Financial and tax due diligence are a few of the many moving parts involved with selling a business. Most of the time, sellers provide buyers with plenty of financial data long before due diligence even begins. All the additional requests for information can seem repetitive, but financial and tax diligence is critical for both sides of a deal. We were joined by Justin Thomas, Partner in Charge of Transaction Services at Cohen & Company, to the financial and tax due diligence process and the purpose it serves for buyers and sellers of businesses. Among other topics, Justin covers:
I hope you find the interview useful and informative. If you have any follow up questions, or have a topic idea for a future podcast, please reach out to Chris Hren at chris@mcmcapital.com
Financial and tax due diligence are a few of the many moving parts involved with selling a business. Most of the time, sellers provide buyers with plenty of financial data long before due diligence even begins. All the additional requests for information can seem repetitive, but financial and tax diligence is critical for both sides of a deal. We were joined by Justin Thomas, Partner in Charge of Transaction Services at Cohen & Company, to the financial and tax due diligence process and the purpose it serves for buyers and sellers of businesses. Among other topics, Justin covers:
I hope you find the interview useful and informative. If you have any follow up questions, or have a topic idea for a future podcast, please reach out to Chris Hren at chris@mcmcapital.com
hello and welcome to well capitalized I'm your host Bobby Kingsbury managing director at MCM Capital Partners and today we're continuing our discussion on M&A due diligence and today we're talking about the financial and accounting financial tax side of it and with us today we have Justin Thomas from kony company thanks for having me back thanks for joining us can you just start by giving us a little bit of your background and maybe a little bit about about Cohen sure all right Coenen company is a little market focused accounting firm based in Cleveland Ohio you know offer traditional accounting and tax services primarily done privately owned companies and we also have my group is a part of I run our transaction services division so we specialize in doing accounting and tax due diligence for companies that are entering into an acquisition whether that be for the buyer or as the seller yeah and just a little bit of background yourself sure I've run the practice at Cohen for a little over five years the 13 years before that I was doing the same type of work for PwC one of the big four accounting firms great so getting into the the crux of of the subject what does the financial and tax diligence actually entail from a transaction standpoint sure thing so our work primarily entails a deep dive look at the historical financials and tax position of a company so as you know an investor you're going to be looking hard at the historical financials of the business to make sure that they align with your understanding of valuation that you've offered to a business owner usually prior to the point we get involved someone like yourself has had minimal minimal access to the company and its financial statements probably some high-level information but haven't had a chance to deep dive so what we do is we go in you know and I try to in a condensed timeframe understand the financials at a very specific level understand what's going on with the business understand any add back Steve Itza which we can talk about in a minute what those mean and just generally try to sure all the parties have a good understanding of the financial condition of the business and any tax risks that might exist yeah that's so you know I'm sure the list is pretty voluminous but what what information are you going to request from a business owner sure some of it will depend on the company and the type of company but the general things are just detailed financial records usually for the last three years usually the period we look at is three years back it may go up to five years but generally three years so detailed financial records of your income statement your trial balance you know some things like detailed sales analysis you know whether that be sales and potentially margin by customer or by product line things like that again to get a better and deeper understanding of where the sales dollars in margin of the business are coming from and then more you know typical things would be understanding the accounts receivable position of the company looking at details of the inventory over time just to make sure we understand the assets that will be acquired in the transaction from the tax side we're going to be making sure that all of your filings are up to date when looking at it from a state level that you're filing it returns whether they be income income tax returns or sales and use tax returns in the right States depending on where you have activity that can be you know one that that is a little tricky because just from time to time those states like to change the rules and small business owners don't always have the ability to stay on top of that and that generally is again a three to five year period but we're looking back at that activity and then I you know when we had talked before you were kind enough to offer a just a standard diligence checklist that we can provide to the business owners listening in and watching yep and then that should give you a good idea of at least the basics of what should be requested in a general sense and you know depending on your business there may be may be more or less from there but that should be a good start yeah when some business owners may look at that and look at this list you know I think you know to a certain extent the answer is obvious but but why does this need to be done yeah well it needs to be done like I said before just so we have a real fulsome understanding of the business and understanding in detail what's going to be acquired so somebody is making a significant investment in your business and you know while the the real value to the buyer is in the future right you're kind of acquiring the future cash flows of the business to really make sure that that projection makes sense we have to understand what's happened in the past and make