The Playbook by SMBootcamp

The Silent Killer of SMB Acquisitions? The “90 day cash crunch”. And the worst part is most buyers don’t even recognize that it’s going to happen. All throughout the buying process, the entrepreneur is focused on understanding the systems, roles, and growth opportunities of the business. They’re focused on getting the lender, investors, and sellers on board with the process. And they miss one of the most critical concepts in operating a business: cash flow

Until you’re in the business, it all looks clean on a spreadsheet: monthly earnings = cash flow. But it doesn’t exactly work like that in the real world.

To help you avoid making these critical mistakes, we enlisted help from Reid Tileston. Reid is an amazing educational resource, offering both real-world and academic perspectives that have educated thousands in the ETA community. We’d highly recommend checking out Reid’s information on his website and following him below. He also has a great book about entrepreneurship called Grit it Done.

Before we dive in, thanks for subscribing and being part of the SMBootcamp community. You’re a big reason this ETA space is what it is. If you know someone exploring small business ownership, we’d love if you shared The Playbook with them and to show our appreciation, we’ve got a few referral rewards along the way.

Introduction

What is the “90-day cash crunch”? Put simply, the 90-day cash crunch refers to the business running out of cash within the first 90-days. Now, it might seem like quite a daunting task to tank a business so quickly to end up without liquidity in something as little at 90 days, but it happens more often than it might seem. Though we do not contemplate a cash crunch beyond the 90-day period in this article, many of these concepts can be applied to any stage of operating a business. Understanding the root causes outlined here is a great start to mitigating future cash flow issues. At the end of the day, the entire Entrepreneurship Through Acquisition (“ETA”) concept relies on two fundamental concepts: 1) an effective acquisition, and 2) effective operations. One without the other leads to failure (most of the time).

For the acquisition, the buyer (who often is a first-time buyer in SBA funded ETA deals) could make an incorrect analysis of sufficient working capital. In one scenario the buyer under-negotiates working capital because it was  the only way to get the deal done. In another similar, but related example, Buyers often choose to maximize post-close ownership rather than post-close liquidity leaving little in the way of excess cash to float for any unforeseen cashflow issues. Lastly, the Buyer did not fully understand the ramifications of not asking for a line of credit (“LoC”) from their lender. Though this happens less frequently than it used to, there are still Buyers out there who do not have an LoC available for additional liquidity. And worse, some banks don’t even offer them! Lastly, in SBA transaction escrows and holdbacks are frowned upon thus a working capital true-up ends up changing the Seller note that isn’t paid until years down the road; but you need cash now!

On the operations side is where it gets more difficult. Employees can leave when they find out the owner sold the business. They might just march into the new owner’s office to ask for a raise or a bonus— and if they don’t get paid they walk. The #1 customer the Seller’s known for 15 years decided to go with another service provider since his relationship left. Not to mention this is all happening while the new owner’s learning a new business in an industry they (likely) haven’t worked in before.

One thing is guaranteed in small business— expect the unexpected. There are hidden costs in any transition and for that reason… Cash is King, especially in your first 90 days.

Understanding the Hidden Costs of the Transition

On the most basic level, an acquisition entrepreneur is purchasing a business with limited industry or executive experience. Naturally there will be hiccups and learning experiences. It will require an immense amount of grit and hard work (Grit it Done is an excellent read for aspiring acquisition entrepreneurs). In every acquisition or entrepreneurial endeavor, there will be trials and tribulations. Among those are the Hidden Costs of the Transition.

• Initial performance dips

• Working capital surprises

• Side effects of starting a new entity

• Contract cancellations and client attrition

• Employee turnover and retention issues

• Logistical issues in receiving payments

When thinking of initial performance dips, the term “J-curve” likely comes to mind. This usage of the term J-curve requires clarity… used correctly, it refers to investment in the business that results in a short-term performance dip, but long-term growth driven by said investment. But we will be coining this new term, the “U-curve”, since the beginning and end of the letter end up in the same spot. As mentioned above, the acquisition entrepreneur is entering a new industry, likely for the first time and likely with limited executive experience. Based on what we’ve seen in our experience working with hundreds of individuals through the process, the “U-curve” drop is often somewhere in the range of a 10-15% revenue dip within the first few months of ownership. This is a precarious position to be in, especially if there is leverage on the business, and can provide a significant drain on cash flow.

