Sellers: What Are You Worth and How Do You Support That?

Your investment banker may tell you that a seller’s valuation is mostly based on current multiples in the market and how the company’s reported metrics compare to its peers. However, financial due diligence practices show that there are many other factors (consistency, transparency, pro forma adjustments and other preparation) that can materially affect a company’s valuation and make the difference between a successful deal and failed expectations.

In recent sell-side preparation engagements, some of the aforementioned factors have resulted in as much as 30% of deal value premium and improved negotiation leverage for our clients. Alternatively, not pursuing the methods outlined below has prevented some companies from realizing the true value that they deserve.

The following are a few due diligence preparation examples that sellers can follow in their efforts to optimize value.

Clean up reporting to show consistency

Why it is important

Buyers evaluate the consistency of year-over-year monthly, quarterly and annual trends, which gives them more confidence in the target company’s ability to consistently generate reported (and often unaudited) earnings. Therefore, consistency usually merits better valuation multiples.

Consistency also helps in evaluating your true normalized trailing 12 months (TTM) performance on which most valuations are based.

In addition, consistency helps you prepare for the terms and conditions of the purchase agreement and understand how the terms associated with earnouts and other future payouts depend on the monthly performance you reported and will continue to report. Misunderstanding in this area can significantly affect your total payout and often times lead to post-closing M&A litigation.

What to look for

Here are some examples of financial reporting that may need to be addressed prior to a transaction.

• Revenue recognition can often times be inconsistent under the cash basis of accounting as compared to accrual, which can skew the numbers in or against the seller’s favor.
• Accruals can be irregular and again skew due diligence period numbers that a valuation is based on (e.g., if software or other capitalization is not properly accrued every month that lowers your TTM EBITDA).
• The seller’s tax accountant may have made year-end adjustments that can be favorable for tax reporting purposes, but hurt the company’s reported earnings as it prepares to exit or raise money (e.g., creating a year-end balancing/reconciliation lump sum “plug” that then drags down the month of December as compared to other months; or using the wrong accounts as quick “plugs,” such as payroll instead of owner distributions, could lower your EBITDA).

Prepare your supporting evidence

Why it is important

It’s critical to maintain credibility and trust with a potential buyer. Show them that you have the supporting evidence to back up any of your claims. Otherwise, you may be handing the buyer an opportunity to knock down your value because of lack of substantiation.

Supporting evidence and the manner in which the seller arrived at it can be included in the seller’s closing adjustments and post-closing earnout/escrow structure, so it minimizes risk of losing value on the tail-end of the deal closing. Proper documentation can shorten the due diligence and deal closing timeline and ultimately save both sides significant unanticipated transaction costs. It also minimizes the possibility for post-deal M&A litigation – something both sides will want to avoid.

What to look for

Here are some examples where supporting evidence may need to be provided to a buyer.

• If the seller recently consummated an acquisition or launched a new line of business, that pro forma annual impact needs to be carefully calculated and can amplify valuation.
• In founder-owned businesses, it is common to run personal and “related party” expenses through the company’s tab. These could negatively impact reported earnings and valuation and should therefore be excluded as non-recurring during preparation. Detailed evidence helps a potential buyer accept these add-back adjustments.
• Any new performance improvement initiatives that have affected the business in the past year can be noted as pro-forma adjustments to the trailing 12 months (TTM) EBITDA for valuation purposes. They need to be carefully documented so that the buyer’s due diligence team can clearly follow the logic and evidence and thus give credit to it.

Correct any major reporting issues or opportunities prior to going to market

Why it is important

Get your house in order before you list it for sale. If a buyer finds major reporting issues or inaccuracies, they may lose trust in the seller, deem the target company’s accounting capabilities subpar, and therefore discount the value. On the other hand, if accounting inaccuracies are in the buyer’s favor, your company could leave value on the table.

You should address these issues and opportunities before you go to market, and be transparent and proactive about resolving any issues that come up during the transaction process.

What to look for

Here are some examples of financial reporting that may need to be addressed prior to a transaction.

• Seller has not accrued important expenses that are typically required to be accrued as per GAAP (e.g., not having written off bad debt where necessary).
• Seller has not capitalized amounts that can be capitalized under GAAP.

Prepare, analyze and highlight underlying KPIs

Why it is important

Key performance indicators (KPIs) are equally as important as a company’s reported financials, and tying the two together allows the business to stand confident in front of any buyer and demand a premium.

While in the past KPIs were mostly evaluated in the context of technology M&A, the fast pace of evolution and competition in most industries nowadays has rendered KPI evaluation critical in any M&A scenario. Buyers want to know if the business can consistently continue to deliver the value it has demonstrated historically, and KPI diagnosis can support that. It amplifies the company’s financial due diligence preparation and can often times enhance its valuation and negotiation leverage.

What to look for

Depending on the company’s industry, operational and monetization model, KPIs include, but are not limited to, metrics such as sales per sq ft, contribution margin per unit, customer acquisition cost and contribution margin, customer lifetime value, cluster analysis,  and many more.

Analyze pro-forma impact of material events or changes in strategy

Why it is important

These events and changes can materially affect the company’s bottom line and may significantly affect value. In order to fully realize the benefit, pro-forma normalized adjustments to TTM reported earnings is one way to adjust and incorporate that into company valuation.

What to look for

Examples of material events or strategic advantages include winning a material long-term contract, investing in a new facility that will drive further growth, and cutting costs through a performance improvement initiative.

Show ease or process of post-deal integration

Why it is important

Integration costs of a business can be material and influence a buyer’s interest as well as valuation offered. They can affect the projected performance of the business and the earnout and any other future payout which is based on realized performance post-integration.

Buyers don’t want to lose value after a deal has closed, and post-deal integration is a critical period for realizing that value. To that end, a potential buyer may want to know how successful a seller has been in generating synergistic value through past acquisitions and understand what to expect for integration in the current transaction.

Failure to integrate or costly integration can result in decreased valuation, decreased future payouts and potential litigation.

What to look for

• Automation of your reporting and operating systems
• Standard operating procedures as a guide to how the business is run
• Ease of data integration

Analyze and present quantified NPV (Net Present Value) of synergies

Why it is important

Many sellers do not include the future estimated synergies if entering into a M&A transaction with a strategic acquirer or as an add-on to portfolio of a financial sponsor. While the synergies will be realized post-transaction and under the new entity, the benefit should be split prior to the transaction. A buyer will often rely on the lack of sophistication or preparation of a seller and reap full benefit of the NPV of synergies.

What to look for

• Reduction in shared sales or marketing force costs
• Increase in reimbursement rates
• More favorable contract terms
• And many others

Sell-side due diligence can help you realize value

The above are only select examples of actions a seller or company raising funds can undertake and prepare to realize the optimal valuation of the business they have so carefully built. Some of them will vary depending on the industry, the stage of growth and the financial and operational structure of the business.

Too often we see sellers who have been meticulous, cost-sensitive and shrewd when building their company, but end up leaving significant value on the table by not properly preparing or rushing through an ill-advised transaction process.

Contact me or another member of Kaufman Rossin’s transaction advisory services team to learn more about how we can help sellers plan an exit strategy, navigate the deal process, conduct sell-side due diligence, and gain negotiating leverage to maximize value.