D4 or “D to the 4th power” is a new term I coined earlier this month as I watched two acquisitions crash and burn on a Friday afternoon within two hours of each other (almost to the minute). As I write this, the embers are still smoldering but a primary culprit of both is D4.
D4 is Disappointment During Due Diligence. It is a phenomenon created by the seller and their advisors (who often know better but can’t always control their client) whereby unrealistic expectations are created by excessive adjustments to profits (usually defined as EBITDA which is Earnings Before Interest Taxes, Depreciation and Amortization) and then those expectations are dashed on the rocks of reality as buyers and their advisors look under the covers.
In small companies, it’s not uncommon to addback excess owners’ compensation or perks that roll through the business. It’s also not uncommon to adjust earnings to be in line with GAAP (Generally Accepted Accounting Principles) as some small company accounting practices are less than ideal (I’m being kind). But sellers need to understand that beyond a certain point, every adjustment starts to stretch credibility. And once credibility is broken, the buyer starts to question everything.
Years ago, every time I met with the partners hoping to sell their business, their expectation of the sale price had increased. Against my advice, they threw everything they could against the earnings adjustment including the kitchen sink. Simultaneously, they kept looking for examples of higher earnings multiples. First 6x, then 7, then 8 or more. One of the partners was literally figuring out how to spend his millions. They were deeply disappointed when they got the perspective of real buyers. Sellers need to remember, their investment bankers are cashing a check, not writing one!
Here’s my advice to sellers.
- Be transparent. Disclose the good, the bad and the ugly early on. The truth will come out eventually during due diligence. And if not, you’re opening yourself up for a lawsuit after the deal closes.
- Be reasonable. You may overpay your administrative assistant who has been with you for 20+ years, but don’t’ add back half their salary and tell the buyer they can replace that person for half the price. The buyer is going to need that person’s institutional knowledge.
- The buyer is purchasing the business as it sits today and isn’t going to pay for the hypothetical improvements that you’re suggesting you could have made but didn’t. If it was that easy, you should have done it.
- When you’re asked for data, provide it. Stat. The longer it takes for me to receive it, the less I trust it. Same goes for not providing all of it. And don’t send me PDFs when I know you could drop it into a spreadsheet just as easily.
Smart sellers don’t let their deals fall victim to D4.
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