M&A Due Diligence – Buyers Should Exercise Caution When Relying on Financial Statements

Comprehensive due diligence is an essential part of acquiring a business. But it can be a daunting task — especially for inexperienced buyers. Fortunately, financial professionals can help evaluate historical and prospective financial statements, identify potential hidden liabilities and misrepresentations, and prepare independent forecasts and projections. This information is critical when determining the optimal offer price and deal terms.

Looking Back … and Ahead

When figuring out how much to offer, buyers need to review copies of historical and prospective financial statements. In terms of the acquisition target’s historical performance, it’s important to evaluate a full business cycle, including cyclical peaks and troughs. If a seller provides statements during only peak years, there’s a risk that the buyer could overpay. It’s generally advisable for a potential buyer to examine at least five years of financial statements to help determine possible future business trends.

On the other hand, prospective financial statements are based on management’s expectations for the future. Likewise, a buyer’s offer is based on how much return the business interest is expected to generate. Fair market value is a good starting point, but buyers may be willing to pay more (or less) depending on the situation.

Playing Devil’s Advocate

When reviewing the prospective financial statements, it’s important to evaluate the underlying assumptions. For instance, suppose management expects to grow at 20% annually. The buyer needs to recognize that fixed assets and human capital have limited capacity, so fixed costs probably can’t sustain such high growth over the long run. At some point, the business will need to buy more equipment, open additional facilities and hire more managers to achieve forecasted revenue. So, carefully review the terminal (or residual) value that’s included in any discounted cash flow analysis. 

Also, ask who prepared the prospective financials. If they’re prepared by an outside accountant, do the reports follow the standards provided by the American Institute of Certified Public Accountants (AICPA)? Buyers may have more confidence in projections and forecasts prepared by outsiders — especially if they conform to AICPA standards — but these reports are typically based on management’s assumptions. Because current management (the seller) may have a financial incentive to paint a rosy picture of financial performance, it’s a good idea to hire your own expert to perform an independent analysis.

Digging Deeper

Historical balance sheets tell buyers about a company’s tangible assets, acquired intangibles and debts. But some liabilities may not appear on the financial statements. Examples of unrecorded liabilities include pending lawsuits, warranties, insurance claims, bad debts and underfunded pensions. Some issues, like broken equipment or obsolete inventory, can be unearthed only during a site visit.

Hidden liabilities can be a major issue in stock sales. Unlike asset sales, in which the buyer cherry-picks assets and liabilities to acquire, stock sales transfer all outstanding shares of stock to the buyer, and the business continues to operate uninterrupted. From a legal perspective, that means the buyer may be vulnerable to future lawsuits, such as employee discrimination or intellectual property claims that relate to conditions that existed before the deal closed.

Buyers also need to be skeptical of representations the seller makes to seal a deal. Misrepresentations that are found after closing can lead to expensive legal battles. An earnout provision or escrow account can be used to reduce the buyer’s risk that the deal won’t pan out as the seller claimed it would.

Avoid Costly Mistakes

Many private business owners are inexperienced when it comes to these complex deals. Overpaying in M&A can cause problems down the road — and even lead to impairment losses in future periods. So, it’s prudent, over the long run, to hire an outside valuation professional to help vet the deal.