that connection between the two so that's why we look at things in such a detail levels to make sure it marries up with the forecast and ultimately the value that's been proposed for the company got it so when we look at specific businesses and we're looking at at diligence requests how long does this usually take and then who from the company is is going to be involved because we talked you know with the legal side and sometimes business owners prior to a letter of intent all right sometimes even after a letter of intent don't want to disclose the fact that they're selling the the business but to do all this work on their own might be pretty difficult it generally generally is yeah so I think you know when you think of it in terms of how long does this process take it's a bit of a sliding scale so again from the financial and tax due diligence side we're usually the first group to really kick off the detailed due diligence after the letter of intent is signed so what you're going to get is that first initial list from us and then there will be you know a flurry of activity right away and so over the first couple days to a week from when we get engaged and have a kickoff call with the the business owners company there will be a large amount of data processed right away then continuing on over the next couple weeks there will continue to be some back-and-forth but hopefully that's the type of lease on the financial and tax we can front-load that work and then from there we're just doing analysis and asking questions to your point about who should be involved it's you know a bit of a sensitive subject sometimes with business owners who they let know when in the process but I would say you know your key financial person or people are are going to be very important to you in this process it's a lot of information that we ask analyze and then have a bunch of questions on again to make sure we get it we get a full analysis of the business so trying to do that without your you know whether it be CFO controller bookkeeper outside accounting firm yeah whatever it is without having them understanding what's happening is is generally difficult and you know the other thing is you know you don't want to insult someone's intelligence with all of a sudden you're asking for a bunch of information and digging through things that you may not have ever looked at before people will start to figure out what's going on and oftentimes it's worse for them to speculate on what's happening rather than having that open conversation about why we're asking for these things and how they can be helpful right so are you just having conversations with them remotely or is there a point you know I'm sure business owners would would wonder are you actually going out and visiting the facility but we can do it both ways I think we've generally found that after we've done the bulk of our analysis with all that information we've requested generally the most efficient thing to do is have a face-to-face meeting to go through all of our QA follow-up requests and those things and that generally will take a day or so of time and we get we generally find that having that be a face to face conversation whether that's at the company or you know at at your attorney's office or wherever that may be just helps the process go more quickly yeah and that's something at MCM that we've required you know obviously we've we've used Cohen on a number of times and would request that that management or at least a business owner allow you the opportunity to to visit one of the other sticking points I think from a business owners perspective and diligence and creates some consternation or worry or concern is generally there's a lot not a lot but there's personal expenses that would be run through a business and the business owner entrepreneur is worried that you know our financial and tax diligence that it's an IRS audit or coming out to to get me right you know right and and I assure you it's not you know it's kind of ties back to the conversation we were having before you know around why we're asking for a lot of the information we are I'm one of the key things we want to understand is adjustments that you bit to right so there is the there's the financial results of your business as you report them and then you know what we're really trying to get to is okay well what are the results of this business as you know it would be under future ownership Yeah right so those are things often like well you know if this is not owned by one individual you're probably not going to have things like country club dues or you know travel that may not be a hundred percent business-related or other things like that running cars or yeah wife's car cellphones things like that which you know at the end of the day might add up and you know if you're a business owner with you know a company that has three million dollars of earnings if there's you know 150 to 200 thousand dollars of that type of stuff going through the business and we can identify that well that just makes your company look better because that's extra cash flow that would be there to service debt you know investing capex other things going forward so it's all part of the the process of just really making sure that we understand what's you know what's really there in the business in terms of a recurring level of cash flows right now at the end of the day that's it's beneficial to owners because it increases their eveyday we're always paying a multiple you know of a vba so that $200,000 can mean you know one to one and a half sometimes even two million dollars of value that's right depending on the business so you know becoming more commonplace now today has been a sell side quality of earnings I guess first maybe we we take a step back and kind of define what quality of earnings actually is for the business owners that that don't know and then we can into the second part of that sure so our work on the financial due diligence really gets boiled down into a report and the hallmark of that report is what we call it the quality of earnings analysis which highlights some of the things we just talked about that is an analysis where where we will kind of bridge the reported results of the business down to what you know what we understand and believe to be the recurring you know operating EBIT