M&A due diligence is a critical and necessary step when a company is looking to sell and attract potential buyers. During the due diligence process, acquirers will examine a company’s financial records, sales processes, customer contracts, and revenue streams to assess the accuracy and sustainability of its profitability and earnings potential. These results allow for an acquirer to uncover potential risks, such as discrepancies in revenue recognition, customer concentration, or declining trends, which could impact structuring or even valuation.
To avoid having deals become hampered, it is important for the seller to make accessible reliable financial information to ensure transparency and provide for a smooth transaction.
Below are three areas where businesses can improve and prepare themselves prior to going out to the market.
#1: Standard Practices
It is common for owners to analyze their own business in a different manner than how a buyer will examine their business. Sophisticated buyers generally analyze businesses they are looking to acquire in a consistent manner, and as a result, will expect to receive financial information from a target entity that is consistent with standard accounting practices. This can be troublesome for entities that keep their financial records using personalized methods and then attempt to explain their underlying logic to the buyer. Receiving financial information that’s not in line with standard accounting practices can create doubt and uncertainty for buyers, which in turn may lead to a lower valuation or a buyer who is no longer interested.
#2: Revenue Recognition Basis
Along those same lines, many small businesses keep their financials on a cash basis. The cash basis of revenue recognition will record revenue only upon the receipt of payments from customers, whereas the accrual basis of revenue recognition will reflect revenue when the underlying product or service has been delivered to customers.
Cash basis is an acceptable method for certain businesses and is also an acceptable method for tax reporting purposes. However, a buyer looking to acquire a small business is likely to use the accrual basis of accounting themselves and would be interested in evaluating a target entity on an accrual basis of accounting as well.
Sharing cash basis financial information can cause delays in the financial due diligence process, as the buyers will attempt to convert the financial information themselves. As a result, if a business owner is interested in selling their business in the future, they should consider converting their financial statements onto the accrual basis of accounting to help expedite the diligence process.
Please note, keeping financial records on an accrual basis of accounting does not necessarily prohibit a business from filing their tax returns on a cash basis.
#3: Customer and Revenue Segment Information
When buyers are looking to acquire, they are attempting to access information regarding the level of risk to get a sense of whether revenue streams will be sustainable into the future, especially after they are the new owner of the business. Consequentially, they are very much interested in reviewing customer and revenue segmentation information. Without such information, the buyer cannot adequately address any potential lack of diversification or customer concentration risk. Conversely, by providing the buyer with an abundance of information, they can easily analyze such risks and ideally gain comfort.
Examples of customer and revenue information include:
- Revenues by customer
- Revenues by product or service
- Recurring revenues versus one-time revenues
- Revenues by location or geographical region
- Revenue by project or job
Acquirers look for accuracy, relevance, and reliability in supporting information, from which data that does not reconcile to overall financial information may negatively impact earnings before interest, taxes, depreciation and amortization (EBITDA). Therefore, any data brought together should reconcile to the financial statements and reflect the pattern and timing of revenue recognition.
Benefits of Being Prepared for a Sale
Ultimately the buyer will be using the seller’s financial information to determine whether they are making a wise investment that will yield an adequate investment return. The reliability, consistency, accuracy, and quantity of information will either make the due diligence process easier for the buyer or more difficult. As a result, when sellers are prepared to provide financial information in an expeditious manner, this instills confidence in the buyer and creditability in the seller. The combination of the two will not only allow the transaction to close in a shorter timeframe but it will also reduce the workload on the parties involved. If you would like assistance preparing for a transaction or accessing a potential acquisition, please contact a member of our M&A/Transaction Advisory Services team.