5 pointers for business buyers

Whether your client is looking to acquire a business as an investment, growth strategy, or new career, you can help by pointing out that due diligence is about more than just risk and payoff. A well-executed due-diligence process can:

• minimize the time and cost invested in the acquisition process;
• secure the best possible deal for your client;
• enhance potential return on investment; and
• improve the clarity of risk for the buyer and his financiers.

Here are five things to consider.

1. Strong management team

A strong management team is critical for any business to remain sustainable. If the current owner is leaving but has been actively involved, the buyer must ensure a capable management team is in place to run the operation, and retain customers and vendors.

Advise clients to talk to members of the management team about top customers. Ask questions to determine who has relationships with each, and how likely it is that customers, especially those not bound by contractual agreements, will stay once the owner leaves.

2. Positive cash flows

A quick scan of the numbers isn’t enough. The value of a business is based on its ability to be profitable in the future. Historical earnings are a good indicator, but dig deeper to understand whether the historical earnings the vendor’s claiming are sustainable. Look at trends in sales, gross margins and expenses.

For example, a business might show a significant increase in profitability in the current year compared to the prior year. At first glance that’s good news, but look closely and you might find a transaction took place that will never be replicated.

This also applies when analyzing expenses. A decline in expenses might be positive, or might mean a cutback on maintenance and repairs because the owner is selling.

Spend several hours talking with management of the target company before looking at the details behind the financial statements, says Eli Brenner, VP of MNP Corporate Finance.

And if it impacts the value of the business, the buyer and vendor should renegotiate the deal in the buyer’s favour. If renegotiation isn’t possible, it’s often better not to proceed with the transaction.

The buyer sometimes stands to benefit even when information that could potentially increase the price of the business is uncovered. “On one file, we found a $150,000 error to the seller’s advantage,” says Brenner. “If the seller knew about it, he could have increased the price by the five times earnings multiple our client was paying for the business, totalling $750,000.” But the seller didn’t read the report. That meant the buyer knew she was getting a good deal and had $750,000 in her pocket to negotiate with.

3. Up-to-date and accurate tax records

When buying the shares of a company, up-to-date tax records are extremely important because the buyer inherits any potential tax liabilities associated with the company. Look for filings that were not made, overly aggressive or done incorrectly. For example, if the company does business in the U.S., it may be required to file tax returns with the IRS. If your client buys the shares and is contacted by the IRS six months after the transaction closes because the company owes taxes plus interest and penalties, then your client’s the one on the line.

4. Quality of balance sheet

Understanding how quickly current assets will convert to cash, and the time it’ll take to settle current liabilities will help the buyer understand cash-flow needs and determine if any additional working capital is required.

If the buyer wishes to finance only a portion of the purchase price, the financier will look to the balance sheet to secure the loan. A due-diligence report will allow these stakeholders to gain clarity on the business and the underlying value of its securable assets.

A buyer needs to understand the assets and liabilities on the balance sheet, and those off it. Due diligence involves a review of major contracts, obligations, or contingencies the company is bound by in the future (rent, customer, vendor, lawsuits, etc.) to understand future obligations and their impact on the business and purchase price.

5. Fair market value price

“Assessing the fair market value of a business requires a certain level of knowledge about prices for similar companies sold recently in the marketplace. This tells the buyer how the market views that business in terms of worth, and ensures she isn’t overpaying,” says Brenner.

Mergers-and-acquisition activity is heating up as boomers execute their retirement plans. The best advice is to avoid rushing into a transaction. Due diligence can save money, time and stress.

Potential issues and how to deal with them

Issue	Procedure
Pre-recording sales and deferred recording of expenses	Conduct cut-off testing and predictive analytical tests
Changing margin patterns and incorrect costing of goods	Analyze gross margins to source documents
Obsolete inventory never written off, and reducing EBITDA	Analyze accounts inherent to management estimation
Weaknesses in financial management of the enterprise and inaccuracies in reporting of results	Analyze trends in ratios

John Caggianiello , CA, is senior vice president and director with MNP Corporate Finance in Toronto.