The M&A Mini-Series: Avoiding the Backlash of Accounting Implications (January 2017)
Day One was a resounding success.
But, if you’re inclined to take a deep breath and relax,
You’re now flying without a net.
How well you navigate the first few reporting periods
depends on how thoroughly you’ve researched,
documented and aligned everything that went before.
In my last newsletter – part three of my four-part “M&A Mini-Series” – I discussed how an early start on integration planning and implementation led by seasoned experts can enable transition to the new entity with the fewest number of surprises.
In this newsletter, I’ll move on to the last of the four interoperable requirements – accounting implications that can crop up during negotiations – and how this issue can make or break your deal depending on how well you and your team identify and document potential pitfalls while performing due diligence, structuring the deal and implementing the integration strategy.
I’ve said throughout this mini-series that M&As are incredibly difficult and complicated to transact and that there’s never been one without a hitch. So, it might seem an exaggeration to say now that the intense pressure of negotiation can feel puny next to what’s expected from Day One forward.
But … everything is harder from Day One forward. Until Day One, you could walk away or execute a delay or renegotiate terms. You had options that blurred the fact that even in the midst of incredible, nonstop pressures, you were actually in the cocoon of transition. Now, by a couple of pen strokes, you’ve entered a new, harsh reality where almost every issue has been elevated to material status requiring you to perform center stage without a net – faster, better, perfect. You have obligations to shareholders, employees, debt holders, the press, etc. to show evidence quickly that the reason you entered into the deal was correct and beneficial to all parties.
If you’re really smart, this should scare you more than anything that went before … which leads me back to the importance of parts one, two and three of this mini-series. All the work that went into due diligence, deal structure analysis and integration by your internal team and those independent, battle-tested experts should have led you down the right path to a place where goals are on track and you’re able to articulate positive results in timely, compliant financial statements. And, it typically does. In my experience, there’s a direct correlation between hewing to a stringent, all-encompassing endeavor and getting your deal off to a fast and successful start.
That said, one of the hardest issues I and my fellow consultants face is convincing clients to hire us at the start of an M&A journey to identify accounting implications that can affect the end of the journey. It seems counterintuitive to hire us before you think you need us.
But, here’s the reality. Consultants make lots of money helping clients clean up such situations after the fact – more money than if we had been hired at the outset before issues can morph into critical, reputation-damaging fodder.
By way of illustration, here are three case studies – all Blythe Global engagements – that illustrate the good, the bad and the ugly of what I’m saying.
- The Good: A U.S.-based software provider in the midst of an IPO acquired a foreign company. Wanting to keep ahead of the curve, they hired Blythe Global to review and assess the acquired company’s books. When it came time to do the audit, they had full understanding of the acquired company’s financial picture. Put another way, their early, proactive actions ensured that a $50 million acquisition didn’t negatively affect a $1 billion IPO.
- The Bad: A private equity firm neglected to consider the lack of accounting competence of their target – a carve-out purchase of a division within a corporation – during negotiations. Once the deal was finalized, both the private equity purchaser and their acquisition were left in the lurch when the acquisition’s former corporate accounting function ceased providing the anonymous, invisible services they had rendered for years. After the first few reporting periods didn’t pass muster, Blythe was engaged. In addition to ensuring the newly public company met their monthly reporting requirements, Blythe also provided training and built an accounting function. It took several months, but the acquired company was finally able to meet its reporting requirements without assistance.
- The Ugly: A publicly-owned industrial parts manufacturer purchased a private company to obtain its highly attractive inventory. Anxious to leverage the inventory as quickly as possible, they consummated the deal without performing adequate due diligence. In their attempts to get an ultra-fast return on their investment, they also released all noncore personnel including the accounting function. When it came time to close the books, they couldn’t. The accounting irregularities were myriad with no one to explain anything. By the time Blythe was called in to rehabilitate the books, the company had missed several reporting deadlines and their stock had plunged.