of a business so that will take out things like the owners personal expenses that may be in the business it would also adjust for things that are maybe one time in nature that have happened over the last 12 months so if there was a lawsuit and you had an extra legal fees or you know a lawsuit kind of went your way and you had kind of a payment come in those things that aren't really part of the recurring you know cash flow or operations of the business those touch things or any things that we would think of as non-cash right so if you're if you have booked or reserved to pay out a big bonus and then didn't well there's gonna be financial statement implications to that and we just try to take out all that noise and get down to what we call the adjusted EB of the business which really then factors into your ultimate valuation and the goal is just to have that be kind of a clean number that's free of any of those one-time unusual or non-cash items right so this this type of work has historically been very heavily you know the work of a buyer group or it's been very heavily a service purchased by the by the buyers to make sure that again the company they're buying the financials match up to what they've seen before they had a chance to dive in deep something that's really developed over the last five or six years is a lot more business owners have been electing to have somebody like ourselves go through that same process for them before they go to market for the bid with the business so we saw we call that a sell side quality of earnings and that's got a lot of benefits for the seller in particular if you're company is not audited you know and you've not really had that hard external look at your numbers before you know other than there's maybe a bank examiner coming every once in a while right so that has a lot of benefit because it will a prepare your team for the process you're about to go through we can shake loose any of the items that as we see them it may typically be a concern for a buyer if they didn't know about it and help you prepare to either just have that conversation with buyer groups on why these things happened what they mean and how does it impact your value yeah and sort of solidify the veracity of the numbers that's right so that you know the one thing you really want to avoid and the thing that can really cause issues during a process is if you've presented potential buyers with some financial results and they've they've developed a value based on those results and then ultimately they find something in their due diligence that that gives them a different picture yeah so doing the sell side quality of earnings will help you avoid that from happening and you know avoid having the the stress of being a situation where you know hey maybe at the beginning of this we've valid your company at twenty million dollars but then we found out these things and now we actually think it's closer to fifteen to seventeen having that knowledge upfront just sets expectations and makes the whole process go more smoothly and then the secondary benefit is when the buyers do come in to do this process they've already got 75% of the work done right they know somebody else has taken a look at it a lot of the analysis and schedules that we would do on the buyer sign is already prepared and it's ready to be handed off to them so it shortens that time between signing the LOI and closing and you know that's critical that's a critical time for the seller right because that's when they're at most risk of value leakage yeah that's when there's the biggest risk from that headline number that was put in the LOI to what's ultimately paid and so keeping that period of time short concise and controlled really important they seller and that self/psyche oh we you know gives private equity firms or buyers less reason to try and reach rate you know because you're putting everything up and out front yeah you already did all the guess your own financial due diligence and in the quality of earnings and would certainly help certainty of clothes and you know again buyers are less apt to to retrain or they at least they don't have a leg to stand on yep and you know and I think from the from the business owner in the seller's perspective you know if you have someone do the sell-side Givi you know having that process unearth both positive and negative items is a good thing either way because you're just prepared to have that conversation and you know ahead of time where pain points might be for a potential buyer it's not gonna surprise you you can prepare you know or at least alleviate mitigate some of the risk and some of your answers so I have to put you on the spot here but generally you can give me a range of what a quality of earnings generally cost the the real answer is it depends like with anything else yeah size complexity of the business you know what the shape of the financial records are in now but you know it really you know for a middle market company can range anywhere from you know thirty to seventy thousand dollars based on how much work is needed yeah but in in my mind if I was a seller or a business owner that's thirty is seventy thousand dollars well spent going into a transaction knowing all the great things the flaws and setting expectations for myself and not allowing that potential buyer to come in and try to retreive yeah did the the level of you know additional certainty that it gives you as a seller I think we found has been really helpful for our clients on the sales and so now I'm the quality of earnings what if I'm a smaller business or you just on the diligence side I'm a smaller business and I'm operating QuickBooks or a less sophisticated financial reporting software is that a problem I generally no I don't don't think it is in particular if you're a business using QuickBooks so that is such a ubiquitous system and the in the lower-middle marketing especially it's that's such a ubiquitous instrument in the lower-middle market especially that firms like us we have our own ability to to use QuickBooks so if the business owner is comfortable with it we can just take that whole file which may have 60 70 % of the stuff we're going to ask you to produce for us and we can just pull those records ourselves that saves time for you know you the business owner your team and compiling