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Wednesday, January 30, 2019

4 Common Areas of Scrutiny in M&A Due Diligence


Due diligence is the framework that acquiring companies use to ensure the deal they are considering is worthwhile, and most investors are willing to pay top dollar to do it right. If you’re the seller, the outcome from due diligence proceedings will directly impact your company’s valuation, and you can improve your chances of a positive outcome by preparing to be reviewed in a few critical areas.

Revenue

First, acquiring entities will look at the history, expected growth and reliability of your revenues. But more importantly, they will look at the revenue recognition models themselves. They want to know that revenue is recognized in accordance with generally accepted accounting principles (GAAP). When revenue recognition policies are front and center during the normal course of business, the valuation will reflect that readiness positively.

Changes to revenue recognition policies, such as those required by ASC 606, will be inspected closely. Acquiring entities understand that your auditors or other consultants may have assisted in drafting the new policies, so they will put your managers to the test to ensure those policies have been adopted. You should be prepared to speak intelligently about your accounting policies and be ready to discuss the changes you have made to comply with the new standards.

Equity

When buyers want to learn about sellers’ equity, they look to the company’s owners. Buyers will ask: Who are the owners? What are their goals? What options and agreements do they have that may impact the sale? Beyond understanding the faces behind equity, due diligence will look to other balance sheet items that will impact equity, including outstanding warrants (the right to buy stock at a specified price) and convertible instruments (a convertible note that can be converted into stock shares).

The effect that convertible notes and outstanding warrants will have on your company’s valuation depends on what lies beneath the surface — on what is written in the notes’ or warrants’ terms and conditions. Will the value be repaid to the owners, with interest, upon acquisition? Will they be repaid at a premium? Or will the notes and warrants be converted into common shares before the sale? Each outcome will affect valuation differently, and you should be ready to reveal the details of these arrangements.

Taxes

It is all too common to find tax deficiencies during due diligence proceedings. Taxes are far-reaching, compliance is burdensome, and the requirements often seem insignificant to a company’s management compared to the day-to-day demands of running the business. But uncovering noncompliance can severely slash valuation. Penalties and interest that may be applied to a noncomplying entity can cripple businesses, so acquiring entities will steer clear of targets whose taxes are a mess.

Prospective buyers will look at the following areas of your taxes:

  • Net operating losses
  • Deferred taxes
  • Tax provisions
  • Tax credits
  • International operations
  • Transfer pricing
  • Sales taxes

If you know about deficiencies before the start of M&A proceedings, you should address those problems before due diligence begins. In some cases, your auditors can help address potential issues before they become a problem during valuation. This may be a months-long process (or longer), but it is worth the effort to ensure the due diligence team finds your business in a solid tax position.

Accruals

Revenues or expenses that are recorded as they are incurred, known as “accruals,” present their own challenges. These accrued revenues or expenses do not always align with cash received or paid, so buyers will want another process to ensure that all accruals are accounted for. In other words, the concern is not what is seen, but what is not seen. A thorough audit provides comfort that all accruals are accounted for, helping you prepare for the due diligence team’s questions.

If you have not had an audit within the past year, or if its scope was limited, the buyer might be concerned about missing accruals, since they almost always mean understated expenses. Adjusting expenses during due diligence proceedings will affect your sale price significantly.

Final Tips

Casting a critical eye on the most vital sections of your financials will prepare you for the due diligence proceedings. Two other tips can also help.

First, trust your gut. If you are nervous about the accuracy of your books, do something about it before entering into a merger or acquisition. Second, build strong relationships with your business advisors. Your lawyers can answer questions about entering into a new contract, and your auditors can help answer questions as you prepare for the transaction.

To listen to our experts review the importance of M&A due diligence, access our recent webinar, M&A Advisory Series: Planning & Due Diligence.

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