Outsourcing Due Diligence when Buying or Selling a Business

Matt E. Turpin

CPA, CVA, CMAP, CGMA

A Certified Public Accountant is able to play a multitude of roles when it comes to the purchase or sale of a business. In today’s interview, we speak with Matt E. Turpin, a Certified Public Accountant and Certified Valuation Analyst at Carr, Riggs & Ingram, LLC. Mr. Turpin is just the professional to answer our most complex questions as they relate to both the CPA’s and CVA’s role in various business transactions. Above and beyond the topic of how a CPA is able to assist in tasks such as due diligence, Mr. Turpin also introduces us to some key concepts, such as how Working Capital Adjustments relate to a business purchase or sale.

Key Points from our Conversation

  • In the ordinary course of business, a buyer will want to review no less than five years’ worth of financial information.
  • An honest seller will build trust with a buyer by addressing the big issues upfront.
  • Involving  a CPA that  is  experienced  in  mergers  and acquisitions  can save  you time,  money and frustration.
  • Communication in every deal is extremely important. Having one firm conducting the due-diligence process can greatly improve communication.

Interview

Tina: How involved should my CPA be in the process of selling my business?

Matt: The seller’s CPA should be involved in every step of the potential transaction. Initially, your CPA can review the potential buyer’s financials to make sure that they are qualified, or that they are a legitimate buyer. Once a buyer is qualified, your CPA can facilitate the information gathering process, all aspects of the due-diligence phase, negotiation, and the deal structure to minimize the tax consequences of the transaction. All this is necessary in order to allow the business owner to continue normal business operations without disturbing growth or company moral.

 

Tina: I am buying a business; when do I need to consult with an accountant or a CPA?

Matt: In my opinion, you should contact your CPA before purchasing a business. I have been in many situations where a client comes in with a potential business opportunity, and as we look at the pros and cons of the business, we determine that the risk or return does not justify spending more time looking at the business. Involving a CPA that is experienced in mergers and acquisitions can save you time, money and frustration. CPAs normally have a long list of clients, and it just might work out that your CPA has a client who is looking to sell his or her business. Even if that is not the case, a skilled CPA with Merger and Acquisition experience can help guide a buyer to the best business. Once a potential business has been identified, if your CPA is experienced in Transaction Advisory Services, he or she can break down the financial information to measure the quality of earnings (Q of E). Measuring the Q of E will help a buyer determine if the risk of the purchase is worth the reward of buying.

Post-closing items can arise from poor communication, a lack of adequate bookkeeping, or any other item out of the blue.

Tina: Will there be a conflict of interest if both the seller and acquirer appoint the same firm of accountants for due diligence advice?

Matt: No, CPAs must maintain a high level of independence. If the appointed firm believes they are not independent, then they should say so immediately. Typically, many firms have more than one CPA.  The buyer and the seller can have a CPA in the firm represent a buyer, and a different CPA represent the seller. Each CPA should then represent their client with the highest level of transparency and independence. I have seen on many occasions two CPAs within the same firm represent the buyer and the seller. In most cases, the transaction ends with both the buyer and seller walking away with the satisfaction that they achieved their goals. Communication in every deal is extremely important. Having one firm conducting the due-diligence process can greatly improve communication.

 

Tina: What will a buyer review during due diligence, and how should I prepare for the process?

Matt: Any potential buyer will want to verify what they see on the financial statements, as well as verify the potential items that are not on the financial statements. Typically, the pre due-diligence or due-diligence is being done because the buyer is interested in the seller’s business. Now the buyer has to come to a degree of satisfaction with the financials. The buyer will review source documents (bank statements, invoices, payable vouchers, lease agreements, contracts, etc.) and anything else to arrive at a high level of satisfaction in the quality of earnings.

Extending the due-diligence period as a result of findings or questions that arise during due-diligence is normal.

