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Preparing for Sale – Financial Due Diligence

Sep 24, 2019

You have considered the pros and cons to selling your M&D business and have decided that the time is right to sell. You have hired an experienced trusted investment advisor and are taking the first steps in the process, but are unsure of the steps ahead, especially as they relate to financial reporting and accounting matters. Many entrepreneurs fail to realize that proper and timely planning and preparation for the “sell-side” process is critical to consummating a successful, timely, and fairly-priced transaction. Preparation and readiness will contribute to maximizing the value of your company and mitigate the risk of surprises at the critical stages of the proposed transaction.

What are some of the things you can expect in due diligence as it relates to the financial side of the business?

A prospective buyer’s/investor’s due diligence will include a demanding and thorough analysis of your business, focusing efforts on accounting, tax, intellectual property, legal, commercial, marketing, environmental, and other technical areas. This process of due diligence can be onerous and complicated as a buyer/investor attempts to understand, analyze and properly value your business in the few weeks or months before close.

A prospective buyer/investor will inevitably ask for comprehensive details underlying your company’s financials to validate the information utilized to make their offer. The buyer will likely undertake a financial due diligence/Quality of Earnings (“QOE”) process to establish a historical “as reported” baseline as well as a “pro forma adjusted,” normalized sales and EBITDA (earnings before interest, depreciation and amortization) financial metrics, which generally serve as the primary basis for establishing a value and offer price for a company.

QOE provides a buyer/investor (and the seller) a detailed analysis of the key components of a company’s revenue and expenses from both an historical “as reported” and a “pro forma adjusted” basis for GAAP, normalization, one-time, and non-business-related adjustments necessary to more accurately reflect the potential future performance of the entity to be sold to a third party. This in-depth historical and pro forma analysis will likely be completed by a third-party CPA or advisory firm and includes scrutinizing your financial records over a period that could span several historical periods.

What are steps you can perform to be best prepared for the financial due diligence/QOE process?

  • Plan and Allocate: Transactions always take longer and are more complex than expected. As a result, it is imperative that you ensure that all of the various transaction due diligence teams (internal and external advisors) are organized, communicative and well-connected in terms of transaction objectives, process and deliverables. Every transaction needs an experienced project manager, someone who is an adaptable leader, possesses the above-mentioned traits, and is also multi-task-oriented and technically proficient. This transaction project manager would typically be an internal executive who will ultimately have primary responsibility for the transaction and underlying business post-transaction from an operational and financial performance and ROI perspective. Alternatively, the seller can contract with a third party experienced in corporate transactions, financial analysis and transaction negotiation and structuring.
  • Perform a Financial Clean-Up: Sanitize, vet, and organize the information you will provide to potential buyers. Buyers are typically interested in reviewing monthly financial results for the last two-three historical years and the most recent year-to-date interim period. It is important for the financial information provided during due diligence to reconcile and be supportable (i.e., significant accounts reconciled to subledgers and other schedules). It is also important that there is a clear analytical understanding of the monthly trends underlying historical results so that any unusual or one-time items can be isolated to best represent the historical earnings generated by the business on a “normalized” basis.
  • Organize: Create a well-organized and robust electronic data room and comprehensive, Excel-based data pack with important and relevant financial, contractual, operational, and legal information, including data analysis and contract abstracts.    
  • Maintain control of the transaction process, including the amount, timing and detail of information that is provided to prospective buyers.Maintain Transparency: disclose and address key due diligence questions and data request items. Prioritize information flow to ensure relevance, accuracy and appropriateness in light of the overall mutual transaction goals and objectives.

Who are the key external players in an M&A transaction and what are their roles?  

It is important to engage experienced transaction advisors -- early in the process -- who are familiar with the manufacturing and distribution industry and have experience with buy- and sell-side transactions, as this allows for issues to be vetted on a timely basis:

  • Investment Banker – Assists the company with identifying potential suitors and advising on realistic, market-based valuation metrics. Helps package, communicate, market and negotiate your proposed transaction to qualified and interested third parties.
  • Tax Professional – Assistance with structuring a tax-beneficial transaction and identifying potential tax pitfalls to both the buyer and seller in contemplated agreements.
  • Financial and Accounting Professionals –assists with cleaning up financial information, performs sell-side financial due diligence and assists with the question and answer process with the buyer’s due-diligence provider. Generally an independent CPA firm.
  • Legal Counsel –Assists with the deal documents and negotiations. Counsel should also thoroughly review key contractual terms to determine risk exposure and assist management with the post-close integration and synergy assessment. Should have M&A experience.
  • Insurance Professionals – Most buyers will request an escrow or holdback from the purchase price for potential breaches in representations and warranties in the purchase agreement (typically 10% to 15% of the purchase price for one to two years). By obtaining an insurance policy, the buyer recovers any damages directly from an insurer and the seller receives more of the transaction proceeds when the transaction is consummated.

What can you do to put your financial information in the best possible position?

A critical step to prepare and present your financial information in the best possible light is to perform a sell-side QOE analysis of your business with a key focus on revenue cycle (including revenue recognition), purchase cycle (including cost of revenue and employee-related expenses) and normalized earnings. Sell-side due diligence analysis focuses on the matters most likely to be of concern to the buyer. This analysis can prove to be beneficial to maximizing the value and efficiency of the transaction, and helps you:

  • Avoid surprises through the identification of potential financial concerns that could be raised by buyers and assist with providing well thought out and candid responses as part of the buy-side due diligence question and answer process.
  • Relieve the added pressure and demands on your finance team resulting from voluminous transaction requirements, allowing your finance team to focus on day-to-day running the business.
  • Identify possible positive adjustments to operating income and potential upside in the sale price.
  • Provide vetted, detailed financial information to prospective interested parties in an organized manner which increases confidence in the financial information presented and bolstering the buyer’s perception of your business.

Selling your business is a time-consuming, fully-encompassing, potentially disruptive, and emotionally stressful process which can span a 6-12 month period from onset of negotiations to closing. An entrepreneur can significantly improve their chances of a successful outcome by properly planning the overall transaction process and building a team of experienced professionals that can help the entrepreneur navigate through the complexities of the transaction to a successful close.

M&D Intelligence - Q3 2019

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Phil Bergamo

Phil Bergamo is a Managing Director overseeing engagement teams that perform financial due diligence on buy and sell-side transaction.

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