Fall 2015 Issue of Horizons

Common adjustments include normalizing owner compensation and personal expenses, one-time professional fees, fixed assets that were expensed and should have been capitalized, and revenue or expenses generated by unusual events within the historical periods being presented by the company. Ultimately, the goal of this analysis is to represent the company as a stand-alone, efficient operating entity being run as if it were owned by a group of outside investors, as opposed to a single individual or family. Proactive sellers should identify possible adjustments to earnings before providing their financial results to prospective buyers. The number of adjustments made before negotiations and the quality of those adjustments can build trust early on, which is crucial to easing tension later in the negotiations. For example, being aggressive with seller add-backs that can’t be validated by a prospective buyer begins to erode buyer trust. This approach can often be more detrimental to the deal value than taking a conservative, and honest, assessment of true one-time or non-recurring items affecting the profit or loss. Net Working Capital Requirements During a transaction, an income or market- based valuation depends upon the company’s ability to continue as a going concern. The buyer needs an accurate calculation of required net working capital as purchase agreements are drafted to presume a normal level of net working capital will be delivered to the buyer at the close date. For many acquisitions, a company is sold or purchased on a cash-free, debt-free basis (CFDF). When the CFDF basis is used, net working capital is adjusted to exclude any cash and cash equivalents from current assets and bank debts and other interest- bearing balances from current liabilities.

The accounting due diligence is often referred to as a Quality of Earnings analysis. Third-party accountants analyze numerous facets of the company in order to assess its financial health and determine whether the target company’s financial results represent an honest depiction of the company’s historical financial performance. This process is intrusive both in terms of the level of detail involved in the analysis and the time required by the target company’s accounting staff in responding to diligence requests. On the flip side, the seller may also choose to perform due diligence on itself. This process, referred to as sell-side due diligence, is less frequently used than buy-side due diligence. However, in the last twelve months, we have seen a significant increase in the number of sellers who are having sell-side due diligence performed prior to marketing their companies for sale. Sell-side due diligence prepares a seller for the transaction and helps clarify which aspects of their business – and potential red flags, in particular – will be of interest to the buyers. And most importantly, it helps validate the company’s adjusted EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization. There are several common sell-side due diligence assessments that can lead to a smoother transaction if performed and presented on the front end of a transaction. Quality of Earnings Adjustments Calculating EBITDA is the starting point for any transaction. Buyers perform analysis to uncover non-core and non-recurring revenue and expense items. Often, these items will include revenues and expenses generated by one-time projects as well as non-routine expenses.

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