Acquiring a business may appear to be a straightforward process. The owner presents a compelling narrative. The asking price seems justified by margin growth, and projected revenue appears to be increasing as well. Then the deal closes.
After the acquisition, the buyer may uncover hidden tax liabilities, uncollected receivables, and important contracts that expire within three months. One of the biggest areas where acquirers make mistakes is relying solely on the information disclosed by the seller. This is why professionals are brought in to identify potential problems and assess risks before the deal is finalized.
Chartered accountants play an integral role in the pre-acquisition process. They provide insights into what the buyer is actually acquiring and highlight the key financial, tax, and compliance issues the buyer should be aware of after closing.
Understanding “Risk” in the Context of a Transaction
Generally, risk in an acquisition breaks into two different areas: financial and commercial risk. Financial risk are exposures related to a target’s financials. Concerns related to financial risk include the reliability of reported income, the quality of assets, and undisclosed liabilities. Concerns related to commercial risk are one level of abstraction beyond the financials and focus on concentration of key customers, key suppliers, and market position. Is the growth sustainable?
A common error is to treat these separately. In reality, they are intermingled. An example is a commercial risk of one key customer who accounts for 60% of business; this also impacts the finances, since losing that customer will impact the basis of the valuation.
Testing Earnings Quality
Most of the time, headline profit is small potatoes. The important numbers are how much real profit is repeatable. Accountants analyze profit quality and distinguish operating profit from extraordinary gains.
To illustrate, suppose a company’s profit underwent a material increase in the sale year. Upon further analysis, the profit may include the sale of land, the deferral of payments to suppliers, and an increase in sales-related profit. The land sale and the deferral of payments to suppliers may warrant a less favorable valuation, while the increase in sales may be valued more favorably. Skilled analysts remove the noise, which may drastically change the potential valuation of a company.
Hiding Behind Liabilities
Balance sheets primarily show what companies decide to show. The significant work is determining what is important yet is omitted. These may include unpaid obligations, employee claims, warranties, and pending litigation.
In India especially, undetermined tax positions may be a concern, as these may become the buyer’s burden after the sale. Potential trade disputes and unresolved tax liabilities, as well as GST and TDS defaults, may become the purchaser’s problem. A rigorous analysis of tax control frames and filed returns may help anticipate potential demands. The best chartered accountants in gurugram provide seamless financial, tax, and legal assurance spanning the entire deal to prevent gaps that may occur between the different disciplines.
Reading the Working Capital Story
Many deals assume a generic level of working capital. To enhance short-term cash upon sale, some sellers may extend payment terms and speed up collections. This may enhance cash, but the buyer will need to pay to restate working capital post-sale.
A thoughtful accountant makes a monthly working capital report for the last two to three years, identifies a reasonable baseline, and helps the buyer with the working capital adjustments. This analysis is frequently very effective in preserving deal value for the buyer.
How a Due Diligence Company Structures the Work
Larger deals with complex risks often require the support of a specialized due diligence company to conduct a thorough investigation with a focused structure. These processes typically consist of defined steps designed to identify financial, legal, operational, and compliance risks before the transaction is completed.
a. Scoping: Outlining what is important for this deal specifically, since a manufacturing acquisition vs. a software acquisition will require different emphases.
b. Data collection: using a structured checklist, requests for financial statements, tax records, contracts, and management reporting.
c. Analysis: assessing the potential for earnings, assets, and liabilities to be overstated and understated and assessing tax and commercial risks.
d. Reporting: providing findings in the format of emerging issues and the estimated effect of each on deal value, deal considerations, and post-deal integration.
The real worth is not in the length of the report, but in the value and impact of the findings the buyer can rely on when approaching negotiations.
Turning Findings Into Deal Terms
A good review does more than just point out problems. It suggests a path forward in considering the deal. For example, if analysis negotiates a dispute for unpaid taxes, the buyer may ask for an indemnification, or a petition escrow, or even ask for tax related concerns to be resolved by the seller prior to dealing closing. In the case of a high concentration of customers, the buyer might ask for considerations to hinge upon those clients staying on following the deal closing.
Where financial analysis meets commercial negotiations. Each issue that is dealt with early on can be either priced, transferred, or managed instead of being dealt with later, which is likely to create problems and add cost to the deal.
Buyer Advisory Tips
Buyers should conduct the review before they get committed to a deal. Buyers should get more review access to find information beyond audited statements, which can provide insight when dealing with more context. An evaluation of the tax exposure should be part of the deal consideration. The people doing the evaluation should also prepare a summary of the numbers which could impact the negotiations.
An acquisition is the one decision where the saying “you get what you pay for” definitely applies. The deal review surveys usually help the deal avoid surprises later.
Frequently Asked Questions
How long does a financial review take prior to closing a deal?
A review for a small to mid-sized business usually takes 2 to 4 weeks, depending on the organization of the records of the business and how timely information is provided.
Is an audit the same as due diligence?
No. An audit detects compliance of financial statements with reporting standards. Due diligence focuses on the true risks of purchasing the business and how those risks affect the deal.
Can due diligence ensure there are no surprises?
No process can guarantee certainty. A thorough review tends to reduce the large unexpected surprises and helps the buyer make an informed decision, but there are always some risks that become evident only after completing the deal.
Should professional reviews still be done for small acquisitions?
Yes, but especially for smaller transactions. Because smaller businesses tend to have less organized records and higher compliance and tax exposure risks, scrutiny for smaller deals is critical.