A seller can prepare by:

  1. Having all the source documents in clean order. When a buyer is reviewing the accounting records and requests details, having information on hand that is easy to follow, or that is explained in great detail lowers the perceived risk of the purchase.
  2. Keep clean accounting records. A good set of books will give buyers confidence in what they are looking at. Make sure that all prior year adjustments from your CPA have been recorded in your accounting software.
  3. Have a CPA experienced in transactional advisory services perform pre due-diligence on the seller. Performing a test run on what a buyer would look at is always better than being thrown into the lion’s den. Performing internal due-diligence will more than likely speed up the due-diligence process for the buyer. Test runs like this can lead to quicker closing dates.

 

Tina: How should the areas of potential overlap between legal and financial due-diligence be minimized?

Matt: A smart business owner has a team of professionals, and it is very important that the business owner’s legal and accounting advisors communicate and have a good understanding of the services they will be providing, as well as the areas of due diligence that they will be performing. Both the buyer and the seller should remain hands off when it comes to due diligence, or in other words, they should allow the CPAs and attorneys to do their work. The buyer and seller should be kept informed of the progress at all times. Regular communication between the buyer, seller, and the professional team will expose any overlap between legal and financial due-diligence. Lastly, a competent legal advisor is not going to step into the financial aspect of due-diligence, just like a competent CPA would not opine on legal issues.

Performing a test run on what a buyer would look at is always better than being thrown into the lion’s den.

Tina: How many years of financial information does a buyer typically want to review?

Matt: In the ordinary course of business, a buyer will want to review no less than five years’ worth of financial information. Normally, five years will show a trend or pattern in business revenue and expenses. In some situations it is advisable to review more than five years; for example, if a business has experienced a natural disaster or some other transition that affected the business, or any other circumstance that influenced the business’s operations. Again, this is a great example of the need for a CPA to be involved in every step of the transaction process.

 

Tina: What type of information do I need to disclose to a buyer, and when should I offer this information?

Matt: If you ask ten different M&A professionals, then you will get ten different answers. In my opinion, being honest with the buyer is the best route.  An honest seller will build trust with a buyer by addressing the big issues upfront. By no means am I saying that a seller should perform due-diligence for the buyer, but if a seller knows something is in the financials that is a one-time occurrence, or there is a lawsuit pending, then I suggest that the seller disclose such information. If it is important to the buyer, and the information is disclosed further along in the due-diligence process and the buyer decides to back out, then the seller could have saved time had the issue been brought up sooner. This is another very important reason why one should take a team approach to selling or buying a business. Consulting your professional advisors about disclosure will pay off in the long run.

If the transaction is a stock sale, then the buyer is inheriting the tax situation of the company.

Tina: What are some things to watch out for during due diligence?

Matt: Review the financials for revenue trends, be wary of a seller that increases revenue and accounts receivable in an effort to inflate the sales price. Contrary to my opinion, some buyers purchase a business based on a multiple of sales. Inflating sales leads to an inflated purchase price. Watch out for intercompany or related transactions. If you are buying a division or subsidiary of a company, focus on the transactions between the related parties. Many items can be manipulated if there are related entities. Be careful of obsolete assets, and ask yourself whether you are buying old or out dated inventory. It is important to have industry knowledge, or to have access to industry knowledge. This information is key when knowing the “tricks of the trade.” Finally, watch out for transactions involving key personnel. If you are buying a business, ask yourself whether the seller’s current customers, and or clients, will continue to do business with the company after the seller is gone.

 

Tina: What steps are taken in financial due diligence in order to assist in identifying hidden liabilities and potential exposures?

Matt: Although there is no way to discover potential exposures with 100% certainty, the buyer should do everything possible to bring these issues to light. Contacting the seller’s attorney or legal team and requesting a legal representation letter should confirm any potential legal issue known at the time. Another way is to review the company’s bank statements for any recurring payments to any banks or institutions. If liabilities are being paid by company funds, tracking the money is the best way to research what is not on the books that should be.

