ordered and arrives immediately

• Monthly costs and revenue are constant every month.

Figure 1 depicts the above situation for the first month of ownership.

After month 1, we have paid overhead/salary of $55,000, we have $30,000 worth of material in payables due at the end of month 2, and we won’t ship month 1 orders until the end of month 3 so there are no receivables. Let’s look at the cash situation after month 2 as shown in Figure 2.

At the end of month 2, we have now paid 2 months of overhead/salary and month 1’s material cost. Leaving us with cash used of $-140,000. There are still no receivables or cash collected from customers. Figure 3 continues to chart month 3.

After 3 months of operating, we’re left with a $225,000 cash burn because of 3 months of salary/overhead and 2 month of material costs: $225,000=($55,000 x 3) + ($30,000 x 2) We’ve finally shipped our month 1 orders so $100,000 is now listed as receivables.

After 4 months of taking over our hypothetical machine shop, we’ve now used $310,000 worth of cash: ($55,000 x 4) + ($30,000 x 3). Our receivables have increased but no cash had come in yet.

At the end of month 5, we’ve finally reached the worst of our cash needed $395,000: ($55,000 x 5) + ($30,000 x 4). Receivables are up to $300,000 from orders delivered in months 1-3. Receivables will stay constant going forward.

After 6 months we’ve finally increased our cash position, but only by our monthly profitability of $15,000. We received cash of $100,000 from the orders of month 1, but our other expenses have stayed the same, so getting back to zero is going to take a while as we can see in Figure 7.

Finally, after 32 months, we’ve received back all our carrying costs from the profit we’ve made. This is significant, because although it sounds like we purchased for 3x earnings expecting our money back in 3 years, it’s more like 5.6 years and more cash than intuitively assumed. To calculate the break even time frame using different payment terms the following formula can be used:

where

x = amount of time to break even

a = Payment Terms

b = Lead time

c = Vendor Payment terms.

and

Mat = monthly material costs

Rev = monthly revenue

OH = overhead and salary costs

x=(Mat(c-1)-(a+b-1)*Rev)/(OH+Mat-Rev)

Using this formula you’ll notice that payment terms and lead time makes a large difference. If your payment terms, lead time and vendor payment terms are all one month, with the same amounts we used in our example, your break even time frame is only 6.66 months.

Even though you may be surprised by the amount of costs in the beginning, you will get your carrying costs back should you sell the business. Let’s run a scenario where you sell and close immediately after the 32 months. Here’s what you should expect for cash flow on month 33 as per Figure 8.

Since all the revenue, material cost, overhead/salary for month 33 and on is the responsibility of the new buyer, your cash increases to $80,000 from the previous $10,000 balance: $100,000 of month 28 orders - the $30,000 of month 32 payables + 10,000 cash = $80,000. Continuing to the end of the cash collection is shown in Figure 9.

You will collect the order value from month 29 in month 34, collect month 30 in month 35, and so on. Post sale, you’re collecting 5 months of revenue, with only 1 month of payables +$10,000 cash on hand: $480,000 = (5 x $100,000) - $30,000 + $10,000. Notice that the receivables stay constant for months 33 and 34 even though we’re taking in cash, this is because at any given time, two months of revenue are not accounted between receivables or cash in our specific example with these specific payment terms. Notable point when running any type of business.

Although, I’ve brought up carrying costs here relating to buying a business, they also apply to growing a business. Here are some articles discussing a how fast your company can grow and explaining the cycle of converting inventory or costs into cash.

Conclusion

Despite the challenges listed above, I still believe there is value in expanding by acquisition. I continue to search, but I’m more efficient now as I’ve learned what to look for. I hope this article will help you do the same.