You are a business owner or CEO who has built up your private company over time and have made the decision to sell. You put your company on
the market and hope to arrive at a favorable enterprise value figure with a
purchaser. While your company may or may not have been audited or reviewed by a
CPA firm, your ability to complete a transaction will be significantly influenced by this issue and your ability to complete the due diligence process.
Most of the sell side
transactions I have been involved with, were private firms that had a history of being
audited by an outside CPA firm. In cases where sellers have not been audited or
reviewed, the batting average for completing a sell side transaction is lower based on my experience.
The
reasons for having your private company audited or reviewed typically include:
1) To eventually go public or raise equity;
2) to eventually sell the business or take on a partner;
and
3) to issue debt or meet partnership agreement
requirements, among other factors.
To complete an audit successfully, your accounting
function will have to deliver prepared by client schedules (PBC's) before
fieldwork begins, support audit fieldwork by answering questions and providing
documentation, support internal control testing and be responsible for
preparing financial statements and footnotes in a required format that is the
basis for the CPA firms audit opinion. In regard to PBC's, the PBC's will need
to tie to the company general ledger-trial balance and basic financial
statements (i.e. balance sheet, income statement, cash flow statement and footnotes
where applicable), as well as be in a lead sheet and balance sheet roll-forward
format. The company will typically designate a member of the financial team to
be the liaison to the audit firm that has enough clout in the organization to
influence the company's priorities to complete the project successfully (i.e.
on time within a budget resulting in a clean opinion). In this day and age the
audit process has become much more complex due to the increased complexity of
GAAP and other factors that result in a long complex deliverable list for the
business being audited.
In addition to baseline requirements described here, sell
side transaction itself adds to the burden and complexity of the audit process
due to financial reporting and other requirements related to the sales
transaction itself that must be adhered to by the seller or buyer or both.
If you are seller who has the ability to successfully
complete the audit process in general or in connection with a transaction, your
incremental overriding management issue will be managing the sell side
transaction due diligence deliverable requirements and overall process within a
typically tight stressful time line while simultaneously running the business
day-to-day. Unless you have the necessary transaction related human resources
and expertise, you will typically not have the ability to do both.
Sell side transactions I have worked on typically begin
with information that is provided to the general marketplace of prospective
buyers within an industry. The buyer list is then narrowed down to a smaller
list of prospective buyers where additional information is provided followed by
identification and agreement with a single buyer. At the initial stage until a
purchase agreement is signed off key factors and disclosures in the due
diligence process may include:
1) Is the seller selling assets or stock? The answer to
this question directly affects the
seller's after tax returns on the sale. This is a seller decision that may or
may or may not be negotiated with the buyer;
2) defining
and calculating net working capital;
3) analyzing
key metrics such as sales trends-key markets & customers, margins and other
key performance metrics;
4) defining
and calculating earnings and/or ebitda on a trailing twelve month basis or
other historic time period as a basis for the valuation; and
5) Other
factors depending upon the nature and specifics of the transaction including,
industry trends, Comps-benchmarks, KPI's, key competitors and technology issues,
for example.
At this
stage, the transaction process has just begun. At some point in the process the
buyer is identified and a purchase agreement is entered into that must be
adhered to in order to get to the transaction close. What follows are typically
a list of due diligence requests and requirements that put further stress on
the accounting function of the seller, some of which may or may not precede the
transaction milestone of reaching a purchase agreement. In general a
significant list of buyer requests that are uploaded to a data room after the
purchase agreement has been reached typically include the following;
1) Additional
detailed financial information that includes current and historical internal
financial statements and analysis specific to the company or industry or both;
2) audited
financial statements, where available;
3)
internal budget, budget to actual and forecast data;
4) stub
period financial information;
5)
trailing 12 month, 24 month, 36 month or longer financial history;
6) trends
in revenues, costs and margins;
7)
information about key products, customers and markets;
8) key
contracts and agreements;
9)
litigation and legal matters;
10)
ownership and debt issue related information;
11)
environmental and technology issues, where applicable;
12) labor
force information, among other factors;
13) new business
and market information;
14)
requests for unique, customized and specific information not normally produced
by the seller;
15)
detailed information about specific assets and liabilities, and;
15) other and
ad hoc information as well as a long list of deliverables that are unique to
the transaction and much longer and more specific than this summary.
It is safe
to say that the process will be a stressful experience that demands specialized
transaction and project management experience. It will also produce a
significant workload in a compressed timeframe.
The
accounting function of the seller will bear a significant burden in support of
the transaction. Accounting departments that are often viewed as overhead and
less important to a business become a high priority in the transaction, which
can be problematic if their importance is not recognized, prioritized and
supported by the business during the transaction.
Successful
transactions I have participated in, were sales of companies that typically had
a history of external audits performed by a reputable CPA firm. In some cases
this was mandated by industry regulations or financial stakeholders (equity
and/or debt holders). In other cases, the company themselves undertook this
exercise voluntarily. No matter what the original reason was, when it came time
to sell, the external audit, even if not a requirement, was a significant
factor in the sale transaction.
While not
a rule of thumb, potential sales of entire businesses or specific assets within
a business I witnessed that had not been audited or reviewed in several cases did
not make it through the due diligence process. There are a number of reasons
for this, but the primary factor is overall seller credibility and the fact
that financial information included in financial statements and/or internal
controls could not be relied on by the buyer without a significant amount of
work being done at a large cost. Given that companies typically sell at a
multiple of earnings, cash flows or revenues, an investment in an external
audit or review typically more than pays for itself. Having said this, getting
through the due diligence process of a sales transaction takes more than
completing an external audit or review.
