by: Raymond Chang, CPA
avoid these 5 surprises when preparing your business for sale
As the CFO of a company that is likely to be sold in the near term, it makes good sense to perform some due diligence about the sales process, well before you meet the buyer.
The CFO’s role in a business sale transaction is a lot like playing double agent. Not only do you retain a loyalty to your current boss to see them through the deal, but you also want to impress the buyer to ensure you still have a job after the deal closes. The toughest part of the process for the current business owner is proving the company’s value and dealing with the emotional side of handing over the keys after so many years of building a business. The CFO may not have to deal with all of that but they do have to prove that the shop is well kept and clean. That not only means financial and tax compliance but showing that the company is clean of financial or physical clutter.
Here are the top 5 items the CFO should be aware of prior to and during an extensive business sale transaction.
1. Decluttering starts today
Owning and operating a closely-held business is a lot like home ownership. There is always something needing to be fixed and there is always something else that ultimately is more important that takes priority. It’s a delicate dance between priorities and resources, but no one wants to buy a business fixer-upper. Not unless you want to take a huge discount for it – and what business owner wants that? This tango of sorts can impact everyone in the organization but in particular it impacts the CFO, who is often tasked with wringing the most out of the least resources.
When finding themselves on the sell-side of a business sale transaction, CFOs often have little to no resources in dealing with the requests at hand. For example, the buyer’s team will customarily provide a Due Diligence and a Quality of Earnings list. These are two separate lists going to two separate teams. Although many items overlap between the two lists, the Due Diligence list takes aim at the operations while the Quality of Earnings (“Q of E”) list focuses on the financial reporting. Or more precisely, what’s not reported. The Q of E, aside from reviewing your financial statements, basically looks for two things – over stated assets and understated liabilities. So, in addition to managing the day-to-day of reasonably accurate financial reporting, the CFO is now charged with delving into certain areas to enable the buyers to ferret out these and other items.
Typically this is in areas such as:
- Uncollectible accounts and inventory reserves;
- Inventory on hand variances;
- Inventory costing variances;
- Warranty reserves;
- Vacation and other compensation accruals;
- Deferred compensation;
- Sales and use and other tax and unclaimed property noncompliance; and
- Financial policies and procedures documentation.
Some of these items are not necessarily processed, managed and monitored with a high degree of precision in the normal course of operating the business, primarily due to resource constraints. In a sale transaction, CFOs are often solely responsible for cleaning up or fortifying these items that may not have been given the attention they deserve. They need to do this while also maintaining confidentiality and their normal daily routines. Knowing this may be the forthcoming situation, CFOs may want to be proactive by attacking these items in the early stages and spreading this additional work-load over time.
2. Audit, Audit, Audit
With any sale, there’s a possibility there will be a call for an audit. A financial statement audit is larger in scope and more expensive than a review or a compilation, which many small to medium sized business typically obtain. It’s certainty more intrusive to your finance team and your daily operations. “Theoretically” the end result to the numbers and even the notes to the financials should be the same, assuming the books and records are reasonably maintained under U.S. Generally Accepted Accounting Principles (US GAAP) without material errors. If the Company has not been through an audit and there is a sale planned in the near future, you may want to suggest to the owners that an audit be performed. To assess this, you need to know the owners’ exit strategy, hold old they are, what their plans are for the business and the timeline for such plans. If the exit strategy is five years down the line, you may want to get started on company audits in years two or three as that window tends to compress as time passes. If the owner says next year, you might want to start your audit now.
So why go through with an audit?
Having an independent professional sample test at the transaction or invoice level could identify potential issues that would have otherwise been missed. A deeper dive could also help in preparing for the Q of E preemptively. But the most important reason is the buyer. Most buy-side M&A professionals and financial groups are only interested in audits. Most loan documents are preprinted with “US GAAP Basis audits.” Can that be changed? Sure, but then you have to explained why and it also takes time to work through the various interest groups.
You should also be aware that preparing for an audit takes time. You can’t just wake up one day and decide, “I’m going to have an audit.” Especially if you’ve never gone through one before. There is a significant amount of preparation involved. While many consider annual periods to be the past 12 months, those who are undergoing an audit must also prepare to present activities from the beginning of the new annual period.
