Last month, I shared the top five seller mistakes that kill M&A transactions. Today we’ll dive deeper into the #1 deal killer—poor financials.
Most entrepreneurs with revenues under $15M don’t see a benefit in strong financial reporting. They know their businesses inside and out and run them by gut feel. If there’s sufficient cash in the bank, all is fine. As such, most owners engage low-cost bookkeepers who perform basic tasks—entering transactions in QuickBooks (sometimes correctly), doing monthly bank reconciliations, and providing just enough detail to file the tax return. Sure, business owners can “get by” with unsophisticated bookkeeping, but trust me on this—low-caliber recordkeeping will prevent you from selling your business for anything approaching fair market value.
If you want a premium valuation, you must present your books so the “real” earnings can be validated by buyers. Because buyers of $5M–$50M companies usually value businesses on a multiple of earnings, earnings are the most scrutinized element of any deal. As such, the following activities are essential:
1. Normalize Earnings:
Earnings are adjusted on a Pro-forma basis to reflect the expected cash flow to the buyer. Common adjustments include adding back personal expenses owners run through their businesses (very common), adjusting owner and family member compensation to market (common), and ensuring the business pays fair market rent when the owner also owns the commercial property. A qualified M&A professional will guide you through this straightforward process.
2. Convert from Cash Basis to GAAP/Accrual Basis:
Many small companies report on a cash basis. That’s fine for filing tax returns, but it ignores key valuation drivers such as working capital (receivables less payables). Professional buyers look at hundreds of deals annually and compare them on an apples-to-apples basis in accordance with GAAP (Generally Accepted Accounting Principles), which mandates accrual-based reporting. As an example, a software company should accrue revenue over the term of the license, and not reflect full revenue on the date of sale. Otherwise, revenue and earnings are overstated. A qualified CPA/interim finance expert will oversee this process, which is more involved than just clicking the “accrual” checkbox in QuickBooks.
3. Have Books Sanity Checked by a CFO/CPA with M&A and Relevant Industry Experience:
Before we take a company to market, we insist the seller engage a third-party CFO/CPA for an independent review. Sellers scoff at this expense, finding it unnecessary, but I can assure you—it is critical! This financial pro will come in on a part-time basis and bring invaluable industry and M&A expertise to the review process. On a recent deal, the interim controller found $1M of expenses that were not run through the P&L. Had this not been caught, the deal would been DOA on day one of buyer diligence, causing tremendous frustration for all involved. I have had many conversations with heartbroken business owners who honestly thought their earnings were two to three times higher than they actually were. Better to find out before going to market than to get a nasty surprise when the deal falls apart!
The time and expense of having your financials professionally reviewed will pay for itself ten times over. You should consider your M&A advisor and CFO/CPA as small but vital insurance policies that significantly increase your odds of success.
As you consider selling your business, we encourage you to speak with us. Kinected Advisors has an 84% success rate in our transactions, well above the 20–30% industry average. We can help you get the best possible deal for your business.
Kevin Berson is an M&A Advisor with Kinected Consulting, based in Los Angeles. He specializes in helping business owners maximize outcomes in selling their businesses. He is also the founder of Kinected, a Management Consulting firm that advises companies with strategic planning, exit planning, and merger and acquisition diligence. Kevin can be reached at firstname.lastname@example.org.