Businesses are sold for various reasons, from owner retirement to a strategic divestment. Likewise, there are a variety of investors available, from acquisitive corporates to private equity-investors, who can all benefit from undertaking a well targeted financial due diligence (FDD) to ensure that they pay a ‘fair price’.
Enterprise value is often based on a multiple of the target’s EBITDA, hence the vendors are incentivised to present a high number. In the well published legal case between Hewlett Packard and Autonomy, it is claimed that Autonomy had frontloaded its revenues in order to achieve performance projections set by the analysts. This case highlights the risks of financial presentation and how a thorough FDD is key to paying a fair price for a business acquisition.
Autonomy was a large public company that was subjected to audit. Whilst this is not necessarily a protection to the future acquirers, there are instances where an entity is too small to require an audit, and an FDD process can be the only firewall against creative accounting leading to an inflated price.
As well as assessing the sustainability of EBITDA, an FDD process will help investors identify any undisclosed liabilities, some of which even the vendors themselves may be unaware of. A good example of this is the changes to IR35 tax rules, which will be effective from April 2020. Under the new legislation, the contracting company will be responsible for assessing the employment status of its contractors. In the past, this responsibility lay with the contractor themselves. We have come across a business, as part of our FDD work, which was unaware of the IR35 changes, so was unprepared for April 2020. Our FDD work helped the investor to factor the extra costs associated with making the business compliant into the fair price.
Another instance when an FDD is key to paying a fair price is at the completion stage of an acquisition. Agreeing what is part of the working capital and what is debt, is usually more contentious than establishing a normalised EBITDA. More contentious still, is agreeing on what is a ‘normal level’ of working capital. This is where a well-presented diligence report will give the investors an upper hand in negotiations. Through a better understanding of the balance sheet, investors can be better prepared to argue their point of view and pay a fair price for an acquisition, whilst ensuring that the business has adequate working capital going forward.
On a more positive note, an FDD process can help investors find opportunities in the target business. Whilst most of the time synergies are identified through a commercial due diligence process, FDD still has a role to play in highlighting the opportunities. For example, in the majority of our FDD projects, we are asked to detail the finance function of the target. This helps investors identify the weaknesses as well as better understand how the existing processes can be integrated into their wider group and therefore determine the fair price.
