Getting to the Numbers Behind Your Business

Financial due diligence (FDD) is a fundamental part of getting the buyer comfortable with a contemplated transaction. Its purpose is to provide the buyer with a clear understanding of the target company’s financial situation, identify potential red flags, and support valuation. While serial acquirers will develop a degree of standardization in how they approach FDD, the scope and thoroughness of FDD are tailored to the unique characteristics of each deal.

Is Financial Due Diligence an Alternative to an Audit?

FDD is not an audit. For one thing, they have fairly divergent aims. Audited financial statements are used by readers like current or potential investors, creditors, vendors, and customers to assess the health of the reporting entity for a variety of reasons, including supporting investing, lending, selling, purchasing, and other operating decisions involving the company. FDD, on the other hand, is used specifically in contemplation of an M&A transaction to provide the potential buyer with sufficient germane financial insight on the target company. The exercises themselves are also quite different. An audit is a regulated assurance activity performed on financial statements to ensure they have been prepared in accordance with very specific standards. In contrast, while certain generalizations can be made about FDD, it may be performed in whatever way the buyer sees fit, and on less defined financial information. If the target company’s books are unaudited, the FDD team may start by performing a proof of cash, a rudimentary verification procedure to ensure cash receipts and disbursements per the company’s books reconcile to the bank statements. If the company has audited financial statements, the diligence team will use them to support FDD. But it is important to know what audited financials are to understand their utility and limitations for a buyer trying to assess a target company from a financial perspective.

Generally Accepted Accounting Principles (GAAP) are accounting and reporting standards that help ensure an important degree of consistency in format, measurement, and disclosure in financial statements across different companies, and even across industries. GAAP is established by an accounting industry group known as the Financial Accounting Standards Board (FASB) and the Public Company Accounting Oversight Board, (PCAOB) has the final word on what constitutes GAAP for SEC registrants.

But rules are of little value unless they are enforced. To give readers a level assurance that a company’s financial statements comply with GAAP in both form and substance, some companies have their GAAP financial statements audited. Audits are assurance engagements conducted by CPA firms in accordance with performance standards set by the American Institute of Certified Public Accountants (AICPA). The auditor’s report prefacing the financial statements is its expression of the CPA firm’s opinion on the financial statements’ adherence to GAAP.

Capital markets function better because of the discipline audited financial statements provide in communicating financial information. But not all companies are required to incur the cost of having their financial statements audited. The SEC requires publicly traded companies to file audited financial statements. Banks may require audited financial statements from privately held borrowers and loan applicants, depending on the amount and nature of the debt. And current and potential equity investors in private companies may require regular financial statement audits as well to allow them to assess whether the company’s managers are serving as good stewards. Because common accounting format, language, and principles are used across companies reporting on a GAAP basis, users of these financial statements can much more readily understand what they are reading. And when the financial statements have been audited for compliance with those common reporting standards, readers can have a greater sense of trust in the veracity of the information they contain.

GAAP requires fairly comprehensive disclosure and presentation, typically for two years of activity. So readers will find GAAP-basis financial statements useful for most common business purposes. But GAAP does not require presentation in highly granular form (e.g., transactional-level detail, highly detailed line-item presentation, or monthly performance) or broken down along every conceivable dimension. Such prescriptive standards would be too exhaustive for FASB to administer, and prohibitively expensive for companies to follow and have audited. So despite the high degree of standardization and assurance audited financial statements carry, their basis of presentation is not flexible enough to satisfy all the needs buyers face when making M&A decisions.

