When a buyer is evaluating the potential purchase of a target, due diligence is a critical component in getting a sense of the quality of the business beyond the stated revenues reflected in the annual income statement. Intangible factors to be explored and understood include the type of customers, the competence and skills of the technicians, and the tenure of customers and technicians. You also should become familiar with the quality of management in terms of maintaining proper records, overall customer satisfaction level, and the efficiency and cohesiveness of the business in terms of minimal technician turnover and customer defections because of poor service.
Beyond operations, there are also administrative factors such as technician injury claims, property damage, vehicular claims, delinquent sales tax, income tax and payroll tax filings, cash transactions coming in and going out of the business, etc. These are some intangible factors that shape and define the quality of a business being targeted for acquisition.
A proper evaluation of these intangibles often are overlooked or not properly evaluated in the context of the quality of the business being purchased. A buyer should use due diligence to examine these aspects as a meaningful component of decision making, because they could mean the difference between getting sucked into a mess or gaining a solid platform for sustained growth.
Applying an industry rule-of-thumb multiplier to the target company’s revenue is a simple, but often wasted exercise, given various determining factors that make one business more valuable than another. The mix of recurring revenues from annual customer contracts vs. one-shot treatments, for example, highlights the difference in each dollar of revenue being reported on the income statement, which will cause significant differences in the perceived value of the overall business being looked at by a buyer.
The ballad of the balance sheet
Many buyers focus predominantly on income statements when looking at types of revenues, corresponding gross profit margins and expected free cash flow of a business. The balance sheet is the forgotten stepchild that tells a different, but important story that shouldn’t be ignored in the evaluation of a targeted business. For example, consider the following situations and their impact:
1. If accounts receivable are 60, 90 or 120 days past due, are customers just slow to pay? Are they unwilling to pay? Or are staff’s collection efforts ineffective?
2. Does the paid-in-capital section and retained earnings (equity section) show little money invested and/or left in the company by the selling owner? An under-capitalized company is more likely to cut corners, which could tarnish aspects of the business. Therefore, its reputation might be one of a low-cost and low-quality business.
3. Does the accounts payable section of the balance sheet seem excessive? Does the aging reflect that vendors/suppliers aren’t getting paid on a timely basis? Extended accounts receivable and accounts payable is a bad combination, and could be a sign of problematic customers or poor internal administration. Either way, it’s a serious concern.
4. Are there outstanding balances owed to employees? Are payroll and sales tax liabilities paid to-date? Are taxes filed in a timely manner? Companies with cash flow problems borrow from employees, vendors and the government when they fail to make vendor payments or payroll tax payments on time. These problems point to a poorly run company — or one with significant cash-flow problems.
The balance sheet tells a unique story, and the buyer should practice due diligence to get a 20/20 view of the potential acquisition under consideration. This includes the balance sheet and the intangibles mentioned earlier. A seller should prepare to answer the tough questions that a prospective buyer will (or should) ask during due diligence.
Conversely, if you have positive answers on many of these potentially adverse issues, it’s a way to command a premium price. After all, now you can easily distinguish yourself with solid evidence of why your business is worth more than others with similar revenues.
Beyond scrutinizing the balance sheet, additional areas to properly vet are the types of commercial insurance policies in place to cover — not only property damage and personal liability — but also errors and omissions coverage and employee worker’s compensation claims. Are these policies on a “claims-made” basis (the most common and least expensive)? Or are the policies occurrence-based? That term means the policy procured still stands in place for any claims arising from acts or omissions while the policy was in force, but the claim is made years in the future (a more expensive proposition, but clearly a greater value). If it’s a claims-made policy, a tail cover will need to be purchased for several years. This is an added cost that’s usually paid by the seller for claims made after the sale, because the act that gave rise to the claim occurred prior to the closing of the transaction.
If a buyer plans on constructing an asset purchase transaction, with no assumption of any seller liabilities, why does any of this matter? It’s a logical question, but what about the theory of successor liability, which allows a buyer to be sued for a seller’s prior acts under certain circumstances, even if the buyer didn’t agree to assume any liabilities when it purchased the assets of the seller’s business?
As a result, a buyer should take heed to study the seller’s in-force policies to get a sense of whether the seller can meet any indemnity obligations owed to the buyer, especially since the seller is liable for any claims that arose before the closing of the deal. If not, the buyer should focus on limiting any unwanted exposures, including a holdback of a portion of the sales price to cover any potential exposures that might exist that aren’t completely covered by existing occurrence-based insurance policies or tail cover policies, extending claims-made policies.
John P. Corrigan, Esq., Hall of Famer Norm Cooper and Daniel S. Gordon, CPA, comprise the PCO M&A and Succession Specialists practice at PCO Bookkeepers. For more information, email at firstname.lastname@example.org or visit PCOSuccessionPlan.com.