Selling a company, subsidiary or division may be one of the most significant events in your career. The stakes are extremely high because, while a successful deal is likely to yield great financial rewards, a bad deal can have devastating repercussions that last for years.
One way to diminish surprises is to understand how your counterparts across the table may gauge the financial health of your business and to understand how that aligns or differs from your own measurement.
In the context of mergers and acquisitions, potential buyers may get some level of assurance when the seller has the company’s financial statements audited or reviewed. However, buyers typically do not—and should not—rely solely on audited or reviewed financial statements when making an investment decision. The purpose of an audit or review is to provide assurance that management has presented a company’s financial performance and position it fairly, not to identify issues likely to be of interest to a buyer.
Here are some considerations for aligning expectations between buyers and sellers:
Quality of Earnings Reports
A sell-side quality of earnings report is focused on providing potential buyers with a deeper understanding of the business. This includes sustainable economic earnings; historical revenue and expense trends; historical working capital needs; key assumptions used in management’s forecast; and tax, information technology, human resources and risk management matters, as appropriate.
For obvious reasons, buyers are particularly concerned with fair valuation. Because businesses often are valued based on a multiple of EBITDA, a sell-side quality of earnings report will focus on the “quality” or sustainability of the company’s earnings.
Trend Analysis and Working Capital
Audit or review procedures may include analytics to understand trends and relationships over the historical period, but the reports do not comment on the market drivers behind those trends. Sell-side quality of earnings reports address key market drivers, sales strategies, customer relationships and customer churn, while also attempting to show whether the trends reflected in the financials are sustainable.
Buyers and sellers typically negotiate a target of working capital to be delivered at transaction close. The negotiated amount is usually based on the average working capital balances over the previous year. It should also consider recent growth trends; industry conditions; the seasonality of the business; and the specific composition of working capital accounts.
Perhaps most importantly, the sell-side quality of earnings report may provide important qualitative observations arising from discussions with management. These observations may include key findings regarding the company’s internal control structure, management and accounting team, and accounting information systems. Qualitative observations rarely appear in financial statements but may be just as important in helping a buyer make an investment decision.
Craig Arends is the managing principal of the private equity practice at CLA and has more than 25 years of experience in public accounting and mergers and acquisitions. Contact Craig at craigarends@CLAconnect.com.