Spokane Journal of Business

Accurate financials key when selling a business

Inconsistencies can raise red flags, jeopardize deal

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The market for buying and selling privately held companies has changed substantially during the last few years. The economic downturn significantly reduced sales and profitability of many companies, decreasing the number of companies for sale as would-be sellers delayed retirement.

Moreover, the downturn changed many buyers’ perceptions about future uncertainty and the potential for risk. The result was a drastic decrease in the number and value of business acquisitions, which had reached an all-time high in 2007. 

Now, five years after the worst of the downturn, the numbers of active sellers and buyers have recovered substantially. Liquidity is at an all-time high, interest rates remain near all-time lows, and lenders are active with acquisition financing. 

Consequently, there are highly qualified buyers looking to take advantage of these low rates by acquiring solid companies. This is a good environment for business sellers, particularly those whose companies are growing in sales and profitability.

But having a solid, profitable company to sell isn’t enough to ensure a successful transaction; it’s also important that the business is packaged properly to ensure maximum value and to prevent the deal from being renegotiated—or worse, falling apart during the sale process. 

Properly “packaging” a company in a confidential offering memorandum is an important step toward a well-structured transaction. The offering memorandum represents your first opportunity to describe the company’s past performance and future potential to prospective buyers, and to disclose operational challenges. Although it may be counterintuitive to include negative information that may cause some buyers to lose interest, this approach will save time, build trust, and better position the company for due diligence. 

Another key step in a successful transaction is a thorough letter of intent, which lays out all the important pillars of the transaction, not just the price and payment terms. Writing an offering memorandum and getting agreement on a thorough letter of intent takes time. If you receive such a letter quickly, then you probably haven’t done enough disclosure or your letter isn’t as robust as it should be; either case is likely to cause challenges as the deal progresses. 

Even with a detailed offering memorandum, buyers make certain assumptions about the seller’s operations, financial health, and future potential in their letter of intent. Accordingly, offers are always subject to the buyer’s due diligence, similar to the way a home purchase is always subject to a buyer’s inspection. In the case of a business acquisition, due diligence involves a detailed review of all kinds of financial and operational information by the buyer and its team of lenders, accountants, and attorneys, so everything needs to be in order. 

Consistent, transparent financial statements are probably the most important aspect of analyzing a business, not only because a company’s financial performance is a significant factor in determining value, but also because inconsistencies or inaccuracies in the financials can raise red flags and cause buyers to lose confidence in the business as a whole. On the other hand, high-quality financial statements showcase the strengths of the company, help establish the seller’s credibility, and prevent disruptions in the sales process. 

Most buyers are going to rely on federal tax returns and the company’s internal statements when evaluating a company’s value. It’s more difficult to manage taxes by shifting revenue and expense from one year to another under the accrual method, so accrual-based statements give buyers a more accurate picture of your financial situation than cash accounting. 

Regardless of whether you use cash, accrual, or a hybrid accounting method, transparency and consistency are key, so carefully document your tax strategies, inventory management processes, cost of goods or work in progress calculations, bonus calculations, year-end adjustments (particularly with cash basis accounting), and any historical changes in accounting principles.

Audited financial statements are the gold standard, but can be expensive and aren’t required to support the operation or the sale of many small companies. However, if a company is sold to a private equity firm or a publicly-traded acquirer, then an audit likely will be required before the transaction closes. It may be advantageous to produce audited statements—or reviewed statements in the case of smaller companies—prior to the sale process, particularly if there are complex accounting methods being used, if the company has adopted aggressive tax strategies, or if the bookkeeping practices are relatively unsophisticated compared with the company’s operations, revenues or profits. 

Otherwise, obtaining audited statements or performing a quality of earnings assessment during due diligence can be intrusive and add weeks—if not months—to the closing process. Perhaps more importantly, financial issues that aren’t discovered until due diligence can change a buyer’s perception of value and ultimately prevent a transaction from closing.

As a case in point, we recently had a seller client proceeding through the due diligence process after agreeing on price and terms with a buyer in a letter of intent. The buyer’s lender required a quality-of-earnings analysis, which included a detailed assessment of the company’s income and expenses. In this case, the quality-of-earnings analysis revealed some small but important financial discrepancies that made the lender uncomfortable and shook the buyer’s confidence. 

As a result, the buyer and lender required a full audit by an outside accounting firm; the audit carried a significant cost and delayed the closing by several months. The seller was required to pay for the audit, as it is the seller’s responsibility to provide accurate financial statements. All of this could have been avoided had the seller adopted better accounting methods or commissioned a reviewed statement prior to the letter of intent.

It is the seller’s responsibility to communicate the value of the company to potential buyers, and transparent financial statements help buyers evaluate the company more quickly and accurately. Engage your CPA as early as possible and talk to him or her about your options. Accurate financials will contribute to higher value and a smooth closing. 

In addition, an experienced M&A firm can help you understand your company’s value and point out other operational issues and value drivers—or value detractors—beyond just the information presented in financial statements. These initiatives will more than pay for themselves when the time comes to transfer ownership.

 

Ed Kirk is a Spokane native, a Gonzaga alum, and a principal at ASG Partners. ASG is a sell-side merger and acquisition firm with offices in Spokane, Seattle and Portland. Contact Ed at ed@asgpartners.com or (425) 450-4800.

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