This is where analyzing the strength of the balance sheet becomes critical. We see two common outcomes: i) In some cases the Seller takes the inventory and AP while the Buyer brings the working capital ii) the Seller leaves a pre-determined amount in the business while the Buyer infuses the balance sheet with cash. Both methods are viable when proper Balance sheet diligence is done.  

Let us now transition to a major contributor of cash flow issues— the working capital true-up. In larger private equity transactions, there will often be some of holdback or escrow as the source of any working capital deficit agreed upon in the purchase agreement. In SMB-land these don’t often exist, primarily because the SBA frowns upon them. That leaves buyers and sellers with a natural remedy to cure any shortfall in the deal: The Seller Note. Seller notes are often used as the purchase price adjustment mechanism since it’s fairly easy to adjust post-closing. The challenge with the Seller note is that by definition they’re paid over time (and often on a multi-year standby period). If the Seller doesn’t leave enough working capital, then the Buyer is still stuck fronting the cash now and getting a remedy years down the road which does not alleviate the cash crunch.

Perhaps the most forgotten of the list is the side effects of starting a new entity. Asset deals are more common than stock deals in SMB land— and for good reason. They limit a TON of the liability that the buyer takes on from the Seller’s entity, but they have downsides. Starting an entity without history has ramifications that are often forgotten about by first-time acquirors. New entities often lose their credit with vendors resulting in net zero terms! All of a sudden that cash conversion cycle that looked so clean on the spreadsheet has climbed by 30 days, leading to a HUGE strain on cash. Instead of having 30 days (assuming net 30 terms) to come up with the money to fund purchases, the Buyer has to dip into the bank account immediately. Over time the business will build up credit with the vendor or re-apply for net 30 payment terms again, but for the initial period of your ownership net zero terms might be the reality.

With asset purchases, the business will be using entirely new bank accounts, leading to unexpected days sales outstanding (DSO) spikes. Each check that comes in from the mail, the dreaded snail mail, will have to be deposited. But customers have the old entity name written on the check… so sometimes the bank might just deny the deposit, especially when the new entity name is different). Buyers might end up in a scenario where they’re fighting the bank to deposit those checks. Even The few extra days it takes to deposit checks can be the difference between making payroll or not.

Most would think something as mundane as a PO box wouldn’t cause a crisis, but it happened to a sophisticated buyer with industry experience and a PE background. The change of PO Box, increase in DSO and the choice not to get a LoC caused the operator to have to raise additional money from investors. Many sellers close out their old PO box without thinking, and checks get lost in USPS limbo. Or worse, customers keep sending payments to the wrong address and Buyers don’t even know they’re missing them until the balance sheet looks strange. And since there’s a new entity, the bank might not accept the check anyway since the name doesn’t match perfectly.

Now here’s one most Buyers likely thought about for the transition: employee retention. And this is one that we mentioned in our prior article, “What to do after you buy a business”. Put simply, employees don’t like acquisitions. At the very least, it injects uncertainty into their livelihood. And at the very most, they hold a vendetta against new ownership, because they thought they’d be the Seller’s successor. Some are more benign than others, but all of these are suboptimal scenarios. There are a few different ways these materialize to put a damper on cash flow in your first 90 days as the new business owner. Both Reid and I have lived through these scenarios and have mentored hundreds (if not thousands) of acquisition entrepreneurs by educating through SMBootcamp and Reid’s career as an ETA Professor.

Two recent examples of SMBootcamp alumni that stick out to illustrate what can happen: The license qualifier for a blue-collar trades business demands a raise or he leaves. If he leaves, the business can’t actually make any money until a new qualifier is found (probably more expensive), so the new owner could be out of luck if the employee doesn’t get a raise (also expensive). Yes, this actually happens. Employees know they have leverage and will probably leave if it doesn’t go their way. And any raise or bonus has just added unexpected cost to an already tight cash budget (amongst other cultural and signaling issues).

The other example is something less drastic, but nonetheless hurtful for cash flow. The dispatcher left, leaving a very clear gap on an already small team. The result was new leads were missed and the business had scheduling hiccups leading to lost time on existing work.

A graduate of one of Reid’s classes bought a business with a lead mechanic who left shortly after close despite the buyer having met with the team member as part of diligence and being assured by the team member that they would stay.

At the end of the day, employees are people, and people react unpredictably, especially when their livelihoods feel uncertain. Unfortunately, there isn’t any spreadsheet cell for the transition process. It’s not always catastrophic, but it is always disruptive.

