A vast majority of lower middle market business owners have not taken the time to plan for their future exit from the business.There are a number of steps that can and should be taken in the years leading up to this event.The topics discussed below are certainly not all inclusive but meant to give an overview of areas to start with when the eventual exit is likely to be a sale.
When thinking about the long-term preparation for an eventual exit, business owners need to put thought, time and effort into the company’s financial reporting system. How accurate is the current system? How timely is the output? When you get to the buyer due diligence phase, the faster you generate accurate updated financials, the easier the process will go. Having clean, accurate books is key. When a buyer starts finding errors, or items that cannot be readily explained or supported, trust begins to erode which can lead to a slower process, loss of value or even loss of the deal.
Competent Accounting Support and GAAP Compliance
Along the same lines, it is important to have competent accounting support, whether internal or external. Someone should be well versed in the numbers and systems to answer questions and quickly provide supporting documentation. Further, buyers are likely to require reporting in compliance with Generally Accepted Accounting Principles (“GAAP”). In many cases, the company has not had a need for GAAP financials and may be maintaining the company’s book on the cash basis or a hybrid accrual basis that is not fully GAAP. This was adequate for the day-to-day operations but may not be when it comes to selling the business. Putting advance effort into converting financials from non-GAAP to GAAP will save time and eliminate surprise adjustments from the buyer later. External accountant prepared financials will also help in gaining the trust of a buyer, especially if they are audited. Audited financial statements give the buyer some level assurance that the books have been vetted for accuracy. Be sure to use a reputable, size appropriate firm for the financial statements as this will add credibility.
In addition to historical data, buyers are going to be interested in seeing projected earnings. By developing a solid financial model to forecast the next 12 to 36 months, you add support to the valuation of the company and provide a buyer with a great jumping off point for their consideration of the company’s future. Keep it reasonable, very few companies experience hockey stick revenue growth and it will be questioned in a forecast.
Another important item to consider is the capitalization table.These tables can quickly grow in complexity and sellers will need to know who has to approve the deal and who gets paid when the deal is done.Same with equity-based compensation, owners need to know if and when these arrangements need to be settled and what impact that has on the cash distributed at closing.
QOE or Sell-Side Due Diligence Reports
As you get closer to the exit, consider getting a quality of earnings (“QOE”) or sell-side due diligence report. This is an opportunity to put the microscope on your business before the buyer does.You identify potential issues, clean them up and control the narrative.When buyers find issues, you’re on your heels. When you find them in advance, you’re prepared with the appropriate explanation. This also puts you on the offensive with regard to normalizing earnings.You’re leading with your own calculations that the buyer would then have to challenge instead of the other way around.
So what is normalized earnings? In a nutshell, this means identifying and adjusting non-recurring and non-operating revenues and expenses (normalization adjustments). This can be professional fees related to preparing for sale, above-market compensation, etc. The QOE will also give you a look at normalized net working capital which will be a key data point as you approach closing.
You will need to provide support and rational explanations for all normalization adjustments.In the context of long-term planning, it can be beneficial to adjust the actual business operation for anything that might be considered for normalization. For example, discontinue excess fringe benefits, adjust rents to market rates, discontinue non-contributing family members on payroll and so forth.This will show the buyer that the business can function that way, rather than handing over numerous adjustments and saying, “trust me, this will work”.
Takeaways
Finally, make sure your taxes are in order.Are you up to date on all tax filings in all jurisdictions?It’s best to hire a firm to complete a comprehensive nexus study to ensure you are reporting in all applicable jurisdictions.Non-compliance can, and does, quickly halt a transaction if it is determined that significant liabilities may exist.
Working with an advisor versed in business exits will make a significant difference in the outcome of a sale process.The advisor will take you through the above considerations and help identify others that may be specific to your business.Preparation on the front end will result in a better outcome every time.
Contact Us
For more information on this topic, please contact a member of Withum’s Transaction Advisory Team.
