While the volume of M&A transactions was down for 2019 versus 2018, most M&A advisors view the year as a success and are bullish on activity in 2020. If you’re considering an acquisition, joint venture, or merger, then a business valuation or M&A professional can help you vet a prospective deal and improve your chances of success.
Conducting due diligence
M&A due diligence typically starts with a review of the company’s historical financial performance. Audited financial statements offer prospective buyers’ greater assurance than reviews, compilations or internal statements. Unaudited financial statements may require a so-called “quality of earnings” report to get a clearer picture of what to expect.
Even so, what you see may not be what you get. Adjustments to the historical financial statements may be needed to estimate the buyer’s expected return. Examples of these adjustments include:
Valuation experts can also spot hidden costs and help buyers verify a seller’s intellectual property ownership claims. Inexperienced buyers may not realize how costly it can be to train newly merged employees or integrate IT systems, or how difficult it can be to dispose of real estate holdings.
A valuation expert will be able to assess whether a seller has positioned their company for long-term growth by investing in equipment maintenance, staff training and management succession. Additionally, they will be able to identify potential risk factors that might warrant a lower offer price, such as weak internal controls, reliance on key people, aggressive tax strategies and unfavorable contract terms (or lack of formal contracts).
Projecting financial results
When determining the offer price in the M&A market, historical financial performance should not be weighed too heavily. After all, historical performance is only relevant to the extent that future performance may follow a similar trajectory.
Projected financial statements, therefore, must become an important part of an offer price evaluation.
The input of a valuation expert is key for the consideration and examination of projected financial statements, as new changes to the tax code were made in December 2017 with the passing of the Tax Cuts and Jobs Act (TCJA). TCJA created the need to ensure that property adjustments reflect a company’s operating conditions and not just their tax benefits.
Each business will be affected somewhat differently by TCJA. As such, it’s important to understand how all the TCJA changes have been reflected in a company’s projected financial statements.
Changes to depreciation rules allow companies to expense capital improvements either immediately or on more favorable terms. The result is lower reported income, but adjustments should be considered both from a financial reporting perspective and a cash flow perspective.
If a seller’s financial projections were prepared in-house, inquire as to how well the person who prepared them understands the TCJA. In some cases, a valuation professional who’s familiar with the TCJA may need to prepare (or adjust) the company’s projections.
Structuring a fair deal
How much are others paying for similar businesses in today’s hot M&A market? Mere reliance on industry rules of thumb or EBITDA multiples can be misleading and potentially lead to over-payment. A valuation expert can use private company transaction databases to generate pricing multiples based on real-world transactions. They can also adjust these transactions to reflect growth, the nature of the transaction (e.g. a strategic financial, or troubled company transaction), and the relevance of the transaction to subject company. Moreover, private company transaction databases provide insight into typical deal terms in the company’s industry. In general, sellers prefer stock sales, because they provide a clean break — the buyer purchases all assets and assumes all liabilities, including undisclosed and contingent obligations. Stock sales also may lower the seller’s tax obligations, because proceeds are taxed at long-term capital gains tax rates, which have historically been lower than ordinary-income tax rates.
In an asset sale, proceeds are typically taxed as a combination of ordinary income and capital gains. Buyers like this type of deal because it allows them to cherry-pick what’s included (and excluded) in the deal. Additionally, asset purchasers are generally only responsible for the liabilities expressly assumed and those secured by the purchased assets.
As a general trend, the TCJA lowered ordinary-income tax rates, narrowing the disparity between stock and asset deals. This may make an asset sale more attractive to some sellers.
What can be done?
M&A transactions can be complicated and require expertise that most private business owners simply don’t have. A business valuation professional brings critical assets to the negotiating table — including M&A experience, modern tax know-how and objectivity.
To assist you in understanding the Middle Market, UHY has recently surveyed business leaders across the country on a number of topics, including whether they expect market multiples to increase (over two-thirds do!), will they be growing via international expansion or acquisition and whether they have created a succession plan.
Click Here to download your copy of our 2019 Middle Market Survey.