Preparing Financials – Mastering the Numbers:
Preparing for an M&A Transaction
In order to present your company to potential buyers and investors, it is necessary to share (under cover of an executed non-disclosure agreement) intimate details on the company, its operations, sales and other pertinent information. This includes business formation documents, operating agreements, financials, bank statements, tax filings, contracts, human resources, budgets & projections, liabilities, leases, etc. Not all buyers will require all these items however you should be well prepared for the these and other requests a buyer will need to understand your business. This will also enable you to be well prepared in advance of the due diligence process.
Navigating the intricate landscape of mergers and acquisitions (M&A) requires meticulous preparation and execution. It is essential to ensure your financials are in impeccable order. Whether you’re a seller aiming to attract the best deal or a buyer seeking a thorough understanding of the target company’s financial health, a well-prepared financial portfolio is key. Preparing your financials for an M&A transaction requires attention to detail, transparency, and collaboration with financial experts.
To start, four key areas to address:
• Accounting Method: Cash -v- Accrual Accounting
– Buyers prefer and sometimes insist on accrual accounting on which to base their valuation
• Scrutinize Income Statements
– Look for any irregularities, non-recurring and/or unusual entries in the prior 3 year and YTD periods
• Balance Sheet Statements
– Your balance sheet matters and can impact valuation and bottom line proceeds. Make certain it accurately reflects AR, assets and liabilities. Clean up assets reports and identify if uncollectable accounts receivables are shown, writing them off usually makes sense. Likewise, assets which have been disposed or diminished value should be properly accounted on the balance sheet.
• Historical / Projected CapEx
– This is particularly important for businesses that are capital intensive ie: capital equipment rental. CapEx is the normal capital requirements needed to operate the business. This can impact valuation and working capital requirements for closing.
Conduct Your Own Financial Due Diligence: Before entering into an M&A transaction, sellers should engage in their own financial due diligence review. For sellers, this involves a thorough internal audit to identify any financial irregularities or potential concerns. For buyers, it means scrutinizing the target company’s financial records to assess its true financial health. Typically you will want to gather P&L statements and tax returns for the prior three (3) year period and a P&L for the trailing twelve months (TTM) ending as close to current as possible.
Ensure Accurate Financial Statements: Accurate financial statements are the cornerstone of a successful M&A transaction. Ensure that your financial statements are up-to-date and accurately reflect the financial health of your business. Any discrepancies can raise red flags during due diligence.
Normalize Financials: Normalizing financial statements involves adjusting them to account for owner benefits, irregularities or one-time events that may distort the company’s true financial performance. Normalization helps potential buyers or investors understand earnings and expenses of the business and how it is expected to perform once a transaction closes.
Here are some common methods used to normalize financial reporting:
• Recasting Financial Statements: Recasting is the accepted accounting principle of removing or adjusting items on your financial statements that are unrelated to the ongoing business. You have probably worked hard over the years with your accountants to under-report your earnings for tax purposes. This is perfectly legal and acceptable. But it understates the true value of your company. Items removed or adjusted via recasting can be superfluous, excessive, or discretionary expenses and nonrecurring revenues and expenses. A professional advisory firm, such as Paragon Ventures, can provide valuable insight and guidance on the recasting process to find as many legitimate, defensible items as possible. Buyers and investors are buying your future and usually base their offers on what they see in your financials. So if they are not recast accurately, you may be understating profitability, impacting what buyers will pay for your company.
• Capitalizing or Amortizing Expenses: Capitalize certain expenses, such as research and development costs or new location start-up expenses, that provide long-term benefits to the company. Alternatively, amortize these expenses over multiple periods to match the timing of the associated revenue or benefits.
Normalizing financial reporting is essential for understanding the underlying economic realities of a business, especially in the context of M&A transactions or investment decisions. By adjusting for distortions and irregularities, you can make more informed assessments of a company’s actual financial performance, identify potential risks or opportunities, and negotiate transaction terms most effectively. However, it’s crucial to exercise judgment and discretion when normalizing financial data to ensure transparency, accuracy, and consistency.
Financial Projections: In addition to historical financial statements, provide detailed financial projections that highlight the future growth potential of the business. Realistic and well-supported projections can instill confidence in potential buyers, showcasing the strategic value of the investment and future growth opportunities.
Working Capital Requirements: Working capital is a key factor in M&A transactions, and understanding how it is calculated and utilized is crucial for both buyers and sellers. Be transparent about any unusual working capital trends or requirements. In an M&A transaction, working capital refers to the amount of capital required to fund a company’s day-to-day operations. Working capital is calculated by subtracting current liabilities from current assets. Current assets typically include cash, accounts receivable, inventory, and other assets expected to be converted into cash within one year. Current liabilities include accounts payable, short-term debt, and other obligations due within one year. This enables a buyer to evaluate the target company’s working capital to assess its liquidity, financial stability, and ability to meet short-term obligations.
The Critical Imperative of Accurate and Defensible Financial Reports
In the realm of business M&A, where valuations and acquisition decisions are often guided by numbers and projections, the importance of accurate and defensible financial reports cannot be overstated. These reports serve as the backbone of due diligence processes, offering buyers (and stakeholders) a comprehensive view of a company’s financial health, performance, and potential risks. Whether it’s a merger, acquisition, investment, or any other significant business transaction, ensuring the integrity of financial reports is paramount.
Accurate and defensible financial reports are essential for facilitating various financial transactions, including mergers, acquisitions, IPOs, and debt financings. Well-prepared financial reports expedite the due diligence process, instilling confidence in stakeholders and increasing the likelihood of successful transactions.
Contracts and Agreements: In addition to the financial reporting, a buyer or investor will need to review and understand many other areas of the business prior to closing on an acquisition or investment transaction. Get prepared well in advance and compile and organize all relevant contracts and agreements of the business. This includes business formation documents, operating agreements, customer contracts, supplier agreements, and employment contracts. bank statements, tax filings, human resources, liabilities, leases, budgets and projections. Review the terms and conditions of these agreements to ensure compliance and identify any potential contractual issues that may impact the M&A transaction. It is important to understand the transferability or assignment of contracts in a change of control transaction.
Business owners and stakeholders will appreciate seeing their own business through the eyes of a banker, acquiror or investor. The perspective is important to understand current valuation and what may potentially be detracting from its value. Even if an M&A transaction is not being currently considered, the insight gained serves as an excellent benchmark for future growth and return on investment.
Next up in Paragon Ventures M&A Series
Part 4 – Preparing For The Due Diligence Process
The next area in the Paragon Ventures M&A Series is Preparing for Due Diligence. Due diligence in M&A is a confirmatory process. It includes the verification, investigation, or audit of a potential acquisition target and the specifics of a deal or investment opportunity. It is designed to confirm relevant facts, operations and financial information. Due diligence is completed before a deal closes to provide the buyer with an assurance of what they’re getting and opportunities for potential synergies post-closing.
For more information and additional insight on the M&A for your healthcare business, contact us at partners@paragonventures.com or call 800-719-1555. All inquiries held strictly confidential.