What FDD Does for a Buyer that Audited Financial Statements Can’t

FDD is generally conducted by CPA firms too, but under consulting service standards rather than the attest standards applicable to an audit. As part of the buyer’s diligence process, the FDD team will organize the company’s financial information in ways that facilitate the most meaningful buy-side analysis and will make their own determination on how to allocate their verification and analytical efforts. Compared to financial auditors, who are supplied with the standards that define the final product (GAAP-compliant financial statements), an FDD team must use its judgment to define a work product that provides both presentation and measurement most supportive of the buyer’s purchase decision and valuation. Furthermore, while auditors must comply with stringent testing standards in order for their services to qualify as an audit, an FDD team has far more leeway in determining where to focus its scrutiny and how much effort to spend vetting details. That said, if an audit has been performed, the FDD team will request the seller’s permission to have their auditor release the audit work papers for the most recent years’ audits. These can reveal helpful insights regarding control weaknesses and misstatements the auditors caught and corrected before the financial statements were published.

Unlike audits, FDD need not adhere to output and investigative standards prescribed by regulation. In FDD, the buyer’s diligence team decides how many years of financial data to analyze, determines how the information should be organized and presented, can redefine appropriate measurement practices and make measurement adjustments, and can selectively focus validation efforts. Since different circumstances call for different ways of breaking down or summarizing the company’s financial information, FDD affords the buyer the opportunity to take a more tailored approach to evaluating the financial health of the business. With this flexibility, P&L may be analyzed over a longer time span and is broken down into shorter (e.g., monthly) time increments, revenue may be broken down by various customer cohorts, and innumerable other perspectives can be prepared. The fluidity of FDD allows the team to dynamically generate important questions that provide the buyer deeper and more relevant insights.

When combined with commercial due diligence (CDD) and other key diligence work streams, FDD is therefore a powerful tool that lets the buyer identify potential risks, liabilities, and gaps in financial performance, as well as hidden assets, untapped resources, avenues for growth, and potential synergies.

Sell-Side FDD

It is typical to think of FDD as a buyer-driven activity. But sellers in the lower middle market (LMM) and up are often well served in conducting their own FDD first to be better prepared for the buyer’s diligence process. As an example, a seller-commissioned quality of earnings (QoE) review can reveal:

• Owner/operator perquisites buried in the company’s cost structure that, while valid business expenses, arguably would not have been incurred if the company had not been owner operated.

• Episodic P&L events, such as legal accruals, settlements, or losses on discrete projects that are anomalous. Identifying these gives management the opportunity to recollect the underlying reasons and articulate credible arguments for why they should be considered outliers and removed when assessing the company’s historical performance.

• Shifts in the cost structure and revenue patterns over time. This affords management an opportunity to better delineate between significant phases of the company’s historical development, frame the company’s journey in terms of the reasons for past strategic pivots, and articulate how lessons learned from these initiatives informed the company’s subsequent development and current direction.

When the seller initiates due diligence, including FDD, it is usually referred to as vendor due diligence (VDD). Even though buyers may use outside vendors to handle various due diligence work streams too, the term VDD is reserved for diligence commissioned by the seller, which emphasizes the third-party nature of the work. The VDD report provides a consistent sales message while presenting a robust and independent view. Even though the provider works for the seller, a VDD report can add substantial value for the seller in a competitive sales process. It raises questions and sheds light on issues of interest to potential buyers from the perspective of a third-party consultant, and it adds both ease and speed to the buyer’s diligence phase. Many prospective buyers are comfortable enough with VDD to truncate the time and money they spend on their own due diligence, so that joining the pool of suitors is less cost prohibitive and the pool of competitors is expanded.

If you are the seller of a small or mid-sized business that has massively under-invested in financial hygiene, you’re a step behind, and hiring an accounting firm to perform a QoE review or broader VDD is probably not the best first step. Obtaining consulting services to correct some of your biggest accounting and reporting shortfalls is your most productive next move.

