Moore Stephens North America is comprised of over 40 member firms that provide key services across a wide variety of industries and niches. This month’s “Moore Together” is a collaboration between Mike Thielman, audit partner with HCVT, and Eric Trumbull, tax principal with DMCL.
Business owners are constantly building one of two things: either a nest egg or a legacy. If they’re building a nest egg, they’re investing their time and efforts into a business that they can eventually sell and fund their retirement. If they’re building a legacy, they’re putting the people and processes in place, so they can transition out of their role and have a successor in place to carry on the work.
Entrepreneurs face complex issues and difficult decisions when contemplating growth or exit strategies for their business. Structuring for the sale of a business or conversely, making the right acquisition to expand into new markets, brings risks and rewards. Successful transactions require careful and thoughtful analysis to maximize value to a buyer or seller of a business. Whether an owner is looking to sell or merely step down, seeking an advisor to assist with financial and tax due diligence is a key factor that will help to promote deal success.
Financial Due Diligence
Although the scope of work may vary from one M&A transaction to the next, financial due diligence typically involves providing a buyer or seller with an assessment of the unique risks and opportunities of a company. One of the central focuses of this process is validating or confirming a company’s key financial metrics, such as sales, gross margins, EBITDA (before and after), operating cash flows and working capital requirements.
Common financial accounting and business issues that buyers and sellers should take into consideration include the following:
- Has the seller understated income historically for income tax purposes? A common example of this is under-reporting inventory. Adjusting for this can sometimes be more of an “art” than a “science.”
- Working capital adjustments have gone wrong. Are the accounting policies and methods consistently applied? What is included and not included in working capital?
- Earn-outs (“contingent consideration”). Should the earn-out be based on revenue or earnings? How are earn-outs accounted for under the latest GAAP rules?
- Personal/Owner expenses. Common examples of these expenses are airplanes, condos, country club dues, travel. Where are the expenses recorded in the books and records?
- Poor internal accounting and lack of internal controls. Has the target company had annual audits and reviews? Diligence is often focused on interim financial statements, so it’s important to check how the monthly financials differ from the annual financials? (The results of this diligence can affect representations and warranties, in addition to purchase price.
- Non-recurring revenues/expenses. Are they really a one-off? How should they be quantified?
- Out of period income or expense. Has the target company released accruals and reserves on the balance sheet to inflate income? Do current year financials include charges that should have been recognized in prior periods? For example, switching from cash to accrual or setting up reserves for the first time should both be acknowledged.
- Key executives/employees leaving the business. How much does the business depend on the skills, relationships, and overall leadership of the selling shareholder or key executive? It might be worth considering having the seller retain an ownership post-close. Also, who owns the key customer relationships?
- Concentration risk (customers/vendors). What are the chances a key customer or vendor could be lost? Most buyers will contact key customers during due diligence, so this is important to note.
- Unrecorded liabilities. How will they be identified? What are the EBITDA implications?
Tax Due Diligence
Tax rules within the United States (at both the Federal and state levels) and internationally can be exceedingly complex. As such, companies frequently try to manage their substantive cash tax exposures and tax compliance requirements in a way that balances their business needs with the pressure of being fully compliant with all tax rules. This means that smaller tax issues can often be put aside, but then accumulate over time and unknowingly grow into larger tax issues. It’s also worth noting that management doesn’t always have sufficient tax expertise, either in house or through its tax advisors, to properly diagnose larger material tax issues.
A tax due diligence specialist should be engaged to provide an independent assessment of the company’s potential tax exposures, as hidden tax costs can sometimes materially decrease its value. This in turn could impact whether the transaction goes forward, or as more frequently happens in practice, could impact the purchase price of the deal or the amount of money held in escrow at closing.
Some of the common things examined as part of tax due diligence include the following:
- Review of Federal and state corporate tax returns to determine if they are materially correct and if there are any filings that have been missed that could lead to additional penalties and interest being assessed against the target company
- Review of correspondence from Federal or state tax authorities
- Discussions with management of the target company to see if there are any ongoing audits at the Federal or state tax levels
- An analysis of the tax attributes of the target company (e.g., net operating loss carryforwards, credits, built-in losses, etc.) to determine what impact the potential transaction may have on them
- Review of correspondence with tax advisors on significant tax exposure items, including any prior acquisition or disposition transactions, internal restructurings, or significant tax planning
- Review of employee/contractor arrangements between the target company and its staff
- Review of executive compensation and payroll tax remittances
- Review of state sales and use tax filings and potential exposures based on operations of the target company
- If the target company has subsidiaries, whether domestic or foreign entities, a review of intercompany transactions and agreements
Whether you’re buying a business to start your own legacy, or selling a business to begin your retirement, conducting the appropriate due diligence is crucial to making the best deal. Be sure to give yourself enough time to plan and execute your dealings, and bring in a financial and/or tax advisor early!
Have a question? Contact Joseph Lee. Your comments are always welcome!