Buying a business is an exciting and over-whelming time for a “soon-to-be” new business owner. Buying an existing business should represent less risk, time and resources than starting a new business from scratch, but the venture of becoming a business owner is still very risky. In order to mitigate some initial risk, we suggest that you perform financial due diligence, which is the process of conducting an investigation of the target business to determine the “true financial condition” and any financial implications of the proposed transaction.
Quality of Earnings Report
The most common report requested by potential buyers is a “quality of earnings” report or engagement. The objective of a quality of earnings engagement is to assess the sustainability and accuracy of historical earnings as well as the achievability of any earnings projections. A quality of earnings report provides a detailed analysis of all the components of a target business’s revenue and expenses.
The analysis should present a “normalized” EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) figure. (For more on that topic, see our previous article that compares EBITDA to Cash Flow). The term “normalized” in the context of EBITDA means that one-time or extraordinary items, excessive amounts and non-business items are either added-back or subtracted from EBITDA to show the “true” or “normal” operating income of the business.
An example of a simplified Quality of Earnings Report with “Normalized EBITDA" is presented below:
The Tax-Motivated Seller
Many privately-held businesses are tax-motivated and will have many “add-backs” to their “normalized EBITDA”. The business owner will want to include as many tax deductions in the on-going business to minimize the tax they will owe each year. But when it comes time to sell the business, the owner (“seller”) will want to “add-back” these deductions to maximize the value of the business.
The most frequent “add-backs” that we see related to this “tax-motivated seller” strategy include:
- Property and equipment expenses that should capitalized but were treated as repairs and maintenance expense
- Excessive compensation
- Salaries to family members who provide minimal value to the operations of the business
- Excessive personal items or benefits paid to owners (e.g. automobiles, travel and entertainment, cell phones, etc.) charged to the business
- Related party transactions (e.g. excessive rents)
- Management fees or board fees
- Donations and contributions
- Understating inventory quantities or value to reduce taxable income
- Using LIFO as an inventory valuation method
- Understating (or lack of) reserve accounts for obsolete inventory or uncollectible AR accounts
- Understating (or lack) non-deductible accrual accounts (e.g. warranty)
- Questionable revenue recognition policies (e.g. deferred or unrecognized revenue)
These types of “add-backs” will typically be presented by the Seller or the Seller’s broker in their offering memorandum. These “add-backs” need to be assessed during the due diligence process for proper treatment and valuation.
Keep in mind that this is only one of many items that can be uncovered during the financial due diligence process. In our next article we will discuss other common findings when performing “buy-side” financial due diligence in the acquisition of a privately-held business.
For another blog post on this topic, check out:
Advice for First-Time Buyers by Lloyd Bell, Director of our Corporate Finance Group