In most cases it’s not a big deal – unless you have inventory. A review does not require an inventory observation, so if you need an audit, there’s no way to go back in time and have the auditors observe inventory. Can you still have an audited financial statement if the beginning inventory was not observed? Yes, but the opinion would be modified to indicate the circumstances leading to the modification. That modified opinion may not be an option for the buyer given that the modification indicates that in the auditor’s opinion to the financial statements are fairly stated “except for” the effects of the modification. When it comes to opening inventory matters, this modification is basically seen as having no opinion to support the cost of sales and potentially other areas.
However, depending on the sophistication of your accounting and inventory control system you can observe your current year-end inventory and roll it back twelve months. However, that is difficult, time consuming and typically cost prohibitive. Preemptively, if you’re still not set on doing an audit, you can choose to have the independent accountants observe year-end inventory. This way, should you choose to upgrade from a review to an audit a year or years later, there will be no issue because the beginning inventory was observed. The cost of doing this is relatively small and probably worth considering annually as a means to keeping your on-hand counts clean. Even if you never decide to upgrade, it’s good to always have the option should a need one day arise.
3. Big GAAP vs Little GAAP – Know your buyer’s needs
Current US GAAP allows for reporting alternatives for private companies. Those alternatives include, for example, allowable limited financial statement disclosures in certain areas and non-consolidation of certain related party leasing entities. However, if your potential buyer is a public company (known as an “issuer”), your private company (“non-issuer”) financials may have to be published in a Securities and Exchange Commission filing. As such you may have to follow the same reporting rules of an issuer even though you are a private company. So, for example, if your Company has not historically consolidated its related party leasing entities, it may now be required to do so, even if those entities are not included in the sale.
4. You vs. the M&A Army
Suppose the offer letter is received and you are now in contact with your M&A attorneys and the buyer’s team. Usually, aside from your M&A attorney, only the main owner and the CFO and the auditor are aware of what’s going on. The rest of your company and your entire finance team, including the Controller, are often in the dark about the pending sale. So the Due Diligence and the Q of E lists are all on the CFO. And it all typically starts with setting up an electronic data exchange portal.
Usually your M&A attorney helps set up and maintain this third-party portal. The portal folder structure is set up based on the request lists and users are added as needed. As the CFO gathers the information and uploads it to the portal, every user of this portal is notified of the addition. The users would include the buyer, the buyer’s Due Diligence and Q of E team, the buyer’s auditors, lender and maybe even the insurance company. Total tally on the user side could range between 30-40 people.
Then the CFO must attend meetings to go over the status of the list and address specific questions on items uploaded. What comes of these meetings are additions to the original lists and therefore more information gathering, more uploads to the portal and more meetings with hopefully less additional requests. Let’s also not forget that while all this is going on, there is still a business to run.
5. The Final and Most Important Financial Close
You’re almost there. All the lists and meetings are done and the due diligence is now complete. The sale agreement is signed and made public to all personnel. A closing date is also set. Depending on whether your deal is an asset sale or stock sale, you may have one more task to perform in contemplation of closing. A stock sale means that the buyer buys the seller’s stock or ownership in their company. So the corporate entity and operations continues on after close but under new ownership. An asset sale means that the buyer is buying the business operations including their working capital, customers, vendor relations, workforce, know how, assuming leasing arrangement from the seller and probably leaving behind cash, debt and whatever else they specifically didn’t buy, such as real estate.
In an asset sale, it’s important to note that although the selling corporate entity continues to exist, there is no business, no employee, no equipment or revenue generating ability after cash exchanges hands. Usually the buyer sets up a new entity, probably a wholly owned corporation or a single member LLC, to acquire the business. Their beginning working capital is your ending working capital at closing. This financial close represents your most important financial close because any unrecorded sale or purchase may have a negative impact on how much you are getting for your working capital. The purchase agreement usually stipulates how much working capital must be maintained at the time of close. Working capital usually includes your customer accounts receivable, inventory and current payables. Usually the buyer would conduct an inventory observation at closing with their auditors. It is recommended that the seller should have their auditors present at the inventory observation as well in case there are differences or disagreements. In either case, you want to make sure you fully account for all your cutoffs as of the date of close.
Obviously there are other important items involved during the M&A process, such as transition meetings and systems integrations, just to name a few. Our firm has represented and assisted clients in many M&A transactions on both the sell and the buy side. Every deal is unique but it helps to know the general needs in the process beforehand so you can be more prepared when the day finally arrives.