Written By: Andy Gelfand
Read By: Christopher McKenna
Within the bounds of preparing for sale, the preparation of internal accounts is paramount to ensuring that all financial and potential projections are as accurate as possible.
Consider this scenario: Your receive an unsolicited inquiry from the ultimate buyer for your company. This buyer represents the best business fit, is informed about your company’s products and markets, can justify the highest price, and has a high likelihood of closing. “All” the buyer needs to do to make an offer is review your financial statements. After signing a non-disclosure agreement, you email the buyer three years of financial statements. And then uneasiness sets in.
The reported financial statements are not representative of your company’s earnings – they do not represent “Quality of Earnings” (“QOE”). Remember the Head & Shoulders shampoo commercial: “You don’t have a second chance to make a first impression?” After hitting send, the reported financial statements are the buyer’s first financial impression of your company.
Let’s reset this picture. Before sending your financial statements to the buyer, you ask yourself, “do my financial statements make the best first impression of my company’s QOE?” If the answer is no, then slow down the process to make the best first impression.
Long before receiving this phone call, the business owner can take steps to prepare for the call. These steps will help make the best first impression with the buyer and lead the buyer to the business owner’s view of value.
First, if the financial statements are prepared on an income tax basis, they must be converted to to GAAP basis. The M&A markets value GAAP, not income tax basis financial statements. In addition, the business owner can consider upgrading the accountant prepared financial statements from compiled to reviewed or reviewed to audited. The increase in the standard of the accountant prepared financial statements increases credibility with the buyer.
While financial statements are typically prepared in accordance with GAAP, GAAP is not necessarily QOE. GAAP does not adjust for one-time expenses such as large bad debt, unusual professional fees, or non-recurring employee costs. GAAP also does not adjust for private business owner expenses that the buyer may not incur.
The business owner must highlight these items for the buyer, otherwise the buyer will not be reviewing the most accurate information and will not be able to make an informed offer for the company.
Therefore, the second step is to prepare a schedule setting forth the reported operating results together with appropriate adjustments to determine QOE. In addition to one time expenses and private business owner expenses, adjustments may include rearranging the income statement to put the components of QOE in the right places.
For example, interest expense and city income tax are often included in operating expenses, but they are not QOE. Discounts earned and scrap income are often recorded as “other income”: however, they are included in QOE. This schedule should be prepared for a minimum of three years with all adjustments documented to confirm the stated values.
Determining QOE in this fashion will provide the buyer with the most accurate representation of the company’s historical earnings and will assist the buyer in making an informed offer for the company.
Next, it is helpful to simplify the balance sheet. Action steps include writing off uncollectible accounts receivable and assuring that the stated value of the accounts receivable is collectible. Inventory value should be confirmed by taking a physical inventory, writing off and disposing of obsolete inventory, understanding slow moving items, and generally simplifying the explanation of inventory. Additional company specific balance sheet items should also be addressed.
Finally, it is helpful to prepare a management discussion and analysis (“MD&A”) for the last three years of key income statement metrics such as changes in working capital, capital expenditures, and other material balance sheet items. Preferably, MD&A is prepared shortly after the end of each period while the information is fresh.
While all of these accounting preparation actions take time, the business owner will be providing the buyer with an informed view of the company’s QOE and balance sheet which will lead the buyer to the business owner’s view of value.
The business owner’s ROI for taking these steps includes a stronger offer, increased credibility with the buyer, fewer questions regarding financial statements, and the increased likelihood of achieving a successful closing.