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Increased merger and acquisition activity is a sign that the economy is starting to rebound. However, not everything about conducting a transaction has returned to "business as usual." To some degree, the recession has affected the way we buy and sell. As a result, an added level of due diligence may now be required.
The economic downturn has (and will continue to have) a residual effect on both real and perceived value. Some sellers feel the need to "explain away" the recession by presenting their own version of a company’s financial history, which can be misleading. At the same time, the recession has created some very real business scenarios that potential buyers should know they will need to overcome.
Watch out for these top five post-recession pitfalls:
| 1 |
Seasonal or Cyclical Numbers
Quarterly results can be skewed by seasonal or cyclical numbers. That is why trailing twelve-month results (TTM) are preferred for determining the true value of a business, because it provides a close, real-time look at the company’s financials. To ensure the legitimacy of TTM, financial trends are more important than raw financial data. To identify trends, comparative metrics for EBITDA, revenues and expenses must be reviewed year over year, quarter over quarter and month over month. |
| 2 |
Inconsistent Sales, Revenues and Expenses
During 2008 and 2009, business owners found creative ways to appear profitable. They negotiated vendor pricing agreements, made concessions to customers, delayed capital investments, etc. As such, due diligence should include a review of finances from earlier years to form a baseline of the cost structure required to sustain projected revenues. In addition, a review of the customer base should include an examination of current contracts, including how long they are scheduled to run. |
| 3 |
Unsustainable Working Capital
Valuations assume that the business will deliver a level of working capital that is sustainable for the revenue level of the business. Working capital can be affected by many factors, including accounts receivable, accounts payable and inventory levels. After an economic downturn, it may take longer to return to normal levels of working capital, regardless of how well the company is managed. |
| 4 |
Overly Aggressive Add-backs
Overly aggressive add-backs can lead to a loss of credibility with the buyer or investor, and loss of credibility can be a deal killer. If add-backs as a whole are increasing EBITDA by 10% to 20%, they’re probably acceptable. If they are increasing EBITDA by 50%, something is wrong. All add-backs need to be investigated and documented, but especially bad debt, owner compensation, personal expenses and layoff-related costs. |
| 5 |
Sales and Use Tax Liability
State and federal governments are financially strapped, so they are auditing aggressively and taking a harder line on taxes. Payment of sales and use taxes is becoming a big issue. These are taxes on revenues, so they are payable whether the company is profitable or not. Companies need to get exemption certificates and consider including language in their contract saying that the customer is liable, regardless of whether or not the customer is billed for the tax. If tax issues are not addressed before the purchase of the company, they will become the buyer's problem. |
Thorough financial due diligence will reveal issues that are unique to each transaction. Before making a post-recession purchase, however, buyers should be aware that an added level of due diligence may be required to understand the full effect the economic downturn has had on a business. It plays a critical role not only in negotiating a fair price, but in structuring and documenting the deal.
George D. Shaw, is a CPA and Partner in charge of Transaction Advisory Services at DiCicco, Gulman & Company LLP.
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