Buyer (and seller) beware

The top financial issues in buying and selling a business

By William H. Wiersema, CPA, Principal, Miller, Cooper & Co., Ltd.

Financial due diligence is a major step in mergers and acquisitions for both buyers and sellers. At this stage, the represented cash flows of a business, technically known as Earnings Before Interest, Income Taxes, Depreciation, and Amortization (EBITDA), are subject to scrutiny and verification. Buyers can truly assess a target’s value, whereas sellers may be able to improve it.

In the middle market, businesses generally trade at a multiple of EBITDA. In pre-pandemic times, this was commonly four to six. However, multiples have grown over the past several years for many reasons, which include supportive interest rates, availability of capital, and time pressure for private equity to deploy investor money.

The most critical issues today are: EBITDA before Coronavirus, revenue recognition over time, inventory holding gain, state and local tax, and discounted cash flow.

#1: Compute EBITDAC

In presenting a higher EBITDA, most sellers claim “add-backs,” or certain expenses that the buyer will not have. Just as when selling a home, sellers are motivated to use puffery and overstate benefits. Sometimes these can become so extreme as to lose credibility, as when via alchemy, a business presented $5 million EBITDA, but only after $6 million in add-backs.

Today, EBITDA becomes EBITDAC, with the added “C” for the Coronavirus. Covid could cause lost orders, breaks in the supply chain, safety reconfiguration, closures, remote relocation, layoffs, and on the plus side, forgiveness of Paycheck Protection Program loans. Nonetheless, many middle-market companies achieved record profits as demand resurged in 2021.

Like other adjustments to normalize cash flow, those relating to Covid should include quantified support, as they directly impact value. For purposes of presenting to buyers, EBITDAC is most credible when limited to known specifics.

Paycheck Protection Program loan forgiveness can cause confusion. Under generally accepted accounting rules (GAAP), the gain is non-operating extraordinary income. However, sellers may bury the gain in gross revenue, offset it against payroll expense, or even post expenses against the loan liability. These approaches all incorrectly include forgiven amounts fully in EBITDA. Instead, Covid add-backs still require supporting detail, as the damage incurred always differs from the PPP funds received.

#2 Recognize revenue over time

Under today’s new rules, income statement revenue may have little relationship to billing. Instead, revenue equals the total due for the order or project, multiplied by a percentage representing how far along things are at period end. That percentage generally comes from costs incurred through the end of the period divided by total budgeted costs. You may have $50,000 costs into a project but estimate they will total $100,000, for 50% complete. If total billing is $250,000, then $125,000 in revenue is recognized.

The rules, known as “Over Time” (OT), extend to practically every industry, from consulting to software to media to custom manufacturing. They attempt to provide uniformity that was previously lacking, by requiring OT to be considered before any other option.

While OT’s matching of revenue and cost is sound theory, problems arise in implementation. Even if progress billings align precisely with budgeted costs through the end of the month covered by the bill, actual costs inevitably vary. The truth about budgets is that they’re never correct; the question is how far they’re off. You have to test their accuracy after the fact.

As to subjectivity, a new CEO eager to please investors might underestimate budgeted costs to overstate revenues and profits. Or, a business owner seeking to avoid taxes might go in the other direction and understate profits by overestimating remaining project costs.

Moreover, the method is topsy-turvy for accounts payable. Under standard accounting, a business doing poorly might not enter vendor invoices to improve the bottom line. Under OT, however, the same business might record more payables on their open jobs or credit cost overruns in measuring completion, to inflate earnings. When jobs are open, every dollar of cost generates revenue.

Previously, OT had been known as percentage of completion, and was limited mainly to long-term construction contractors. The following trigger OT revenue recognition: The customer consumes the products or services as delivered, such as medical treatment or online subscriptions; the customer controls the asset as the vendor improves it, as in construction, tolling, or repair operations; or the customer owes the vendor for a custom in-process item’s sales value, not simply costs, and the item has no alternate use to the vendor, for custom manufacturing.

#3 Cost inventory properly

Inventory has always been an area ripe with the potential for misstatement. Companies doing poorly look first to overstate inventory because it’s relatively easy to do and hard to detect. Understanding why this is the case is part of a basic accounting equation: Cost of goods sold equals purchases plus beginning inventory minus ending inventory. Therefore, the greater the ending inventory, the lower the cost of goods sold and the higher the profit margin.

Unfortunately for those who overstate, ending inventory becomes beginning inventory in the next period, so the misstatement must be perpetuated just to run in place. Making operations appear better requires additional overstatement and so becomes akin to an addiction.

Overstatement is particularly a problem in today’s inflationary times. With commodity prices increasing at double-digit rates, otherwise innocent practices, such as short-cutting inventory valuation by using the most recent purchase price, can lead to holding gains that are unacceptable under GAAP. For example, valuing three units on hand costing $500, $750, and $1,000 at their most recent price inflates inventory from $2,250 to $3,000, resulting in a $750 or 33% holding gain.

Restating inventory at current market prices, rather than purchase cost, magnifies the problem. One metals company showed more profit than ever by marking up the metal content of its goods, even some that hadn’t turned in years.

#4 Add SALT

State and local taxation (SALT) was turned upside down when, in June 2018, the U.S. Supreme Court decision in South Dakota v. Wayfair, Inc., granted states the power to obligate out-of-state businesses to register, collect, and remit sales tax based on sales in the state. The new doctrine of “Economic Nexus” means that sales (by themselves) trigger tax, which according to the facts of the case, were $100,000 over the past twelve months. This contrasts with the former ruling in the Quill case, which required a business be physically present.

Many companies face unexpected results. An Illinois distributor of repair parts for manufacturing equipment had no liability under prior law. However, approximately one-quarter of states offer no manufacturing exemption. Under “Economic Nexus,” the distributor becomes liable when it ships to those states.

Beyond sales tax, Economic Nexus expands daily, so there’s no end to compliance issues. It’s not limited to sales tax; it could be any non-income tax. Politics is involved. The 10,000 state and local US taxing jurisdictions each do different things at different times. Out-of-state businesses have no voting power, so their concerns are low priority.

#5 Discount cash flows

Beyond these issues, the uncertainty and instability create a whole set of valuation concerns. A company’s future performance is less predictable than before the pandemic. Bidding on a business as a buyer or pricing one as a seller has become particularly difficult, as multiples rely on stable volume. Perceptions before and after the pandemic heighten the distance between buyers and sellers. However, for the most part, both buyers and sellers desire assurance that pricing is reasonable.

In industries affected by Covid, justifiable values call for a more sophisticated approach. Professionals typically use a method known as Discounted Cash Flow (DCF). Rather than being limited to the trailing twelve months, DCF evaluates multiple years of projected future operating cash flows as objectively as possible.

The discount rate, the reciprocal of a multiple, is built from scratch by precisely quantifying various factors. The rates reflect risk premiums for equity, size, industry, and characteristics peculiar to the company, such as management sophistication and customer or vendor concentrations, beyond a risk-free return. In doing so, the rate encompasses specific business characteristics, risks associated with its size and industry, macro-economy, and capital availability.

The cash flow projections and a terminal value are then discounted at that rate. The resulting present value of an income stream reflects a company’s market value. The projections include the working capital required to sustain future operations. Such methods highlight the issues involved in coming to a proper value. In uncertainty, DCF can be the best approach.

Reprinted with permission from the March 2023 issue of Electrical Apparatus magazine.