Preparing for Potential Merger & Acquisition Activity

October 19, 2020 | Article

How COVID-19 is Impacting the Potential Sale of Your Business

Mergers and acquisitions have always been part of the history of corporate America. Now, more than ever, the merger and acquisition market stands poised to help organizations navigate through the economic uncertainty caused by the effects of COVID-19.

Disruptions related to COVID-19 led to a quick slowdown in the M&A market in the first two quarters of 2020. Significant uncertainty surrounding COVID-19 caused many financial and strategic buyers to pause existing deals, both to evaluate the cash flow situation within their own operations and assess any changes in performance and financial wellbeing of acquisition targets. As the economy slowly reopens, buying and lending activity is beginning to resume.

Despite fluctuating market conditions due to COVID-19, there is never a wrong time to begin preparing for an eventual sale. Merger and acquisition activity is important to consider, regardless the size or industry of your organization. Buyers are looking for management who know what they’re doing and defendable growth projections. You can easily have these, regardless of your size.

Important Mergers and Acquisitions Items to Consider
Divesting or acquiring a business may seem like a monumental task. The key to a successful transaction could be summed up in one word—information. There will always be an element of risk involved in transactions; however, starting the process with certain questions and an understanding of topics will act as a roadmap that can lead to an informed decision of what is best for your organization.

Adjusted EBITDA
Middle market deal prices are often traded based on adjusted EBITDA. Adjusted EBITDA is a term used in transactions to identify unusual and non-recurring events that have impacted EBITDA. For example, the seller may have certain discretionary expenses, relatives on the payroll, non-recurring incentive income or accounting policy differences during the periods being analyzed.

Additionally, current accounting policy elections could impact the analysis of historical EBITDA should the new owner require, or desire, policy changes after purchase. One example could be whether the new owner will elect FIFO vs. LIFO as an inventory method. If the desired inventory method of the buyer is different than what the seller is currently using, adjustments should be made in calculating adjusted EBITDA so that the buyer can make an informed decision.

COVID-19 adds another layer to the adjusted EBITDA conversation. With the potential for lost revenues due to COVID-19, many organizations will be searching for ways to counteract revenue declines in their financials for upcoming quarters. However, many in the merger and acquisition profession are questioning whether these type of COVID-19 based calculations will be fully accepted as EBITDA adjustments.

Working Capital
Sellers and buyers often become fixated on adjusted EBITDA during the due diligence phase, but it remains equally important to understand other financial health indicators of the entity, such as working capital. Inventory and floorplan are some of the most significant items on a balance sheet. Analyzing inventory levels by product line and completing a turnover analysis allows the buyer to detect slow-moving items. Additionally, reviewing for aged inventory can identify future borrowing base issues or the potential of distressed contribution margin on the aged inventory.

Understanding the inventory mix you are acquiring will help you identify issues that could present themselves post-acquisition. Furthermore, identifying adjustments to working capital may help reduce the possibility of money changing hands after the transaction has closed.

Profitability by Segment
When evaluating a potential acquisition or sale, an important metric that should be analyzed is profitability by revenue segment. Appropriate segregation of costs provides buyers and sellers insight into the profitability drivers of the entity. These costs are not often easy to identify retroactively, so it’s important an effort be made ahead of the potential sale to provide more detailed insights into what makes the entity profitable. Furthermore, any insight a seller may be able to provide regarding historical profitability trends reduces the risk of a potential issue stalling the deal.

Capacity for Growth
Along with financial factors, it is important for a buyer to understand what the target company is capable of in the future and additional costs that may be necessary for planned growth. The target may be operating near or at capacity in the facility they are currently leasing. A buyer’s integration or growth plans could be significantly hindered by unforeseen capital expenditures not identified in the diligence phase.

Are you prepared for a sale?

Understand the Importance of Due Diligence in Mergers and Acquisitions
When negotiating mergers or acquisitions, due diligence serves as an in-depth review of the target organization—both its operations and its people. Much of due diligence involves a review of the quality of the assets and earnings to be acquired, but it also includes a review of operations, technology and staff.

Scope
The scope of the due diligence procedures depends on the structure of the proposed transaction. If it’s an asset purchase, you are obviously focused on the assets being acquired and staff to be hired. If it’s a stock purchase or merger, there is more due diligence required regarding organizational issues, since you are stepping into the seller’s shoes in such transactions. The review needs to include a review of organizational documents, as well as tax issues, such as the S corporation election.