Buy-Side FDD

There is not a bright line between FDD and other areas of buyer due diligence. Different diligence work streams often overlap, and their teams build on each other’s work. Together with complementary diligence and armed with an understanding of the company’s business model, FDD commonly covers the following interrelated areas:

• QoE review. QoE focuses on the detail underlying EBITDA and is designed to assess the persistence of the earnings measure that drives the transaction’s value. Typical requests to support QoE analysis include monthly trial balances and reporting packages, aging schedules for accounts payable, accounts receivable, and inventory, calculation of reserves and roll-forwards, details of other current assets and liabilities, and historical capex and fixed asset detail, as well as relevant breakdowns for revenue and margins requested for CDD, such as by customer, product channel, and/or geography. QoE analysis takes a higher frequency viewpoint on the company’s financial information than do externally issued financial statements (monthly vs. annual), and includes transaction-level review of certain accounts for activity that could reveal important information. (For instance, elevated legal costs could be indicative of unresolved or threatened legal action.) Balance sheet analysis is an integral part of the QoE review, allowing the FDD team to identify asset and liability misstatements that have had a corresponding impact on earnings. For instance, overstatement of current assets due to the failure to write off damaged, obsolete, or slow-moving inventory or aged and uncollectible receivables will not only misstate the company’s NWC trends (which are a critical aspect of the price calculation in the definitive sale and purchase contract), but it misstates earnings as well. The QoE work must also adjust out any non-operating earnings arising from the existence of non-operating assets that are excluded from the transaction. In addition,, the FDD team will analyze the statement of cash flows in order to determine how well cash flows reflect the company’s operating earnings, as well as to evaluate the company’s pattern of capital investment and financing activity. Ratio analysis covering the company’s balance sheet, income statement, and statement of cash flows will be used to evaluate the company’s solvency, liquidity, efficiency, productive use of resources, and more.

• Review accounting policies and choices. The timing and amounts for the recognition of revenue and expense often require considerable judgment on management’s part. Not only should recognition policies be chosen to reflect activity in the right time period, but changes in these policies should be well supported to avoid inconsistency between periods. Similarly, the recognition and measurement of assets and liabilities and associated gains and losses upon disposition are significant components of a company’s balance sheet and income statement. Throughout FDD, the team remains alert to signs of earnings management—the practice of manipulating the timing or amounts of transactions to misrepresent financial performance. It is especially important for FDD to evaluate revenue accounting policies and whether management is adhering to them consistently if the company’s financial information is unaudited.

• Assess financial accounting and reporting systems. The company’s financial accounting systems are a critical determinant of value for the buyer. Not only do they play a central role in giving the buyer an accurate financial picture that will support a reasonable valuation, but systems that are appropriate for the company’s business model must be in place so the buyer can manage the business and evaluate results post transaction as well. Whether the company has a simple accounting package in place or uses an advanced enterprise resource planning (ERP) system, the diligence team will acquire an understanding of how accounting activity flows through the company’s systems. The ease with which the seller can facilitate the buyer’s FDD process will also be indicative of how appropriate the target’s accounting setup is.

• Compute the net working capital (NWC) adjustment. The FDD team also computes a price adjustment for the difference between the company’s NWC at closing and its normalized/average level over the company’s business cycle. Most deals are structured to transfer ownership of current assets and current liabilities to the buyer, and give the seller dollar-for-dollar credit for all cash on the balance sheet at closing. But the level of other current assets and current liabilities naturally fluctuates and may not reflect their average levels at closing. Therefore, the NWC adjustment is designed to ensure the transaction price is adjusted up/(down) for the amount of NWC actually received by the buyer in the transaction that is over/(under) the normal average level required to operate the business on an ongoing basis. The QoE review will allow the FDD team to recast the components of NWC so that the monthly balance sheets are consistent with monthly adjusted EBITDA. But just as the QoE review ultimately condenses trailing monthly adjusted EBITDA down to a single, normalized annualized earnings metric to be used in valuation, the FDD team must also use the monthly NWC components, as adjusted, to determine the equilibrium level of NWC needed to produce the company’s earnings. It is this normalized NWC level that is used to compute the NWC adjustment to be used in the transaction price formula. The agreed time period over which NWC should be normalized will be agreed by the parties as specified in the LOI.

