The merger and acquisition (M&A) market is currently hot in many industries. But, before merging with another business, it’s important to do your homework. In addition to evaluating historical and prospective financial statements, a valuation professional can help buyers identify potential hidden liabilities and misrepresentations.
Buy-side due diligence
A buyer’s offer is based on how much return the business interest is expected to generate. Fair market value is a good starting point, but buyers may be willing to pay more (or less) depending on the situation.
For example, when a distressed seller is desperate for cash, a buyer may be able to purchase the company at a discount from fair market value. Conversely, if the M&A market in a particular industry is hot and the purchase enables a buyer to achieve acquisition synergies, the business may be sold for a premium above fair market value. When figuring out how much to offer, buyers need to review copies of historical and prospective financial statements.
In terms of the acquisition target’s historical performance, evaluate a full business cycle, including any cyclical peaks and troughs. If a seller provides statements during only peak years, there’s a risk that the buyer could overpay.
On the other hand, prospective financial statements are based on management’s expectations for the future. When reviewing these reports, evaluate the underlying assumptions and play devil’s advocate. After all, prospective financials are often the primary basis for the buyer’s offer price.
For instance, suppose management expects to grow at 15% annually. The buyer needs to recognize that fixed assets and human capital have limited capacity, so fixed costs probably can’t sustain such high growth over the long run. At some point, the business will need to buy more equipment, open additional facilities and hire more managers to achieve forecasted revenue. So, carefully review the terminal (or residual) value that’s included in any discounted cash flow analysis.
Also, ask who prepared the prospective financials. If they’re prepared by an outside accountant, do the reports follow the standards provided by the American Institute of Certified Public Accountants (AICPA)? Buyers may have more confidence in projections and forecasts prepared by outsiders — especially if they conform to AICPA standards — but these reports are typically based on management’s assumptions. Because management may have a financial incentive to paint a rosy picture of financial performance, it’s a good idea to hire your own expert to perform an independent analysis.
Beyond the financials
Historical balance sheets tell buyers about a company’s tangible assets, acquired intangibles and debts. But some liabilities may not appear on the financial statements. Examples of unrecorded liabilities include:
Hidden liabilities can be a major issue in stock sales. Unlike asset sales, in which the buyer cherry-picks assets and liabilities to acquire, stock sales transfer all the outstanding shares of stock to the buyer, and the business continues to operate uninterrupted. From a legal perspective, that means the buyer may be vulnerable to future lawsuits, such as employee discrimination or intellectual property claims that relate to conditions that existed before the deal closed.
Some issues, like broken equipment or obsolete inventory, can be unearthed only with a physical observation, so it’s important for buyers to tour the company’s facilities with any outside experts that are hired to help conduct due diligence.
Buyers also need to be skeptical of representations the seller makes to seal a deal. Misrepresentations that are found after closing can lead to expensive legal battles. An earnout provision or escrow account can be used to reduce the buyer’s risk that the deal won’t pan out as the seller claimed it would.
Hire a business valuation expert
Mistakes can be costly in M&A. Many private business owners are inexperienced when it comes to these complex deals. So, it usually pays in the long run to hire an outside business valuation expert to help evaluate the deal.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.