Can Your Business Withstand the Scrutiny in a Sale Transaction?

Many years ago you started your own business. At some point – perhaps recently – you reached the point where you no longer want to run that business on a day-to-day basis. Moving forward, you have two primary options: hiring a CEO/operator to run the business while retaining your ownership stake, or selling the business. Each has corresponding risks and opportunities. 

Let’s assume you decide to sell your business. Since most entrepreneurs only experience one exit in a lifetime, this is likely the only time you’ll undertake this process, so you’ll want to be prepared. You’re probably not clear on what the process entails or how to implement it. Accordingly, it’s best to have a good “deal team” around you. This team includes an M&A attorney, accountants and an investment banker. 

Not all sellers utilize an investment banker to facilitate a sale, but their primary role is assessing the company’s value and creating a market for it. An M&A attorney drafts and reviews sale agreements and assists with negotiating the various terms and conditions included in such agreements. However, the most important issue that often is overlooked by a seller is whether the company is prepared to be sold. What does this mean? There are many facets of a business, so a seller should consider whether the company’s operational, financial, tax, legal and regulatory matters are in order.

While this blog primarily is focused on the financial and tax aspects of preparing a company for sale, I will touch briefly on the other areas first. Some issues that should be considered include:

Operational:

  • Is the company at maximum capacity? 
  • Are manufacturing processes current?
  • Has equipment been maintained and updated? 

Legal and regulatory:

  • Are the business’ articles of incorporation current?
  • Do board minutes exist that support corporate actions?
  • Are there any legal contingencies that need to be resolved? 
  • If the selling company operates in a regulatory environment, are there outstanding issues or matters that may cause an exit to be delayed?

Our RyanSharkey M&A team has seen sale transactions delayed or terminated as a result of issues identified in the areas highlighted above. Yet, given that transactions typically are valued based upon historical financial results, a seller should ensure that financial information provided to a potential buyer can stand the scrutiny of the buyer’s due diligence. If the financial information is found to include errors, or the information was overstated, the transaction value could be reduced, or the transaction could be terminated. At a minimum, there likely will be less trust between the seller and potential buyer.

From a financial and tax standpoint, there are several questions that sellers should address as part of the transactional process. First and foremost, has the company been audited? If not, is the internal financial information prepared in accordance with generally accepted accounting principles (GAAP)? If the company’s financials are not reported on a GAAP basis, a seller will want to ensure the financial information is adjusted to reflect GAAP. Depending on the depth of the company’s accounting team, a seller may need to consider supplementing their team with outside resources. For example, a seller could consider engaging an accounting firm to perform sell-side due diligence. This includes performing a quality of earnings analysis (QofE). A QofE determines normalized earnings before interest, taxes, depreciation and amortization (EBITDA). EBITDA is commonly used by a prospective buyer to develop a price to bid on a company. Normalized EBITDA typically includes adjustments made by sellers to normalize for items that do not reflect normal operations. EBITDA commonly is adjusted for “owner costs,” including ownership’s vehicle expenses, excessive salary, personal offices and life insurance. Other items that are adjusted include “one-time” items such as a legal settlement that won’t recur in the future, gains or losses on sales of assets and one-off sale transactions.

Transaction documents commonly include a working capital target so the business is left with sufficient working capital for the buyer to operate it post-transaction. The working capital target is usually determined on a cash-free, debt-free basis, meaning the seller takes any cash remaining in the business at transaction closing and settles any outstanding debt. Additionally, working capital is normalized to remove non-recurring components, including owner life insurance assets and any owner-related liabilities. It’s important to determine an appropriate working capital target so neither the buyer nor the seller is required to fund any significant adjustments to actual closing working capital.

Sellers also get tripped up on tax issues when selling their business. Sometimes it can be at the federal level, such as an invalid S corporation election, or it can be at the state or local level, such as not filing in jurisdictions where the company operates. If there is a tax exposure, the seller and/or the company, depending on organizational structure, could be subject not only to back taxes, but also penalties and interest, which could be significant. It’s important to resolve these matters, or at least have an action plan to resolve them, prior to closing the transaction. These are matters a potential buyer will not want to inherit post-transaction. A seller will want to consult an experienced M&A tax advisor when contemplating a sale to assess any tax exposures.

As you can see, it’s important to be prepared prior to a sale in order to avoid transaction pitfalls that have ended many transactions in the past. If there is an issue that comes up during the process of preparing a company for sale, it can be proactively dealt with, as opposed to having a potential buyer uncover it during their due diligence process, and then a seller having to react quickly in order to keep the deal from dying. This most likely will lead to a decrease in value and delay the closing of the transaction.

Do you have any questions about preparing for an M&A transaction, or other transaction advisory matters? Please contact Ricky White, CPA, at 703-652-1489, or please feel free to leave a message below.

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Material discussed in this article is meant to provide general information and should not be acted on without professional advice tailored to your firm’s individual needs.



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