Now let’s delve into contract cancellations and customer attrition. Now admittedly, this one only affects a sub-segment of SMB acquisitions, particularly those with customer concentration, but nonetheless warrants awareness. Let’s imagine for a second there is a business with $2m of revenue, 50% gross profit margins, and 20% EBITDA margins where the top customer is equal to 20% of total revenue (which isn’t uncommon in SMB land). For sake of example, we’ll assume that revenue is equally distributed throughout the year and each customer generates the same gross margins.

If that customer disappears during the ownership transition, then there’s a major issue. We see a massive cash decrease of almost $17k per month! Customer attrition and contract cancellation happen for a variety of reasons outside of your control:

• The seller had a 20-year relationship and played golf with the decision-maker every quarter (those relationships don’t transfer with an APA…)

• The customer goes out of business

• The customer gets acquired and goes with the acquirer’s preferred vendors

Whatever the reason, it can cause immediate and severe damage to a P&L, and more importantly the short-term bank account. Here’s the real kicker: despite your best efforts this can get missed during diligence.

So here’s the question: if a major customer leaves on Day 10 of ownership, or any of these cash flow hiccups occur, will the business still make it on Day 90? This is exactly why liquidity at closing isn’t just a smart move— it’s a survival tactic.

Why Liquidity is Essential at Closing

Employees demanding a raise, a bank that won’t accept deposits, vendors won’t give payment terms, and a few checks got lost in the Seller’s P.O. box. Sounds like quite a nightmare in the first 90 days— one that very well could sink the ship without preparation. Liquidity at closing isn’t just a financial concept-- it is an insurance policy against the 90-day cash crunch and potentially personal bankruptcy. It’s your get-out-of-jail free card when something unexpected (edit: guaranteed) happens. And it’s what gives a new owner room to learn, adapt, and operate without making panicked decisions that end up creating long-term consequences.

Let’s break it down:

● You need real cash on the balance sheet. Ideally, you walk into ownership with cash on the balance sheet and a line of credit in place. Now how much cash is a different, more nuanced question that depends on the company’s cash conversion cycle and working capital intensity. The way we like to think about it is in X days of operating expenses and/or monthly sources and uses from working capital swings. The line of credit can be a difference maker when selecting lenders for a deal; you might have to make a tough decision on which bank to select depending on the availability of a line of credit or not. (Tip: contact [email protected] for help with your SBA financing needs)

• Use it strategically. The quality of earnings provider will advise on the amount of cash to put on the balance sheet. And many readers may have thought of using it for new uniforms, a new website, or a new marketing campaign (the broker told you they’ve never marketed before, and it’s a huge growth opportunity). But that cash buffer isn’t there for major capital investments. It’s there so when the business is in a tight spot with the hidden costs of the transition, it will still able to make it through to the other side.

• Some transition costs are unavoidable. Even at the highest levels of mergers and acquisitions in private equity, big law, investment banking, etc. there are surprises and things that go wrong. Smart operators plan for them by having access to quick cash whether it be through a LoC or a family member invested in their success who can write an emergency check upon request.

• Lastly, it buys you time. Often it is the case that the business will get worse before it gets better. Cash on the balance sheet and a strong line of credit do exactly that. They mean owners can slow down, make thoughtful, long-term decisions for the Company, and avoid the desperate 90-day cash crunch that takes too many first-time buyers down.

Bottom line? If you’re squeezing every dollar to maximize post-close ownership, but leave yourself with no room for error, you’ve already made the first critical mistake. That doesn’t mean the deal has to be overcapitalized, but that does mean Buyers need to bring enough cash to the balance sheet and sign with a bank that will underwrite a line of credit.

Part 2 Preview (Releasing On July 30th)

Hope you enjoyed Part 1 of The Silent Killer of SMB Acquisitions. We’ll be back with Part 2 on July 30th to cover Common Mistakes Buyers Make, Mitigating the Cash Crunch Before it Happens, and our Final Thoughts. Make sure you’re subscribed to receive Part 2 and future editions of The Playbook.

Thank You!

Thanks for reading— and for supporting SMBootcamp. We appreciate you taking the time to explore our insights and hope you found this issue valuable. If you're ready to take your acquisition journey further, check out our programs below. We've designed them specifically to give you actionable, real-world frameworks and support to successfully buy and grow your own small business.