Pre-M&A Due Diligence Leads to Smoother Processes, Fewer Expenses and Lower Balances in Escrow

In a field where disagreements abound, accounting and tax professionals agree on one thing: due diligence during M&A processes is a slog. Sloppy accounting on the part of sellers often turns the merely tedious task of due diligence into an unnecessarily long and expensive undertaking.

The higher the rate of potential accounting errors that must be verified during due diligence, the more cash the seller must place in escrow as security against any discrepancy. This represents a major risk to a seller’s realized cash upon sale. Escrow accounts are rarely recovered in full, as buyers use these accounts as the go-to source to cover expenses incurred during lengthy due diligence periods.

Invest time and money into reconciling and preparing your books and tax filings ahead of a potential sale to reduce the volume of cash placed in escrow, thereby reducing the slice of the pie subject to shrinkage in escrow.

Before two companies’ records reach a need for financial record reconciliation, M&A targets should identify potential snags and address the items most likely to trigger trouble. More conscientious accounting practices will satisfy all parties during M&A, reducing legal costs, generating greater certainty and reducing inefficiencies.

Getting your finances squared away before a sale may make your business a more attractive candidate for acquisition, increase your valuation, and reduce the amount of cash tied up in escrow.

When clients approach Evolved Tax & Advisory at the beginning of their M&A process to help clean up their accounting records, we break their review into a series of focal points: federal and international considerations, state and local dynamics, overall accounting practices and (if applicable) tidying up loose ends from previous M&A activities.

Getting your finances squared away before a sale may make your business a more attractive candidate for acquisition, increase your valuation, and reduce the amount of cash tied up in escrow. Let’s get started.

Federal and International Considerations

Not all errors are created equal when it comes to federal and international tax filings. Some mistakes trigger audits at higher rates than others, and failure to address such inaccuracies increases the likelihood of prolonged due diligence and greater escrow obligations.

M&A targets can limit the costs of lengthy due diligence and the risk of unrecouped escrow holdings by identifying instances of improper depreciation, erroneous claiming of tax credits for which a company was not eligible, and noncompliance with U.S. trade and/or tax filing regulations. Review tax returns, financial statements, tax provisions and other frequently requested documents to ensure accuracy.

Smaller errors may be considered made in good faith and are unlikely to raise much interest. Firms perfecting their books should not spend valuable pre-M&A time on issues like minor misspellings and missed wholesale filings. Such mistakes, often reconciled by federal or international agencies, present little risk of triggering an audit, and therefore are not worth spending resources on.

State and Local Tax Solutions

State and local regulations represent a patchwork of scrutiny, complexity and initiative. Some jurisdictions, such as California, require M&A parties to navigate byzantine tax codes and aggressive state-level tax collectors. Others, such as Alabama, may have simpler codes at a state level, but a complex overlay of county and municipal tax structures. A third class of states, such as North Dakota and Montana, are easier on M&A transactions if a majority of commerce occurs within their borders; still, sellers should be sure their books are buttoned up to ensure that any litigation, even if less burdensome in these states, is limited or obviated.

When your business is part of M&A, identify which state, county, and municipal jurisdictions’ regulations are most likely to trigger an audit or a tax notice. Doing so allows your business to focus their efforts on satisfying the most complex regulatory matrix, which will mitigate audit risk (and possibly fulfill less burdensome regulations anyway). Buyers will be happier with the greater certainty linked with such preparation, leading to smoother M&A.

Standards for Accounting Methods and Reporting

Sloppy accounting practices result in higher M&A costs, lower valuation for sellers and a rat’s nest of escrow accounts that will rarely be fully recovered. Adherence to accounting methods and standards, internal controls and overall bookkeeping accuracy reflect well on potential sellers, and buyers will use these indicators in setting valuation, forecasting risk and setting financial performance expectations.

Both the buyer and the seller want tight, accurate and reconciled records. Here’s where to focus:

Incomes Statements. Sheets calculating totals such as gross profit margins and operating expenses must be accurate and standardized to ensure efficient review during due diligence periods. Although it may be time consuming to get these details in order before a sale, doing so reduces the likelihood of expensive last-minute fees associated with professional services and may reduce the escrow balance buyers and sellers negotiate.

Balance Sheets. Evidence of timely reconciliations that includes clearly delineated payments and terms should be up to date before due diligence commences. Longitudinal information on inventory and turnover rate should be collated in a precise and neat manner. Detailed accounts showing debt values and structures should also be packaged for review.

Cash Flow Statements. Potential buyers, ever concerned with revenue, want documented operating cash flow, investment information and financing history ready for review. The tidier this segment of your accounting, the smoother your M&A will be.

Don’t wait until the last minute to clean up these easily sorted areas, as the fees associated with rush jobs will eat into the M&A’s ultimate transaction value and may lead to higher escrow expectations.

Mistakes From Previous M&As

The purchase of a company that had previously undergone an M&A transaction presents a unique wrinkle to an already complicated dynamic. One may assume that the due diligence previously run by the earlier M&A sufficiently detected and reconciled disparities. However, loose ends from mutually sloppy accounting might remain, leading to lingering contractual, financial or operational risks that reflect poorly on the M&A target

Less quantifiable concerns may also cause trouble. Issues such as post-M&A cultural misalignment, failures to integrate synergies, and flagging brand loyalty—all of which could affect the profits, debts, and market share that made a target attractive in the first place—could force a buyer to balk at the original terms or demand soaring escrow balances that are subject to reduction. Deals moving forward under these circumstances strengthen the buyer at the expense of the seller, leading to underwhelming valuations and outcomes for M&A targets.

A Specialized Partner Is Worth the Investment

Big Four firms often find their way into M&A transactions, either because of investor preference, deference to brand, or a dearth of creative thinking. In many cases, two of the Big Four firms will have their hands in the pot: one as the initial consulting group that identifies discrepancies, and the other as a team tasked with tidying messy accounting. Using one Big Four firm is expensive enough; using two of them is a waste of resources.

If you’re a potential target for M&A, lean on the experience, expertise, and efficiency of a firm such as Evolved. Our experience in private equity and venture capital deals empowers us to anticipate our clients’ needs. We can also strengthen vulnerable points in a client’s financial structure, making them more attractive to potential buyers and increasing their valuation.

Don’t be a seller forced to accept unfavorable terms at the table because of messy accounting or a failure to address fixable issues before the deadline. Preparation is key. Find an accounting and strategy group that fits your needs—and get started now so that you don’t find yourself subject to soaring fees and high escrow balances. Lower your risk of shrinking valuation during due diligence.

Matthew John McNally is managing partner at Evolved Tax & Advisory, a New York–based firm with extensive experience in private equity and venture capital transactions that also focuses on servicing high-net-worth individuals and companies at every stage of growth. Learn more at Evolvedtax.com.

This article is sponsored by Evolved Tax & Advisory.

Middle Market Growth is produced by the Association for Corporate Growth. To learn more about the organization and how to become a member, visit www.acg.org.