We see it all the time when we’re working on the buy side of M&A transactions: missed EBITDA add backs, disorganized and inconsistent explanations from management and inadequate financial statements. These mistakes have significant impacts on the purchase price and transaction timeline, and they always give an advantage to the buyer.
In the lower middle market, most of the transactions we see have little or no sell-side due diligence. Adjustments to EBITDA are typically identified by management, their investment bankers or the CPA they use for audit or tax preparation. We think not performing sell-side diligence is one of the biggest mistakes sellers can make. While there are numerous advantages to sell-side due diligence, we have highlighted three of the most significant below:
Reason #1: Maximize purchase price
When selling a business, one common goal is to maximize the purchase price. There’s a rare exception every now and then, but generally, I think it’s safe to say that sellers are interested in getting paid for what they’ve built. Typically purchase price is based off adjusted EBITDA (earnings before interest, taxes, depreciation and amortization), a normalized level of earnings from regular business operations. Arriving at adjusted EBTIDA can be complicated, and during the hectic process of taking a business to market, adjustments are often missed.
We spend the majority of our time on the buy side of transactions, working with private equity groups and strategic buyers as they make acquisitions. In this role, one of our goals is to make sure our client is getting the best purchase price. Putting it more bluntly, we’re working to identify negative adjustments or invalidate proposed add backs to decrease the target company’s EBITDA as much as reasonably possible. You can expect any buy-side diligence team to have this same focus on negative adjustments.
So, if you’re the seller of a business, I think it makes sense to have your financials viewed in a positive light. Through sell-side due diligence, we commonly identify nonrecurring or nonbusiness-related items, positive GAAP adjustments, or potential future cost savings that can be implemented going forward. With these adjustments identified, management can present their financials fairly, but in the most positive light.
What does this look like in the real world? We recently worked on a deal for a distribution company. Their financials had been reviewed annually by their third-party CPA. The investment bankers had prepared a financial model and made several adjustments to EBITDA. Management was skeptical about bringing us in as they felt their financials were in great shape ahead of the sale. At the request of the investment bankers, management agreed to hire us. We identified another $85,000 in positive add backs on top of the CPA’s GAAP adjustments and the bankers’ normalizing adjustments. The purchase price of this particular deal was based on an EBITDA multiple of seven, increasing the purchase price by over half a million dollars.
Reason #2: Control the story
Sell-side due diligence helps identify potential concern areas, allowing management to develop a strategy to address issues proactively. If there are areas of concern in your financial statements, address them early and present potential buyers with a consistent message. Often, when issues are discovered late in the deal process, the resulting scramble makes the seller and their representatives appear disorganized, resulting in a loss of negotiating power. There are going to be speed bumps in the deal process regardless, so it doesn’t make sense to allow avoidable issues to impact the process when they can be addressed and solved early with strong, consistent messaging.
During the sell-side diligence process, the sell-side team will be able to point out the key areas on which potential buyers are going to focus. This will help prepare the management team for buy-side diligence and give an opportunity to remediate any potential issues prior to negotiations.
Recently, we worked on the sell-side for a software company that appeared to have a major issue with lost customers (customer churn) in the trailing 12-month period. Customer analysis is a standard diligence procedure, and during our initial conversations with management, explanations were vague and potentially concerning. We dug in and determined that many of the customer losses were artificial, created by mismatched customer names and numbers. We took all the raw data and combined customers appropriately. The presentation to potential buyers was a clear, consistent story of customer sales over several years. Sometimes, a little additional work on the front end can make all the difference in successfully closing the transaction.
Reason #3: Cut down on work for management and time to close
Sell-side diligence can cut down on the time from Letter of Intent (LOI) to close by adding credibility to the seller’s financial statements and preparing management for buy-side diligence. Accurate, high-quality financial information makes buyers more comfortable. Almost all potential buyers will require some level of financial due diligence. Providing them a sell-side report on the front end adds a level of comfort to the earnings.
During the sale process, management is overloaded with information requests from legal, financial, insurance, HR and various other due diligence teams. The information requested in sell-side diligence is principally the same information that will be requested by the buyer. Employees that will be involved in the diligence process extend beyond owners and high-level executives. During sell-side diligence, these employees are introduced to the pace and expectations of the transaction process. The sell-side process serves as a dry run for what they can expect during the transaction. Management also gets practice answering complex accounting questions and defending significant assumptions or estimates in their financial statements.
We just worked on the sale of a current tax client’s business. The seller had always maintained their books on a cash basis. We analyzed revenue by customer, allocating revenue to the correct periods based on terms. We adjusted major costs of sales to align with adjusted revenues, bringing monthly gross margins in line, showing consistent performance. Rather than providing disjointed, cash-basis financials to a potential buyer, the seller sent over monthly normalized, accrual-basis financial statements for the trailing 36 months. We also increased EBITDA by approximately 25% through our normalizing adjustments.
Selling a business can be a challenging, complicated process. For a closely-held business owners, it’s often the biggest financial decision of their lives. Sell-side due diligence can maximize purchase price, simplify a complicated transaction process, add an additional layer of expertise to the seller’s team, and solidify the credibility of the company’s financial statements, thereby increasing the likelihood of a favorable closing of the transaction.
Patrick Hutchinson, CPA, is a Senior Associate in Moore Colson’s Transaction Services Practice. Patrick performs buy-side and sell-side due diligence on M&A transactions for both financial and strategic clients.