Defend Your Business Valuation in Formal Due Diligence

Defend Valuation in Formal Due Diligence

An often overlooked role of a business broker in closing a business deal is defending the valuation of the business during the formal due diligence phase. Formal due diligence is a contingency of a business sale and occurs after a deal is ‘under contract’ by virtue of a signed agreement between the buyer and seller. During formal due diligence, a buyer will fully investigate the business by examining its historical financial data as well as any available information concerning the business. The broker must prepare both parties for formal due diligence, anticipate potential issues, and ensure the buyer is given sufficient information to confirm the business valuation. Defending business valuations during formal due diligence is often contingent on the transparency of the historical financial data and the ability to justify the purported normalized earnings or adjusted owner benefit with an evidence-based approach.

Defend the Adjusted Owner Benefit

In most business deals, the primary aspect of formal due diligence is confirming the annual adjusted owner benefit. This represents the cash flow or Seller’s Discretionary Earnings (SDE), defined as the reportable pre-tax profits from the company’s financial statement (such as a tax return or profit and loss report) plus other adjustments reflecting the true economic benefit that a working owner derives from the business under normalized operating conditions. Such adjustments or add-backs include depreciation (a non-cash expense), interest and principal payments on non-transferable debt, the owner’s salary, unrecorded cash (if provable), and personal expenses of the owner that flow through the financial statement. A business broker must accurately define the annual adjusted owner benefit, and must defend the annual adjusted owner benefit during formal due diligence.

Example of Defending Adjusted Owner Benefit

  • Sherry is selling a large home health company in South Florida to a private equity group for $3M.
  • With the assistance of a professional business broker, Sherry’s business was advertised as having $600K of annual adjusted owner benefit in her most recent financial statement.
  • With little or no physical assets, the present and future cash flow of the business is the primary valuation metric used by the buyer in agreeing upon a $3M purchase price.
  • When the deal gets to the formal due diligence phase, the private equity buyer is using an accounting team to verify that Sherry’s annual adjusted owner benefit is indeed $600K/year.
  • Importantly, the annual adjusted owner benefit includes $100K/year in salary for Sherry, $100K/year in salary for her non-working husband, and $85K/year in Sherry’s personal expenses (such as auto, travel, and insurance expenses) that flow through the financial statement as reportable business expenses.
  • Sherry’s business broker has fully disclosed these adjusted add-backs to the buyer, and has highlighted these add-backs within the financial statement.
  • As the parties move into formal due diligence, the buyer’s accountant questions the legitimacy of the add-backs.
  • Fortunately, Sherry’s business broker is well prepared for this eventuality and has anticipated the accountants’ questions.
  • The broker walks the accountant through the various expense items in the financial statement that contain the personal expenses, and has extrinsic evidence proving the personal expenses.
  • Further, the broker explains how Sherry’s husband is absentee, and explains that Sherry is involved in the business only in a managerial role.
  • Sherry has no operational role such as a caregiver or administrator, and importantly has no marketing role in procuring patients for the company.
  • The cash flow of the business will remain intact after the sale without Sherry or her husband’s involvement, and the salaries for Sherry and her husband should thus be considered add-backs when calculating the adjusted owner benefit.
  • The buyer’s accountants are thus satisfied that the $600K/year accurately represents the annual adjusted owner benefit of the business, and this critical part of formal due diligence is satisfied.

Defend the Business from Red Flags

Besides evaluating the accuracy of the financials and adjusted owner benefit, formal due diligence is primarily concerned with uncovering any red flags or warning signs that impair the present or future cash flow of the business as well as the tangible or physical assets of the business.  Items such as payroll records, insurance policies, sales tax receipts, bank statements, customer concentration data, accounts receivable reports, the lease, the condition of equipment, and more may all potentially reveal areas of concern for a buyer during formal due diligence. In most cases, such areas of concern should have been known by the broker, and as such should have been disclosed to the buyer prior to formal due diligence. Since the valuation should reflect any known weaknesses, the deal should still move forward so long as the buyer is satisfied.

Defend the Business from Unknown Weaknesses

Unknown weaknesses include any areas of concern that for whatever reason were not known by the broker and were never disclosed to the buyer prior to formal due diligence. The valuation of businesses may change rapidly due to unforeseen events and it is sometimes impossible to determine all the risks that a buyer may face from owning a business. Examples include new competitors entering the marketplace, risks from litigation, or environmental liability when real property is attached to the business. If faced with new information uncovered during formal due diligence that impairs the business valuation, then it still possible to re-negotiate the deal in a way that recognizes the adjusted valuation. Both parties should always be prompted to negotiate by the broker until a resolution is found.

By preparing for formal due diligence, anticipating potential issues, and actively participating in the formal due diligence process, a professional business broker may successfully defend the company’s valuation. Disclosing all known information and areas of concern prior to the start of formal due diligence will engender trust between the parties and will create a far better chance of the deal surviving and moving on towards the closing.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.