Preparing Your Company for an M&A Transaction
We expect technology sector merger and acquisition activity to be strong for the foreseeable future as strategic and financial buyers continue to accelerate deploying funds for acquisitions. Driving the activity is a combination of factors including relatively stagnant revenue growth, increased regulatory hurdles in bringing new technology through the R&D process (especially life sciences), and difficulty in achieving significant growth organically.
In case opportunity knocks, you want to be ready for the transaction. In addition to preparing for legal, operational, intellectual property and sales- centric due diligence, companies should also be focusing on financial due diligence. Acquiring companies (buyers) and their advisors will likely perform a “Quality of Earnings” (QOE) analysis, which is a normalization of past results and future projections. A QOE analysis is typically performed by adjusting the past and projected EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) for items such as non-recurring transactions, non-GAAP accounting treatment, costs unrelated to the core business and other non-business related, personal and related party transactions. Potential buyers generally use the QOE to evaluate future projections, which forms part of their decision making process.
While each due diligence situation is unique, following are a few key areas where a seller can prepare in advance to maximize success.
Preparing interim financial information
For many companies, a hard close of numbers may have only been prepared at year end for purposes of the tax return or annual audit. This may have resulted in adjustments that were recorded at or near the end of the annual period.
However, during the due diligence process, a buyer and their advisors will typically want to see interim financial information on a quarterly and monthly basis over the trailing twelve months. This information allows potential buyers to better understand trends within the business including seasonality, unusual trends and non-recurring transactions, as well as the general direction of the business. Therefore, seller should anticipate the request and look more closely at their quarterly and monthly numbers to ensure that revenue and expenses are recorded properly within the interim periods and adjustments recorded are reflected across the interim periods. Making sure expenses are recorded uniformly throughout the past year and most recent interim periods will aid the buyer in gaining an understanding of the company’s operations.
Identification of non-recurring and revenue and expense items
Identifying non-recurring revenue and expense items, or non-core business related items, will also help normalize the company’s results of operations and provide the buyer with a clearer financial picture. For example, it may be necessary to exclude items such as severance or other restructuring costs from the normalized results of operations as these charges will hopefully not continue in the future and their inclusion provides a distorted view of profitability of the ongoing operations. In addition, costs related to legal settlements may need to be evaluated to determine their impact on normalized results. For example, an adverse settlement of a patent infringement law suit may indicate that the company should have been paying a royalty over past periods for use of technology instead of a significant charge in the period of settling the matter. Conversely, a legal settlement that is unrelated to the ongoing operations of the company may overstate the cost of ongoing operations.
Evaluating and documenting your key accounting policies
Although it may seem rather mundane to focus on accounting policies, having clear and detailed explanations of key accounting policies will help the buyer understand your financials and help you effectively respond to their questions. Buyers and their advisors will evaluate the accuracy of historical financial statements by comparing the accounting policies with their own expectations and benchmarking them against other companies within the industry. For technology companies, a few of the key accounting policy areas will include revenue recognition, capitalized software development costs, deferred commitments and obligations and the characterization of costs within the statement of operations.
Evaluating Income and sales tax exposures
Finally, state nexus, income tax and sales and use tax matters have become very hot areas of focus for buyers and their advisors in performing due diligence. Over the last several years, many states have modified their approach to assessing sales tax on software including software as a service, which has created significant exposures for technology companies. Understanding the exposures of the Company before the buyers raise the questions or issues will provide an advantage in navigating the sale process.
The volume of M&A transactions is increasing. Understanding and preparing for a buyer’s financial due diligence will help you successfully navigate any issues raised and improve confidence as to the quality of the business, which should improve the likelihood of a successful sale.