With rapidly changing economic and market dynamics, many middle-market owners are opting to sell their businesses — with a significant number to private equity (PE) firms.
These owners often look to their CFOs to help facilitate these transactions, despite the fact that many middle-market CFOs haven’t previously been through an M&A transaction or been exposed to many of the one-time technical accounting issues involved during the pre-close, at-close, and post-close phases. Each stage requires significant planning and experience to navigate successfully, particularly around fair value accounting-related concepts that many middle-market CFOs may see only a handful of times in their career.
Further complicating matters, the CFO wears two hats: The first is devoted to meeting the seller’s final accounting requirements — predominately from a tax standpoint — and the second is establishing the accounting of the new company and bridging the gap between the old and new companies. This work can become complicated fast due to the financial impact of purchase price adjustments resulting from the final closing balance sheet accounting of the “old” company.
Here are six top challenges facing CFOs in a business combination.
Understanding the anatomy of the deal
Similar to the human anatomy, the anatomy of a deal is made up of many interconnected parts in the form of legal documents and economic transaction that can be 1,000 pages deep in a typical middle-market transaction. Understanding the purpose of each legal document, including their myriad detailed terms, is critical because they have a huge impact on the accounting.
Some sellers choose to forego involving their external accountants prior to the sale transaction because they want to minimize professional fees. This often results in situations where technical deal-related matters are missed, the transaction closes, and the seller (or buyer) is saddled with an unfavorable definition or structure in the purchase agreement that works against them when the purchase price is finalized post-closing.
After deciding to move forward with the deal, the best practice is to bring in tax structuring and technical accounting advisors to review the purchase agreement. Your advisors will help you understand the anatomy of the deal, ensure the tax structure is set properly, and evaluate that the provisions of the purchase agreement that impact accounting for the purchase price are appropriately worded. This includes the all-important provisions for exclusions relating to the accounting method, debt, and assets such as nonoperating assets.
Understanding the principal of consistency vs. GAAP
The accounting method specified in the purchase agreement is very important to the outcome of the final purchase price.
Companies that don’t follow generally accepted accounting principles (GAAP) accounting may be operating on a modified version of GAAP referred to in the purchase agreement as “consistently applied” accounting principles. This is a red flag that requires special attention in the purchase agreement.
For example, in the area of inventory, GAAP would say inventory that’s seldom used or inherently slow moving should be written down to the lower of cost or net realizable value. But if “consistently applied” terminology is used in the purchase agreement and if the seller didn’t historically reduce inventory to the lower of cost or net realizable value, it could mean the inventory should be calculated in accordance with historical accounting principles, and could legally bind the buyer to settle the final purchase price using an inflated inventory value.
When significant GAAP noncompliance is evident in the accounting, a quality of earnings report should be prepared. It will show what GAAP adjustments need to be made and highlight areas that need to be strengthened. It’s critically important to use the quality of earnings report as a guide when determining the definitions used in the purchase agreement. Any adjustments identified in the quality of earnings report are likely a deviation from “consistently applied” or “historical accounting practices.” Therefore, if the diligence report identifies deviations from GAAP or historical accounting practices, these items will generally warrant a specific definition and treatment in the purchase agreement.
Here is additional guidance on minimizing the risk of GAAP-related post-close disputes.
Missed estimates
Missed estimates at closing are a common cause of frustration between buyer and seller, making it critical to have a closing cash and net working capital estimate based on thorough information relating to cash, accounts receivable, inventory, accounts payable, and accrued expenses.
If a hard close is possible immediately prior to closing, that’s the simplest path for an accurate estimate, but in many instances not feasible; if not, it’s important to develop an accurate framework for a soft close that includes reconciliation of the balances that can be rolled forward or backward from the nearest month end. It’s very important for CFOs to maintain detailed records of their estimates at closing so unexpected variances can be thoroughly explained during the determination of the final cash and net working capital balances used for the final purchase price settlement.
Midmonth cutoff
When a buyer takes over control of a business, they effectively must apply a hard close to reestablish all of the accounting principles and underlying accounting for the resulting “new” company. They’ll allocate the amount paid for the business to the balance sheet and account for each nuance of the transaction legal documents within the “new” company’s financial records.
To prepare for this transition, the parties must cut off an accounting period — effectively drawing a line in the sand. On one side is “old” company whose accounting must be up-to-the-minute before the transaction, and on the other is “new” company, which accounts for the transaction date and everything thereafter.
Managing a midmonth cutoff can create enormous administrative complexities for CFOs. Problems frequently arise around proper identification of the effective date (month-end versus any other day) and time of day (end of day versus beginning of the day) for the transaction. Many times, when sellers and buyers are thinking about the net working capital components of the deal, they do not appropriately evaluate the transaction effective date cutoff.
