By Mary Warmus, CPA, ASA – Director
Buying a business is like picking a spouse from a dating app. The picture looks good, the bio reads well, and the prospects seem favorable. Then you sit back and think, “Hey, pictures can be doctored; that person authored his/her bio, and you have no idea if this person has lifetime friends, comes from a good family, is in debt up to their eyeballs, or has a history of stable relationships.”
This same thing happens when a pitchbook hits your desk. Your mind floods with thoughts:
- Is the target business attractive to me?
- Is this a financial or strategic acquisition, or does it provide me with a new growth platform?
- Can this investment be accretive to my existing operation post-integration?
- Who are the owners? Have they operated this business with integrity?
- What is the Company’s reputation? How long has the business been around?
- Do they have a solid customer base, or are there customer concentration issues?
- How reliable are the financials? Are the financials audited?
- What differentiates this business from others in its trade group?
- Does the Company have a strong intellectual property portfolio supported by continuing research and development?
- Does the target have a strong sales organization and a deep bench with a strong and progressive management team?
- Does the target have a superior production process?
- Is the target’s product line cutting edge or on the verge of extinction?
- Has the business coasted in its recent history?
- Have the owners retained profits for business expansion and capital upgrades?
In short, due diligence mitigates risks, uncovers potential issues, and validates a deal’s merits. It gives the buyer intelligence that will allow them to price and structure a deal properly. Often times acquisitions fail because the buyer failed to:
- Properly assess the risks involved;
- Achieve synergies expected in the acquisition;
- Integrate properly; and
- Recognize that the financial projections provided by the seller could be overstated and not validated with historical data and industry trends.
Cash is king and price is driven by expectations of future cash flow. These forecasts are generally provided by the seller and require vetting. I have always marveled at acquirers who place a price tag on historical operating cash flows when it’s the sustainability of future earnings that dictates how much a business is worth. Your perspective may change if you are buying only the assets of an existing business.
Due Diligence Is a Team Sport
Due diligence is a team sport, relying on a host of professionals to help the buyer assess these risks. Diligence is performed in the following areas:
- Financial
- Legal
- Valuation (business, fixed asset, and real property)
- Tax
- Insurance
- Cybersecurity
- Regulatory compliance
- Other specialized fields, as needed
Assembling the right team is tantamount to success. Sellers know buyers today are more sophisticated and have increasingly engaged consultants to perform sell-side quality of earnings to become alert of issues and clean house before they go to market. This is a smart strategy, because who would put their house on the market without getting it ready for sale?
Quality of Earnings and Cash Flows
For both the buyer and seller in the equation, it is important to understand the quality of earnings and cash flows of the business. Earnings before depreciation, interest, and taxes (EBITDA) is probably the most commonly referenced earnings base used to price a deal. This earnings measure eliminates the effects of varying capital structures and special tax situations. Therefore, it is key that historical and forecasted EBITDA be scrubbed or normalized, so that it properly measures the true earnings capacity of the business. Some common adjustments include restating related party transactions to market terms. These adjustments may include:
- Marking leases to market rates
- Quantifying debt owed to shareholders for infusions of debt and working capital to market rates and terms
- Compliance with generally accepted accounting principles (GAAP)
- Elimination of discretionary, non-recurring, and/or non-operating items
Normalized Working Capital
Another important factor in the deal pricing context is the concept of normalized working capital. Establishing a normalized working capital level with the help of your accountants and consultants pre-deal is important. Why? Because this calculation impacts the amount of proceeds the buyer gets at close and is perhaps the most contentious and litigated concept in a transaction. We again note that due diligence goes beyond the numbers. It not only identifies anomalies in the financial records of the target company, but also provides competitive intelligence concerning asset utilization, industry profitability, and prevailing transaction multiples.
Deal Structuring Considerations
Deal structuring must consider the condition of the credit markets, competition, and the general economy. It will impact how the deal is financed. Tighter credit environments require some buyers to invest more equity in deals than in previous periods. Buyers may require sellers to co-invest, a common private equity play, to keep the seller vested in the future operating performance of their business. Although good for the buyers, sellers should be wary, because they can be locked into the deal with limited or no ability to divest and further have the risk of their investment diluted in the future.
How MichaelSilver Can Help
MichaelSilver is a full-service accounting firm that can assist with buy-side and sell-side transaction support and consulting for closely held businesses, private equity funds, and family offices. We can assist you with a variety of projects including quality of earnings, tax structuring, valuation services, and attestation services. Knowing what you don’t know will enable you to make an informed decision about whether to pursue a transaction and give you the ammunition to price the deal appropriately. Contact our trusted advisors at 847.982.0333.