Why Financial Due Diligence Can Save Your Acquisition

By Adam Haberman, CPA, Crowe Horwath

Where does success in an acquisition begin?  Most of us know that we must “do our due diligence,” but what does that really mean?

Many acquisitions are priced based upon a multiple of pro forma earnings before interest, taxes, depreciation, and amortization (“EBITDA.”).  Multiples are often market-driven and can be affected by numerous factors.  Understanding and determining such multiples is an essential part of initial transaction valuation.  Analyzing the earnings (EBITDA) of the target business, on the other hand, is an essential element of financial due diligence.

Note in the diagram below that purchase price is not typically determined based on EBITDA as calculated from reported amounts in the seller’s income statement.  It is determined based upon pro forma EBITDA, which includes adjustments to reported earnings for the seller’s calculation of unusual, non-recurring, or out of period items.  Theoretically this adjustment can increase or decrease earnings.  In practice, our experience suggests that the effect is typically an increase in comparison to reported EBITDA and thus a higher calculated transaction price.

It is important to understand that earnings can be properly reported under Generally Accepted Accounting Principles but still be considered understated on a normalized basis.  For example, imagine if the seller is a privately held business and the owner pays himself a salary of $2,000 as the Chief Executive Officer.  If market compensation for this position is considered to be $500, normalized earnings would be overstated by $1,500, resulting in a pro forma adjustment.  Assuming a five times EBITDA multiple, this means that $7,500 of deal value results from the notion that the CEO is over compensated by market standards.  Other such “normalization” adjustments might include the removal of income from a favorable litigation settlement or exclusion of a loss on sale of property and equipment if not part of the target’s core operations.

This is why financial due diligence is so critical.  If the seller’s earnings are overstated the buyer will end up overpaying for the acquisition by the amount of the overstatement, times the transaction multiple.  In our example, the seller has identified $2,045 of pro forma adjustments, resulting in a pro forma EBITDA of $7,250.  In the most basic of examples, again at a 5x multiple, the purchase price proposed in the letter of intent will be $36,250.  In this example, the buyer is asked to pay $26,025 based on reported earnings and an additional $10,225 based on the seller’s calculated adjustments to normalize earnings.  Either or both of the calculations could be incorrect to some degree.

Our example shows that the adjustments determined from due diligence resulted in a net EBITDA reduction of $2,550.  Because the initial valuation was based on pro forma adjusted (rather than reported) EBITDA, the resulting adjustments would theoretically support a $12,750 (35%) reduction in purchase price.  This would likely result in the buyer renegotiating the purchase price or even walking away from the acquisition.  Simply put, the true earnings of the business no longer support the transaction valuation. 

How could such a discrepancy in earnings occur and not be noted until diligence begins?  How do we find such misstatements?  We discuss all that and much more in our “Art of M&A Due Diligence” seminar, next offered March 26-27, 2015, in Dallas.  Join us for instruction, interaction, and answers to your due diligence questions. 

Photo:  jmu.edu