 

Tina: What is the function of Tax Due Diligence in mergers and acquisitions?

Matt: There are at least two aspects to this question; 1) if this is a stock sale, what tax attributes will a buyer be purchasing and 2) how can the deal be structured to minimize tax on the sale, or to maximize tax benefits on the purchase. If the transaction is a stock sale, then the buyer is inheriting the tax situation of the company. In this case we want to consider whether there are taxable accumulated earnings, whether there are loss carry forwards, etc.  The buyer and seller can make a large difference to the net of a transaction based on the tax structure of the transaction. Engaging a CPA experienced in mergers and acquisitions can help a buyer and seller navigate through the waters of a transaction.

The WCA is a temporary fund that is intended to guide the buyer and seller through the transition period that results from the sale.

Tina: Should I have my financial statements audited if I am thinking about selling my business?

Matt: My opinion on this is yes, the financial statements should be audited before selling the business. Keep in mind the cost benefit of an audit; if the seller is a small outfit, paying the cost of an audit does not automatically increase the purchase price. While a financial statement audit doesn’t eliminate the bumps during due-diligence, it can drastically reduce issues that arise in the due-diligence stage. If cost is a factor, I would suggest having the financial books audited every few years at a minimum.

 

Tina: Are there ways to protect a transaction from post-closing challenges?

Matt: Post-closing items can arise from poor communication, a lack of adequate bookkeeping, or any other item out of the blue. In my opinion, having a team of professionals can help the seller cover many bases when it comes to post-closing issues. CPAs will look at the financial aspect, while attorneys will look at the legal aspect of post-closing items.

The financial information for a strategic buyer should be presented in the same manner as any other buyer with the addition of an adjustment for synergies.

Tina: How long should I expect due diligence to take?

Matt: Due-diligence can take anywhere from one day to six months depending on the size of the transaction and the size of the team performing the due-diligence. Most contracts will allow for 90-120 days from the signing of the Letter of Intent to the performance of due-diligence. Each transaction is unique and will bring new challenges. Extending the due-diligence period as a result of findings or questions that arise during due-diligence is normal.

 

Tina: What are Working Capital Adjustments?

Matt: A buyer expects to purchase a business in an ongoing manner. A Working Capital Adjustment (WCA) is a certain amount of money that is temporarily held back so that the buyer can operate the business with the appropriate cash that is needed. The buyer will need cash for inventory purchases, payables, etc. The seller will want credit for the business earnings up to the date of the sale. The WCA is a temporary fund that is intended to guide the buyer and seller through the transition period that results from the sale.

Having a professional team will pay for itself. Make sure you contact CPAs and Attorneys that are experienced in transaction advisory services for the best results.

Tina: How should financial information be presented to a strategic acquirer?

Matt: A strategic acquirer is buying for that reason: strategy. This can be a competitor, a company currently not in the local marketplace, or a large company establishing a division. The financial information for a strategic buyer should be presented in the same manner as any other buyer with the addition of an adjustment for synergies. Synergies are expenses that can be eliminated by adding two or more companies together. For example, if a buyer acquires the competition, is there a need to have two physical locations in the same town? If the office space of the buyer can handle the new employees, inventory, etc., then there is no need to occupy two locations. In presenting the financial information to a strategic buyer, the M&A professional would add back the rental expense of the seller to arrive at a new quality of earnings. Other examples of synergies are advertising, professional fees, salaries & wages, office expense/supplies, payroll taxes, and utilities just to name a few.

Having a professional team will pay for itself.

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

Matt: Buying a business should not be taken lightly. Many times M&A professionals aren’t notified until after the purchase because the buyer wanted to save some money.  The truth is, the fees for such services are usually justified through a reduction in purchase price and tax savings or synergies, which are created by the purchase. Having a professional team will pay for itself. Make sure you contact CPAs and Attorneys that are experienced in transaction advisory services for the best results.