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The U.S. merger and acquisition (M&A) market hit a record high in 2018, according to data published by Thomson Reuters. And many more deals are expected to follow in 2019. If you’re considering a business combination, a business valuation professional can help you vet a prospective deal and improve your chances of success.

Conducting due diligence

M&A due diligence typically starts with a review of the company’s historical financial performance. Audited financial statements offer prospective buyers greater assurance than reviews, compilations or internal statements. Nonaudited financial statements may require a so-called “quality of earnings” report to get a clearer picture of what to expect.

Even so, what you see may not be what you get. Adjustments to the historical financial statements may be needed to estimate the buyer’s expected return. Examples of these adjustments include:

  • Unusual and nonrecurring items (such as costs to settle a lawsuit or a gain from the sale of a nonoperating asset),
  • Write-offs for bad debts and obsolete inventory,
  • Excess owners’ compensation,
  • Non-arm’s length shareholder loans,
  • Unreported cash receipts, and
  • Discretionary expenses (such as the owners’ country club dues, sporting event tickets or nonbusiness travel expenses).

Valuation experts also can spot hidden costs and help buyers evaluate whether the seller owns the intellectual property it claims it does. Inexperienced buyers may not realize how difficult it can be to dispose of real estate holdings, or how costly it can be to train newly merged employees or integrate IT systems.

Likewise, a valuation expert will assess whether the seller has positioned the company for long-term growth by investing in equipment maintenance and staff training. And they’ll evaluate potential risk factors that might warrant a lower offer price, such as weak internal controls, reliance on key people, aggressive tax strategies and unfavorable contract terms (or lack of formal contracts).

Projecting financial results

When determining the offer price in M&As, historical financial performance is only relevant to the extent that future performance will mirror what’s happened in the past. Starting in 2018, future performance may differ significantly for many companies in light of major tax reform legislation — known as the Tax Cuts and Jobs Act (TCJA) — that passed in December 2017.

Under the TCJA, most businesses are expected to pay less tax and, therefore, generate more cash flow. But not all of the TCJA provisions are business friendly. Each business will be affected somewhat differently. So, it’s important to factor all of the TCJA changes into the company’s projected financial statements.

If a seller’s financial projections were prepared in-house, ask how well the person who prepared them understands the TCJA. In some cases, a valuation professional who’s familiar with the TCJA may need to prepare (or adjust) the company’s projections.

Structuring a fair deal

How much are others paying for similar businesses in today’s hot M&A market? Don’t rely on industry rules of thumb to answer this question. A valuation expert can use private company transaction databases to generate pricing multiples based on real-world transactions.

Moreover, private company transaction databases provide insight into typical deal terms in the company’s industry. In general, sellers prefer stock sales, because they provide a clean break — the buyer purchases all assets and assumes all liabilities, including undisclosed and contingent obligations. Stock sales also may lower the seller’s tax obligations, because proceeds are taxed at long-term capital gains tax rates, which have historically been lower than ordinary-income tax rates.

In an asset sale, proceeds are typically taxed as a combination of ordinary income and capital gains. Buyers like this type of deal because it allows them to cherry-pick what’s included (and excluded) in the deal. And asset purchasers generally are responsible for only the liabilities expressly assumed and those secured by the purchased assets.

The TCJA generally lowered ordinary-income tax rates, so the disparity between stock and asset deals may be narrower under current law than it was in the past. This may make an asset sale more attractive to some sellers.

Need help?

M&A transactions can be complicated and require expertise that most private business owners simply don’t have. A business valuation professional brings critical assets to the negotiating table — including M&A experience, modern tax know-how and objectivity.

© 2019

Return to the Litigation & Valuation Report – March/April 2019