all that data and all we need is the file the password to get into it and you know can really shorten the amount of time and effort your team needs to spend on it if you know you're willing to give us that access and sometimes with a less sophisticated reporting system you know they might not be able to answer some of the questions that you're asking so if you know that they don't have a sophisticated system maybe they don't know gross margin by by product line yeah they might have to do a physical at the end of every month or something like that hi how do you deal with that in a quality every business center can't produce you know the answer to your question yep so I think the first thing we would do is just at the beginning of our process we'd take our standard request list and just walk through it with the company and find out you know hey these are the general things we would ask for you know you tell us do you think you have this or not do you have something similar or not you know because what we're what we're trying to get to as an answer or an analysis so if you don't have exactly what we're asking for well what is the what else do you have how can we how can we find a way around this just to get to the analysis we're trying to do and generally we I think we can find a way sometimes sometimes you just can't get there and you know that just ends up being a finding that we have in our process and we have to let someone like the buyer the buyer our client know that well we can we can tell you these three things but we can't tell you things four and five that we might want to say okay we can we can tell you how much of this product they're selling and whom they're selling it to but just because of lack investigation the system we can't tell you exactly the margin of each of those and the differences in the margin between them and ultimately that's if there is nothing we can do in that regard but again like I said sometimes there are sometimes there's alternate ways to get to some estimates that's not exactly sis system driven information but we can come to some estimates but at the end of the day that will just color the again the overall value assessments of the buyer you know they can't prove out so to say some initial theories that they had on where exactly the margin or the dollars were coming from by by-product or you know by customer you know it just meant some whether that ends up being a you know a big deal to the buyer yeah and but hey at the end of the day we can only analyze what information there is so sometimes we have to find some workarounds and then sometimes we just have to just ultimately caveat it that hey there are some things and ultimately I think everybody knows especially a sophisticated behind a private equity firm is going to know that perfect information doesn't always exist it perfect information rarely exists and sometimes there are things you know and sometimes there's things you don't know on the tax side of it and your experience what have been some of the the common things that might crater a deal on on the tax side you know some of the common things I'm a tax ID where I think a business owner who's thinking of selling their business can do very easily just to get them give themselves ahead of the curve it's just making sure all of their tax documentation around their structure is in order you know if you have multiple shareholders just make sure you've got the documentation around you know who owns what percentage you know who's the rightful owners of all the shares how you've distributed dividends to those shareholders over time that can be very important if you're an S corporation you know you should have certain notifications from the IRS that say you know yes we've accepted that you're an S corporation and can operate and file your taxes as such and so making sure that simple things like you have those documents just in order and ready for somebody like us to take a look at goes a long way and you know from there it's it gets a little more detailed as you go into the state level but again relatively simple things like if you're selling a product and you think you're exempt from sales tax collect some exemption certificates it's we see that a lot it's a simple simple thing that alleviates a lot of risk again and if if you're dealing with particularly if your customers are larger companies they get those requests all the time and you know it should be pretty simple for them to get that to you and just takes a whole issue off the table right away if you just have that documentation especially if it's a stock sale - yes what so and maybe you know that drawing that distinction would be helpful for a business owner but you know in terms of the level of tax due diligence we're going to do if you know you are selling the stock of the company we're gonna have to dig a lot deeper because those past tax issues are going to transfer to the buyer if you're buying the stock of the company if you're doing an asset sale there's there's more of a cut-off on some of those historical potential tax liabilities so that can create a little bit of a difference in the depth of the tax due diligence just because there's less of a risk for the buyer yeah I think this was extremely extremely helpful if is there one thing that you could leave a business owner with you know aside from doing this else iqe didn't to just prepare for this type of diligence both financial and tax I'll just reiterate something I said before is that this will be a lot easier on you if you get a couple key people from your organization involved and everybody's going to make the decision for themselves when that time is but that especially on the financial and tax side that'll really alleviate a lot of the stress on you the business owner because you'll have four or five other streams of diligence going on that really need your time and attention more than the financial side would yeah so I think just really again it's a tough situation sometimes and when you tell folks you're thinking of selling your business but it'll really pay some dividends if you get your financial person involved oh great Justin thank you so much for taking the time we really appreciate it sure thing Bob yeah take care all right thank you for taking the 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