The CPA’s Role in a Successful Business Transaction

Sam Bachstein

CPA

As is common with any medium or large-scale business transaction, the Certified Public Accountant (CPA) plays many roles in the buying and selling process. In today’s interview, we interview Sam Bachstein, an audit partner and CPA at Holthouse Carlin & Van Trigt, LLP. With 15 years’ experience as a CPA, Mr. Bachstein is the ideal professional to answer our most complex questions as they relate to the CPA’s role in various business transactions. Above and beyond the topic of how CPA’s can assist in business valuations, purchases and sales, Mr. Bachstein also introduces us to some important accounting principles as they relate to a successful business transaction.

Key Points from our Conversation

  • The acquisition of a business is a major transaction that needs to be considered in your overall tax and financial planning, and it is your CPA who generally knows your specific tax/financial position, and he or she is the one who can provide you with invaluable guidance in this area.
  • It is essential that the seller’s CPA meets with the seller’s attorneys and other advisors at an early stage to ensure that the seller’s long-term financial plan is not damaged as a result of poor planning and execution.
  • It is important to know how these measurements are calculated when buying or selling a business, because SDCF, EBIT and EBITDA are commonly used as the income basis in various multiple-driven valuation methods.
  • It is important that everyone on the team communicate and be on the same page, as it will always result in a smoother transaction with fewer complications and disagreements post-sale.

Interview

Tina: How involved should my CPA be in the process of buying a business? At what point in the process should I hire a CPA?

Sam: It is essential that a buyer enlist the advice and counsel of their CPA, even before the decision has been made to acquire a business. The CPA can help you explore financing alternatives, identify strategic acquisition candidates, and address tax ramifications. The CPA knows what opportunities and pitfalls to look for that are specific to their client, and along with the rest of the transaction team, can help the client structure the transaction in a way that will both maximize investment return, and help the client manage a multitude of risks.

The acquisition of a business is a major transaction that needs to be considered in your overall tax and financial planning, and it is your CPA that generally knows your specific tax/financial position, and can therefore provide invaluable guidance in this area. The CPA can also perform due diligence and analysis designed to identify potential financial reporting irregularities and risks associated with a target company. The CPA can work with management post-acquisition to ensure that working capital adjustments and other financial covenants are being properly addressed. Finally, the CPA can help the client navigate the many financial, tax and legal considerations involved in an acquisition, which includes determining whether the transaction should be structured as a stock sale or an asset sale.

It is essential that a buyer enlist the advice and counsel of their CPA, even before the decision has been made to acquire a business.

Tina: Can my accountant/CPA value my business?

Sam: Not every accountant or CPA is qualified to perform a formal business valuation. Business valuation is a highly specialized discipline that should be performed by an appropriately licensed and credentialed expert. The American Society of Appraisers (ASA), the National Association of Certified Valuation Analysts (NACVA), and the American Institute of Certified Public Accountants (AICPA) offer programs to certify both CPA’s and non-CPA’s in the area of business valuation. There are national, regional and local boutique valuation firms, as well as CPA firms and investment banks that have valuation practices. 

 

Tina: How involved should the accountant be in the exit planning process?

Sam: Once again, it is essential that a business owner enlist the advice and counsel of their CPA early in the planning process. The CPA is best positioned to provide guidance to a seller that best addresses the seller’s financial position and long-term financial plan. Buyers often require one to three years of audited financial statements; by getting the CPA involved in this process sooner rather than later, certain accounting irregularities or errors can be timely identified and addressed, thus ensuring a smoother due diligence process. Further, the CPA can provide invaluable information to the due diligence team, providing information about the business that could result in significant “add-backs” and other adjustments to the company’s financial statements that would result in a larger sales price and more cash in the seller’s pocket. It is essential that the seller’s CPA meets with the seller’s attorneys and other advisors at an early stage to ensure that the seller’s long-term financial plan is not damaged as a result of poor planning and execution.  

Buyers often require one to three years of audited financial statements; by getting the CPA involved in this process sooner rather than later, certain accounting irregularities or errors can be timely identified and addressed, ensuring a smoother due diligence process.

Tina: What does "recasting financial statements" refer to, and how are you involved with the process?

Sam: “Recasting financial statements” refers to the process of adjusting the financial statements of a business to reflect the actual financial benefits of business ownership. Most privately-held middle-market businesses are managed to minimize taxable income. Accordingly, adjustments to the financial statements are generally necessary to indicate the actual cash flows generated by the operations of the business. These adjustments also facilitate comparison to industry standard metrics. Examples include adjustments to accounts receivable and inventory in accordance with Generally Accepted Accounting Principles that reflect anticipated collection and salability factors; the removal of certain items that would not remain with a buyer (e.g. certain prepaid and accrued expenses), removing excess cash to be retained by the seller, removing amounts due to/from shareholders, “step-up” adjustments of assets and liabilities to fair value, the removal of any real estate, vehicles or other property that is not part of the purchase transaction, adjustments or additions of intangible assets and/or goodwill if necessary, accrual of transaction-related liabilities (including certain contingent liabilities), adjustment of owner salaries to market rates, adjustment to depreciation and amortization expense consistent with balance sheet adjustments and asset lives, adjustment of rents to market rates, and adjustments to expenses incurred at the owners’ discretion (travel, meals and entertainment, vehicles, club dues, bonuses, etc.), and the removal of other certain non-recurring expenses. The CPA is highly trained with respect to financial reporting and is the most qualified of the team to assist with preparing recast financial statements. The CPA can provide guidance to management on how to prepare financial statements in accordance with Generally Accepted Accounting Principles, and in identifying possible “add-backs” to the recast financial statements. The CPA can also audit and report on a company’s financial statements; most buyers generally require at least one to three years of audited financial statements.