It’s important to understand the cash conversion cycle of the business. For instance, if collections are high at the end of the month and inventory on hand is low at the end of the month, it may make sense to negotiate a lower net working capital target since the sellers will have a lower accounts receivable and inventory. It’s equally important for both parties to understand if there should be a minimum cash requirement. We’ve seen instances, where the sellers have withdrawn the entire cash balance from the business before the deal closes resulting in the buyers having to infuse additional unanticipated capital into the business. This capital may come in the form of debt from the buyer or an external lender. Alternatively, we’ve experienced situations where the deferred purchase price such as a hold-back or earnout are excluded from the equity or debt funded at closing. This can put significant pressure on the “new” company to produce positive cash flows to fund the liability at a later date.
Inventory is another area that creates challenges. It’s best practice to conduct the physical inventory when the deal closes or as close to the deal closing date as possible. Some middle-market companies have strong physical inventory controls and routinely conduct cycle counts or full physical inventory observations, and in those instances, the midmonth date will have little to no impact. However, if the sellers of the business don’t routinely perform physical inventory observations, a midmonth close will further complicate the matter. The sellers will need to make sure they appropriately account for inventory movement and related cutoff as of the transaction date. If a physical inventory isn’t conducted at closing, an inventory rollback or rollforward will need to be placed from the physical inventory date nearest closing. Typically, the accounting team is called upon to create inventory analysis to prove out the ending inventory balance. Most physical inventory observations are taken at month-end or year-end; therefore, additional advanced planning is required between the seller, buyer, management, and the external accountants. Without accurate perpetual inventory records, rolling the activity to the closing date can take a significant amount of time to derive the correct ending inventory value.
Addressing accounting issues after closing can result in a significant amount of unanticipated purchase price adjustments, additional professional fees, delayed issuance of accurate internal financial statements, delayed issuance of audit financial statements, and many other operational challenges for CFOs.
Knowing your numbers: Transitioning to a new CFO role
Many middle-market CFOs have limited involvement in forward-looking strategy development activities. But once the company ownership changes — particularly with businesses acquired by PE firms — CFOs are expected to step up and take on an expanded role. They’re expected to know their numbers inside out — revenue, margins, earnings by customer, product line, and geography, etc. — and have relationships with the customers to help drive the business forward. CFOs with mastery in these areas are well-positioned to help drive the change across the organization that the buyer is expecting.
For the transitioning CFO, the focus during the post-close period should be on gaining financial mastery and executing on the 100-day plan — mapping out and integrating all the strategic initiatives that the new owner wants to put in place. The CFO should be concentrating on risk assurance, off balance sheet/new working capital, financial reporting for lenders, value creation reporting, and support for the private equity group and board of directors. This can be difficult, if not impossible, when distracted by post-close details such as the opening balance sheet and working capital and all the other backward-looking items that need attention.
Understanding the differences between GAAP and tax accounting
Depending on the legal structure of the entities involved in a transaction and the respective form of the transaction, such as an asset or stock sale can provide for significantly different GAAP and income tax accounting results. It’s common for middle-market CFOs to be heavily focused on GAAP accounting methods after the transaction closes. It’s important for CFOs to also learn and understand the nuances of the transaction and the impact on tax accounting methods, as well as legal and economic terms surrounding tax returns covering “per-close periods,” “straddle-periods,” and “post-close” periods.
There’s a significant number of administrative and accounting policy decisions that are required to accommodate both the GAAP and tax accounting methods. Working with technical tax and GAAP advisors in the early phases of the transactions can go a long way in streamlining the decision-making process, identifying the differences between tax and GAAP accounting methods, and establishing a framework to track the differences post-closing. Given the complexities in this area, it’s often valuable to develop a matrix outlining the differences between book and tax accounting methods, the responsible parties for pre-close, post-close, and straddle period tax returns, the respective tax returns that will be filed, and the responsible parties (e.g. buyer or seller) for completing those tax returns.
The importance of bringing in skilled advisors
To help ensure a smooth close and hit the ground running on the 100-day plan, encourage both parties of an business combination to bring in an experienced team to spot transaction-related issues, predict what issues may arise in your deal, and tailor the purchase agreement to mitigate those risks.
Plante Moran’s risk advisory and accounting service team has a good mix of company-side and consulting experience. Many of our team members have served as interim CFO and controllers and understand what it means to “sit in the chair.” As a result, we develop a practical approach to solving challenges faced by newly acquired companies. We understand the nuances of one-time accounting items like opening balance sheet and net working capital, and we’ll provide a deliverable that’s auditable. And our expertise doesn’t stop there. We’ve streamlined the close process for many companies, which means financial information is readily available to help management make decisions to drive the business. We can help the company meet its lender reporting requirements as well as develop value creation analysis such as revenue enhance and cost reduction, among other areas. To learn more, give us a call.
