Preparation for Sale: Accounting Considerations for M&A

Preparation for Sale: Accounting Considerations for M&A

Overview

Building a company is a difficult and risky proposition.  Entrepreneurs invest time, money, and make many personal sacrifices to create a successful company.  When it’s time to sell the company, proper preparation can make a big difference in the number of buyers who are interested and the financial outcome of a sale.

One of the most critical aspects is how you manage and present the financial situation of your company.  Financials that are clean and presented using standard accounting principles will gain respect from prospective buyers.  Accurate information also helps to build a level of trust between the buyer and seller, which is critical in closing a transaction where all parties feel that they got a fair deal.

Whether you plan to sell your company tomorrow or at some point in the future, it is never too early to consider the value you are building and how to present your financial information.  In our experience buying and selling technology companies, here are some key issues that arise in preparing your financials.

Key Elements of Financial Reporting for Sale

  • Accrual Basis vs Cash Basis – Accrual basis is the standard for M&A transactions
    • Cash basis recognizes revenue when the cash is received; expenses are recognized when paid. Accrual basis recognizes revenue when the income is earned; expenses are recognized when incurred.
    • Accrual basis is a “real time” method of accounting that gives an accurate picture of the business. Cash basis shows actual cash flows but gives a “rear-view mirror” picture of the business.
    • Accrual basis gives a better picture of the value and financial situation at a point in time, e.g., the time of sale or valuation. If you have historically run your business on a cash basis, you should be prepared to produce your financials on the accrual basis if you are preparing for sale or valuation.
  • Deferred income/revenue
    • Deferred revenue occurs in a subscription/annuity model when customers prepay for services.
    • If the services are provided monthly and prepaid revenue is paid monthly it does not present a problem. However, if the prepaid revenue is quarterly or annually, then it must be recognized over the life of the services provided on a monthly basis.
    • If your company recognizes subscription payments immediately, as earned revenue on the cash basis, it yields a “lumpy” looking P&L statement and distorts financial results from period to period.
    • When a company is being sold, deferred income/revenue and the equivalent amount in cash will go to the acquirer, since it has not been earned at time of sale.
    • This may come as an unwelcome surprise to owners accustomed to running on a cash basis.
  • COGS/COS in SaaS and IT companies
    • Cost of Goods Sold, also known as Cost of Sales, recognizes costs required to provide services to clients in computing Gross Profit.
    • Companies, mistakenly, do not always account for costs directly related to providing their services or intellectual property to clients as a Cost of Sale.
    • Typical Cost of Sale expenses include:
      • Direct salaries for technical service providers
      • Costs of licensed products bundled into the cost of subscriptions sold to customers
      • Sales salaries or commissions (in high-touch sales situations)
      • Costs for cloud-hosting services that are bundled into SaaS fees.
    • These types of costs are variable and are directly tied to the sale of a product or service, so they should be identified as Cost of Sales.
  • Excess Working Capital
    • Excess working capital occurs often in subscription/annuity type businesses.
    • It comes about when the company keeps more working capital (cash, accounts receivable, inventory) on hand than needed to run the business on a monthly/annual basis.
    • An experienced M&A advisor will work with your accountants to perform a working capital review prior to going to market.
    • You should clear excess working capital and adjust your financials to show actual working capital needs before going to market.
    • If excess working capital is left on the books, a buyer may attempt to make it part of the deal, claiming that it is necessary to run the business, effectively discounting the purchase price.
  • GAAP or non-GAAP
    • Buyers conducting a financial review of your business will almost always be doing so using Generally Accepted Accounting Practices (GAAP).
    • Non-GAAP may be useful for operational purposes or to highlight aspects of the business, but GAAP will be the standard.
    • Business owners should be conversant with a GAAP view of their financials before entering into a discussion on valuation in preparation for Sale. Their M&A and financial advisors can help them with this.
  • Adjusting financial reports
    • A key aspect of preparing financials for sale is adjusting financial reports to standardize them versus industry norms. Typical adjustments include:
      • Owner salaries significantly above or below market for the role they are performing for the business
      • Benefits/perks for owner that are not typical for the industry
      • One-time or extraordinary events that do not reflect normal operations (both pro and con)
      • Reclassifying expenses recorded incorrectly, such as recording salaries in operating expenses that should be classified as cost of sales
    • Non-standard items will be adjusted out or added in to give a truer picture of typical operations.

 

The cleaner your financials are when decide to sell your business, the easier the business will be to sell and the stronger value you may expect to see.