Mergers and acquisitions have seen a recent uptick in activity. Flush with cash, corporate buyers are using acquisitions as an attractive alternative to organic growth, while financial buyers with record amounts of capital are looking for new investments.
This increase in buyer interest has many business owners exploring liquidity options. Often these owners have worked for years building a business, and most of their wealth is tied up in non-liquid private company stock. To prepare for a liquidity event, owners frequently ask what they can do to improve the value of their company.
As an experienced M&A advisor, we have found that sellers can improve their deal value by focusing on three key areas of financial due diligence – the quality of financial information, the sustainability of cash flow and management of tax issues – well before any letter of intent (LOI) is signed.
Quality Of Financial Information
Buyers gain confidence in the target company when presented with quality financial information. To minimize cost, however, many business owners opt for reviewed or compiled financial statements rather than audited financial statements. Yet we have found that non-audited statements result in significantly more negative adjustments as a deal progresses. Since any surprise in the historical financial results puts downward pressure on price, business owners can avoid late renegotiation of the deal terms by getting audited financial statements two years or more before the liquidity event.
Buyers also want to know the source and sustainability of revenue growth, including which customers, services and products generate the highest margins and cash flow. That helps a buyer understand how the acquired business will integrate into their strategic plans. Often the highest multiples are paid when buyers get excited about the customer base and the ability to accelerate the growth post closing.
Internal controls are becoming a bigger diligence issue as more public company buyers subject to Sarbanes Oxley (SOX) reporting are active in the M&A market. There is also increased interest in controls by financial buyers who want to know that the operating cash will be protected. An assessment of controls will identify areas of improvement that can be changed prior to a liquidity event.
Sustainable Cash Flow
Most businesses are sold based upon a multiple of cash flow or “EBITDA” (earnings before interest, taxes, depreciation and amortization). The higher the EBITDA, the higher the price. A key focus of financial diligence is confirming whether the EBITDA is real and sustainable. Most failed deals are due to the fact that the EBITDA reported to the buyer did not hold up in a financial due diligence review post-LOI.
Common trouble spots include inventory, the quality of accounts receivable, and unrecorded liabilities such as litigation. Moreover, the recent recession may
have shifted the customer base as companies went out of business, changed suppliers and or consolidated. These changes can impact not only the quality of the revenue/EBITDA but also the quality of inventory and accounts receivable reported on the balance sheet.
Tax Issues
The tax structure of the deal will have a significant impact on the after tax proceeds. Taxes can erode between 20 percent to 55 percent of deal value. As advisors, we often assist business owners in structuring options that will net them the highest after tax amounts.
Managing tax risk is increasingly important. With budget deficits and fiscal pressure many states are using audit compliance efforts to collect additional tax revenues from businesses. Advance tax diligence can identify risk areas and allow the business time to make voluntary disclosures or implement compliance mitigation plans. Buyers are not only concerned with historical liability risk, but also what tax liability will be incurred post closing due to bad tax management policies.
Involving experienced M&A advisors early in the liquidity planning process can help improve deal value significantly. Pre-LOI financial due diligence is an important contributor to improved deal value. If a business owner can improve EBITDA by $300,000, it should result in a sale price increase of $1.5m or more. Analysis of other areas such as infrastructure considerations, customer concentration, budget planning, key performance indicators and succession planning also lead to a smoother and more lucrative transaction.
George D. Shaw, CPA, is the partner in charge of Transaction Advisory Services at DiCicco, Gulman & Company, a Woburn-based CPA and business advisory firm.