• Debt, debt-like items, and non-operating assets and liabilities. Closely related to the NWC adjustment is the treatment of debt and debt-like items, and non-operating assets and liabilities need to be considered as well. A quick run-through of the balance sheet to examine what the buyer is getting helps make this point. Operating assets are, obviously, integral to the company’s enterprise value (EV) for which the buyer is paying. Non-operating assets and liabilities that will stay with the seller can be legally carved out; they don’t contribute to the earnings used to calculate EV and therefore don’t require a price adjustment. Interest-bearing debt paid off at closing or assumed by the buyer are deducted from the proceeds to the seller, so the FDD team must ensure these are completely and correctly reflected on the balance sheet, and there are no unrecorded or under-recorded liabilities. And, finally, items of NWC transfer to the buyer, and a NWC adjustment ensures the transaction price includes NWC at its normal average level over the company’s business cycle. But the seller and the buyer may have different views as to whether certain balance sheet items should be treated like debt, with a dollar-for-dollar price adjustment, or as part of NWC, subject to price adjustment for normalization. As an example, deferred revenue represents a performance obligation on the part of the company. The buyer may argue it should be treated like an item of debt, and it should therefore be deducted from the net proceeds paid to the seller at closing. On the other hand, if it is an aggregate balance similar to accounts payable that is expected to be maintained consistently into the future in connection with the operation of the company’s business model, the seller will prefer this to be considered part of net working capital, since it is an integral part of running the business. Viewed from this perspective, the float provided by the deferred revenue balance actually reduces the owner’s net investment tied up in working capital assets; assuming the normalized level of working capital is close to the balance at closing, its presence could have little or no impact on the NWC adjustment. These treatments have significantly different implications for net proceeds to the seller. How it is resolved may depend heavily on whether the balance arose primarily from recording contract assets in accordance with financial accounting rules or from the receipt of customer cash–and if from the receipt of cash, whether it has been invested in working capital or is still in the bank account and will increase the seller’s payout at closing. Regardless, the FDD team must understand the ground rules for how the parties will handle balance sheet items when performing their work.

• Identify questionable business decisions leading into the transaction.  Depending on the terms of the deal, the seller may have incentive to take actions in the final months of their ownership that are more geared toward last-minute window dressing than preserving the long-term health of the business. This may have started long before the deal process began, such as allowing fixed assets to age. More recent decisions can include attempts to boost short-term cash positions by deferring regular maintenance on operating assets, delaying timely payment of vendors, and failing to maintain healthy inventory levels.

• Identify unknowns. Understanding the business model naturally leads to anticipation of what items are in the financial statements, which allows the FDD team to determine potentially unrecorded balances.

• Tax positions. Tax is the subject of its own diligence work stream, but it overlaps with FDD. It is often combined with FDD and performed by the same CPA firm. The company’s tax assets, liabilities, and valuation adjustments will be recorded on the company’s balance sheet, but the buyer will need to determine whether they will factor into the purchase price at face value. Specialized tax expertise is needed to identify potential misstatements as well as other important tax risks and implications for the transaction.

• Identify potential deal breakers. Answers derived from all the foregoing areas help the buyer in a process of discovery about the company. But they can also unveil unexpected information not previously disclosed by the seller that can quickly refute the buyer’s investment thesis.

• Prepare financial projections.  Financial modeling combines form and history obtained from FDD as well as drivers developed from insights obtained during CDD. It is a critical output that can be used in complementary discounted cash flow-based valuation, and reflects whether the evidence bears out the buyer’s investment thesis for the target company.

Summary

If the seller goes into the deal unprepared, financial due diligence can be messier and more protracted, can leave the buyer more ill at ease about the company’s financial health than necessary. This can easily threaten the deal. But these problems are often avoidable. Sell-side action before the buyer gets involved can make for a more seamless transaction and higher valuation for the seller.

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