In addition, since many acquisitions involve organizations not subject to a financial statement audit prepared under generally accepted audit standards, the strength of internal controls can vary widely. It is through the due diligence process that you identify potential risks and develop a list of issues to be addressed in the definitive agreement.

Due diligence might include a review or inspection of:

  • Financial information
  • Corporate information, including material contracts and agreements
  • Asset quality
  • Lending policies and procedures
  • Asset/liability management function
  • Operations
  • Deposits an analysis of deposit growth, core deposits and rates paid on deposits
  • Internal controls (the depth and effectiveness)
  • Litigation (anything in progress or pending)
  • Environmental issues
  • Employees and human resources (staff capabilities, compensation agreements)
  • Federal, state and local tax reporting
  • Regulatory compliance

Tax Considerations in Mergers and Acquisitions
When a business engages in a restructure, merger, sale or acquisition of another business, proper planning is vital to obtain the necessary information to fulfill various tax reporting requirements for the transaction. The type and extent of tax compliance that will be required depends on a variety of factors.

For example, is the transaction taxable or tax-free? Is the transaction a sale of actual assets or a stock sale? The answer to these questions determines the next steps in the compliance and reporting process.

Information Gathering
It's not always apparent whether a particular transaction is taxable or tax-free. To obtain the comfort necessary for preparing or signing a tax return that will reflect the taxability of a transaction, the following items should be compiled for review:

  • Stock or asset purchase agreement
  • SEC filings, such as DEFM 14A, DEFM 14C, PREM 14A, PREM 14C and S-4
  • Board minutes
  • State incorporation, merger and dissolution filings
  • Organizational charts
  • Cap tables (i.e., shareholder ownership tables)
  • Investment Banker Fairness Opinion
  • Attorney tax opinions

Compliance Requirements
Once the nature of the transaction is apparent, the next step is to think about the compliance requirements associated with the transaction. Since businesses don't often engage in restructuring transactions, it can be difficult to keep abreast of these requirements. Maintaining a working knowledge of complex M&A rules, as well as the transaction reporting requirements, can be daunting and a time-consuming effort.

The Importance of Planning & Implementation in Mergers and Acquisitions
The merger, acquisition and divestiture process typically focuses on the transaction deal and negotiations involved. The implementation portion is often a second thought or prepared for after the fact. However, an implementation that includes a structured plan, defined process and comprehensive communication plan will impact more stakeholders and oftentimes be the measure of a successful deal. Planning and preparing for each of these three significant items and the ongoing management requires tools, experience and leadership.

Structured Plan
First, the importance of having a plan for what the organization's world looks like after the merger, acquisition or divestiture will lay the groundwork for the future vision. This plan can include a detailed business plan for the impact and expected result of the process and should provide an organizational chart or design. An unknown plan inhibits decision-making as leadership and teams are left with questions on scope changes or empowerment changes.

Defined Process
Secondly, it is essential to define a process that will address the gaps from the current state to the future. The structure of this process should include identifying resources and tools that will be utilized to facilitate the changes. The formality of the process is independent of the size of the organization and should be based on need or organizational complexity, including geographic span, number of functional areas and internal resources to manage. Creating a process that includes timelines, milestones, guidelines, status reporting, sub-group definitions and decision-making structures eliminates an environment flooded with uncertainty.

Communication Plan
Finally, a successful plan and process will be ineffective without the communication plan. A successful communication plan should start with a stakeholder analysis to identify the needs for each stakeholder cohort. After this analysis is complete, a robust plan can be created that outlines the timing, delivery mechanism and process for each communication from start to ongoing management of the new organization. A structured communication plan enables communications to be fluid and predictable throughout the transition while enabling the communications team or leadership to react to unforeseen needs without losing the structure.

The Need for a Trusted Advisor as You Prepare for Sale
Does your staff have the experience and capacity to avoid the stumbling blocks mentioned above? It is important to understand that engaging transaction advisors and due diligence providers can be as simple or extensive as the seller or buyer wishes. Involving your advisors early in the due diligence process allows them to better understand your needs and help you formulate an appropriate due diligence strategy for your sale or acquisition. Whether it’s a high-level analysis of the entity in preparation for a potential sale, a gross margin analysis of a seller’s new product offering, or detailed historical four-year and projected EBITDA and working capital analysis, your advisor can make sure you don’t overlook things that could cause surprises.

Preparing for sale comes with no shortage of to-dos. Here’s what you need to consider.

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