 

Tina: What is the difference between Net Income, SDCF, EBIT and EBITDA? What do I need to know about these when buying/selling a business?

Sam: Seller’s Discretionary Cash Flow (“SDCF”) is pre-tax earnings of the business before non-cash expenses (for example, depreciation and amortization), one owner’s compensation, interest expense or income, as well as one-time and non-operating related income and expense items. If there are additional owners working in the business, their compensation is adjusted to market rates. Earnings Before Interest and Taxes (“EBIT”) is the pre-tax earnings of a business before interest expense (and interest income if interest income is not a core revenue-generating activity of the business). Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) is the pre-tax earnings of a business before interest expense (and interest income if interest income is not a core revenue-generating activity of the business) and depreciation and amortization. It is important to know how these measurements are calculated when buying or selling a business because SDCF, EBIT and EBITDA are commonly used as the income basis in various multiple-driven valuation methods. In other words, every $1 of additional SDCF, EBIT or EBITDA would mean an additional $7 to the purchase price of a business that is selling at a 7x multiple.  

Business valuation is a highly specialized discipline that should be performed by an appropriately licensed and credentialed expert.

Tina: What about personal expenses that I run through my business?

Sam: When buying or selling a business, any personal expenses of the owner that are being run through the business are generally pulled out to remove the impact of these discretionary expenses in the recast financial statements. These are generally referred to as “add-backs.” Pulling these expenses out increases SDCF, EBIT and EBITDA, and consequently the value of the business. Another reason why a seller should consult with their CPA is because these add-backs could have various income tax ramifications to the seller that need to be addressed. A seller who intends to remain with the company as an employee after the sale should understand that these personal expenses in large part will not be paid by the company after the sale unless negotiated into an employment contract.

 

Tina: What other liquidity or financing options do I have for my mid-market business?

Sam: Many business owners who want to retain the benefits of ownership sell only a portion of the equity of the business. The owner can sell a majority stake and receive a higher multiple as a result of transferring control to the buyer, or sell a minority, non-controlling stake in the business at a discounted multiple. There are many variations to this type of partial sale, and the owner can provide the buyer with various instruments such as warrants, preferences, conversion options, etc., all of which generally increase the sales proceeds but also transfer more rights to the buyer and confer more risk to the owner. Another popular option is a recapitalization transaction whereby the company takes on some form of debt (line of credit, term loan, etc.), distributes all or a portion of the proceeds of the loan to the owner (as permitted under the debt agreement), and then services the debt according to the terms of the debt instrument. This option is popular for owners who have a significant portion of the company’s equity tied up in the business and who want to “take some chips off the table,” but who do not want to divest any equity.

Every $1 of additional SDCF, EBIT or EBITDA would mean an additional $7 to the purchase price of a business that is selling at a 7x multiple.  

Tina: What valuation methodologies are used to determine a price for a targeted company? Does financial due diligence have an impact on the valuation?

Sam: There are three methodologies that are used in probably 95% of business valuations:

  1. The Income Approach focuses on the income-producing capability of an asset. The income approach incorporates the calculation of the present value of future economic benefits such as cash earnings, cost savings, tax deductions and proceeds from disposition. Indications are developed by discounting expected cash flows to the present value at a rate of return that incorporates the risk-free rate for the use of funds, the expected rate of inflation, and risks associated with the particular investment. The discount rate selected is generally based on rates of return available from alternative investments of similar type and quality. The Excess Earnings Method of the Income Approach measures the value of an asset by calculating the present value of related future economic benefits, such as cash earnings. The Relief from Royalty Method of the Income Approach estimates the cost savings that accrue to the owner of an intangible asset who would otherwise have to pay royalties on revenue earned through the use of the asset.
  2. The Market Approach measures the benefits of an asset through an analysis of recent sales or offerings of comparable property. Sales and offering prices are adjusted for differences in location, time of sale, utility and the terms and conditions of sale between the asset being appraised and comparable properties.
  3. The Asset Approach measures the benefits related to an asset by the cost to reconstruct or replace it with another of like utility. To the extent that the assets being analyzed provide less utility than new assets, the reproduction or replacement cost would be adjusted to reflect appropriate physical deterioration, functional obsolescence and economic obsolescence.

Each of these methodologies has its benefits and limitations, and are chosen by the valuation expert based on the properties of the business or assets being valued.

Many business owners who want to retain the benefits of ownership sell only a portion of the equity of the business.

Tina: Do you have any other tips or advice for anyone buying, selling or appraising a business?

Sam: Be proactive; plan ahead and start thinking about your goals and strategy early. One of the biggest mistakes is to decide today that you need to consummate a deal tomorrow. Assemble your team of advisors at least a year in advance of a planned transaction, preferably two years. This will allow time for your team to properly prepare the business for sale (or identify an appropriate business to acquire) in order to maximize value and minimize risk. A properly executed transaction will include at a minimum a business valuation expert and an attorney and CPA experienced in buy/sell transactions. They may not be your current attorney or CPA, so be sure to have conversations with your current advisors about their experience well in advance. There are many legal, financial and tax considerations in determining the structure of a sale transaction, including whether the transaction should be a stock sale or an asset sale. It is important that everyone on the team communicate and be on the same page as it will always result in a smoother transaction and fewer complications and disagreements post-sale. An investment banker or business broker can also provide valuable guidance to both the buyer and the seller, particularly as the businesses and transactions become larger and more complicated.