Over the years, my partner Dan and I have worked and communicated with hundreds of companies in the lower-middle market nationwide. And if you were to ask me to give you just one characteristic that they all have in common, I would say they almost all have financial statements that can be improved – some even significantly so.
The degree of inaccuracy, of course, varies by case but I think it’s important to understand why accounting issues are so prominent, even in larger companies in the middle market.
First off, almost all businesses start small. Understandably, those small businesses often cannot afford an experienced and competent bookkeeper. Therefore, the books are often kept incorrectly from the start. And, once the books are in disarray, they are difficult to undo. That can cost lots of time and money that owners either don’t have or don’t want to invest.
Most owners can live with imperfect financials, but buyers cannot. Buyers buy businesses to secure future cash flows and if they cannot accurately and confidently understand what historical cash flows have been, they either lose interest or pay less than what the business may otherwise be worth with sound financials.
I was sitting in an M&A discussion panel a few years ago in which a Private Equity Managing Director was asked about how they deal with target businesses that they want to buy with poor financial statements. His response was that in the absence of verifiably sound financials, they automatically assume that they will uncover issues in due diligence (usually overstatement of cash flows) and, thus, build a discount into their offering price as a result.
The thinking behind this makes sense. Private Equity firms carry with them a stigma among many business owners (fairly or unfairly) of being overly shrewd buyers and operators of businesses. Therefore, the feeling is that any attempt to renegotiate (or “re-trade”) a deal will be seen as a calculated effort to take advantage of the business owner, even if the buyer’s position is founded and the financials were in fact overstated. Therefore, the firm builds in a cushion (in this case the figure mentioned was as high as 10%!) so that when issues like these are uncovered, the buyers can live with the new reality without having to go back to the table to renegotiate and risk blowing the deal up or, at a minimum, start the new relationship with a sense of bad blood between the parties. In the somewhat rare instance where the buyers either do not uncover any anomalies or uncover anomalies that actually show that the seller was understating cash flows, then the buyers just got an even better deal! It is a classic lose-lose proposition for sellers.
Alternatively, businesses who wish to be properly prepared for a transition should strongly consider hiring an experienced accounting firm to perform a Quality of Earnings report. These reports will help identify accounting anomalies within the business and propose solutions going forward (in addition to suggesting adjustments to true-up prior year statements) that ensure the statements adequately reflect the true performance of the business.
Taking your company to market with true and accurate financial statements (backed up by a reputable third-party accounting firm’s Quality of Earnings Report) will likely increase the number of buyers that would be interested in the business and, correspondingly, the ultimate price and terms offered by prospective buyers. If the 10% of enterprise value is to be considered, this represents a massive return on investment that business owners would be foolish to pass up. An ounce of prevention and all that…
If you have any questions about Quality of Earnings Reports, or any other questions related to value acceleration or the sale of your business enterprise, please do not hesitate to contact Wes Shelton at SM2 Advisors. ([email protected]).