In our age of increased oversight, auditors will be scrutinizing a first ledger very closely because it’s laying down the baseline narrative – how the new entity came to be and its value, assets and liabilities among a host of other markers. Dealing with all the accounting implications is both a history project and a forecasting effort – requiring experts who know what questions to ask, where to look for the documentation and how to craft the assumptions and judgments. Like integration planning and implementation, it requires experts with specialized skills that most organizations don’t possess and who will provide the bandwidth companies simply can’t accommodate internally during an M&A.
During negotiations, these folks can pick up on nuances that might go unnoticed by lawyers or investors but that can significantly affect accounting principles and, by extension, future business results. They can also help with the conclusions of the valuation firm – verifying models, timeframes, judgments, etc. and creating the supporting documentation – thus ensuring the best ROI on this cost.
Here’s a short list of some of the accounting issues that need to be investigated, documented and accurately recorded.
- What’s the structure of the deal? Was it a business combination? An acquisition? Who were the buyer or acquirer and seller or acquiree of record? What was the official date of the deal? These questions might seem simplistic and the answers obvious, but experience has shown me that the hyperactivity around every minute of a transaction causes everything to blur quickly afterward. By the time of the first reporting period, many companies can’t answer these questions.
- What’s the purchase price and how should it be allocated? Again, a seemingly simple question for which answers are not always clear. Was it a one-time cash payment? Did it involve an earn out, stock options, debt, items to be valued, amounts in escrow? When examining the opening and closing balance sheets of the target, what items did the purchaser buy or not buy? What’s the historical cost of assets and liabilities that must be revalued and documented at current fair market prices to get to an accurate opening balance sheet for the purchasing company? Items in this category include inventory or intangible assets where a valuation firm might be hired to determine value as of the acquisition date.
- How do the accounting demands of the new entity differ from what the target company has been providing – or will be able to provide once the deal is finalized? In the “bad” case study above, the books were in good shape but the buyer failed to consider that there were no in-house resources to meet even the most basic public company reporting requirements – an issue that should have informed the purchase price in the buyer’s favor.
- What other issues might require judgment decisions? – For instance: Deferred revenue? Above/below market leases? Income tax effects? Working capital calculations?
The full list is chock full of many more such complicated issues needing research, documentation and more than a few judgment decisions. And for every one of these issues, M&A accounting professionals – like their integration counterparts – know where the minefields are and what corners need to be turned with extreme caution.
How can a company that’s already running at full throttle ramp up another notch? Here’s my no-frills blueprint that I’ve seen work in many engagements.
- First, assemble the right team; assemble them early; and keep them together. See above. See my three previous newsletters. Enough said.
- Second, meet early with the internal keepers of the flame. Much of the information needed will reside with employees who might be relocated or released or leave by their own choice. Your professional consultants need to meet with these people as early as possible to collect legacy information while people are available, can still easily access files and, importantly, still remember the oral history, dates, etc. This will also enable you to address issues as they arise and can inform decisions made during negotiations.
- Third, carefully consider the closing date. This is an often overlooked issue. Closing at the beginning of a reporting quarter rather than towards the end buys a company more time to prepare their first official report.
As I’ve said throughout this mini-series, M&As involve really hard issues. Success depends on expertise and capacity not available inside organizations.
We at Blythe Global Advisors have provided these services for many clients. We’ve helped them make investment decisions with confidence to meet the expectations of external and internal constituencies.
If you would like to discuss anything in this or any of my newsletters, please contact me. I’d be delighted to talk with you.
To discuss this important topic further
or if you’re looking for general accounting advice and counsel,
- Coordinating the initial audit of a new $3 billion public company that was formed through the merger of two independent companies.
- Assisting a $300 million private equity-backed company with Day One accounting as well as integration related to several recent acquisitions.
- Performing technical accounting assistance to several companies including many that are contemplating IPOs or are in the registration process.
- Providing complete outsourced SOX and internal audit services to several companies.
- Providing part-time controller/CFO services to several private equity- and venture capital-backed companies ranging from startups to $50 million businesses.
- Providing financial reporting, XBRL and technical accounting support to several smaller public companies.
- Providing pre-audit support to several companies preparing for their first external audit.
The newsletters published on this Web site, current as of the dates of publication, are for general information and reference purposes only. They do not constitute specific financial or accounting advice for individual circumstances and/or companies. Such specific financial or accounting advice should always be sought separately.