Furthermore,
even with the completion of years of audits, the transaction itself typically
adds additional burden to the seller as described herein and influences the
audit itself due to the risks associated and financial reporting requirements
specific to the transaction, among other factors.
For
example, let's say your company has been audited and is being asked to provided
comparative financial statements by the buyer in a situation where revenues,
costs and expenses have been reclassified from year-to-year due to changes in
the business or financial reporting processes or transaction types. In this
case your audit firm will ask that your current year numbers be classified
consistently with prior year numbers. If you have not kept your books in this
manner in the current year, this can be a problem that may be expensive to fix
and one that could slow down the completion of the current year audit which in
turn could slow down the close of the company sale transaction.
In
situations where the private company seller that has been audited in prior
years is selling to a public company, where public company reporting
requirements mandate that the private company report on stub periods, and requested
prior year comparative periods that do not match the historic year end
reporting periods of the seller as well as variations on these themes, the seller
may be required to prepare financial statements that have not been prepared in
specific prior periods, thereby putting a significant burden on the seller. For
example, seller company A with historic audited financial statement prepared on
a calendar year end basis, entered into a transaction that closed at October 31st,
was required to prepare audited financial statements at October 31st as well as
internal statements on a TTM basis at March 31st of the current and prior year
to meet the financial reporting requirements of the buyer faced the challenge
of creating interim statements that had not been prepared in the past that
therefore did not have account reconciliations that rolled forward and were cut
off on this basis.
I have
seen more company accounting departments that are not staffed with the depth
and breadth of staff to support an external audit and/or a company sale
transactions than those that are, mainly because sell side transactions, as
described above are not typically
staffed for in many businesses. In cases where the accounting function of the
seller is capable of supporting the external audit process, it often cannot support the due diligence requirements of a
sales transaction due to demands and timeline of the due diligence process due
to gaps in expertise and the day-to-day demands placed on the accounting
function by the business. Simply put, many if not most of the private company
accounting departments I have helped are not structured and staffed to handle
sell side transactions. Outlined below is a generalized description of in house
accounting department capability that I have worked with in medium to small
companies in connection with support of external audits and sell side transactions:
1) The
accounting function is limited to posting daily and month end transactions as
part of a closing process using accounting software;
2) the
accounting function can perform step 1) and can also prepare account reconciliations
and internal financial statements;
3) the
accounting function can perform steps 1) and 2) as well as generate prepared by
client schedules (PBC's) for a year-end audit;
4) the
accounting function can perform steps 1), 2) and 3) as well as financial
statements (i.e. balance sheet, income statement, cash flow statement and
footnotes) that can be opined on by the external audit firm;
5) the
accounting function can perform steps 1), 2), 3) and 4) above as well as
support the due diligence process in a sell side transaction.
In
scenario 1) above, the accounting function typically does not have the ability
to get through an external audit. In scenario 2) the accounting department may
or may not have the capability to complete an external audit and will typically
need outside help to do so. In scenario 3) the accounting function may be able
to complete the external audit in its entirety but may need outside assistance.
In scenario 4) the accounting department can support the external audit but in
most cases not the sell side due diligence requirements or timeline. In
scenario 5) the company has a staff with the depth, breadth and resources to
complete steps 1) through 3) and an external audit 4) as well as support the
due diligence requirements in a sell side transaction that results in the sale
of the business. I have found scenario 5) situations to be somewhat rare in
small to medium companies due to the cost and expertise required to meet this
benchmark.
In my role
as an outside consultant and internal staff, I have been typically asked to
work in scenarios 3), 4) and 5) with or in addition to the existing accounting
department however I have also worked in scenario 1) and 2) situations in order
to assist businesses prepare PBC's in support of an audit. The key here for the
seller is to plan and invest ahead. I have worked with successful entrepreneurs
who invested in their accounting function who had level 5) capability over
multiple years which allowed them to produce reliable historic information and
other information that has bolstered their credibility over the long-term which
made them more attractive sellers to credible buyers resulting in higher exit
multiples. In other words, they generated
a large return on their investment on their accounting and finance function. I
have also seen level 1) accounting function capability businesses that have had
sales transactions stall, enterprise values lowered or transactions not be
completed at all, due to financial reporting and/or internal control issues.
The manta here is that the returns on accounting department capability in a
transaction is significant based on exit multiples. because of this, the case
can be made for engaging outside accounting/transaction expertise when it do
not exist in house. In more basic and stark terms, I have witnessed stalled and
terminated sales transactions due to the lack of investment in the skill and
expertise needed to complete audits and/or transactions.
In conclusion,
the timeline and deliverables in a sell side transaction to complete an audit
and sale transaction are significant in this day and age and create a material burden
on the seller that they often cannot meet with internal resources. Timeline
demands also typically create a significant amount of stress on the seller. Put
another way, the deliverables and
timeline are typically beyond the existing accounting function capability of
many medium and small private sellers unless specifically planned for, staffed
for and invested in. Furthermore, the investment is generally more expensive if
deferred or if not made in prior years to the year a transaction close is
undertaken.
Please
contact me at greggecarlson@gmail.com if you have any questions or are interested
in speaking to me about transaction or accounting function support on an
interim or project basis.
