Keys to adding value

Patrick Donoghue is a senior managing director and Sean Windsor is a managing director in the Transaction Advisory Services group of the Corporate Finance practice at FTI Consulting, a business advisory firm. They can be reached at pat.donoghue@fticonsulting.com and sean.windsor@fticonsulting.com, respectively.

Many financial due diligence advisors will review a target's historical earnings in order to identify quality of earnings issues and/or nonrecurring events. For example, they will adjust reported earnings for issues with revenue recognition; cost capitalization; one-time expenses, such as those incurred in a lawsuit; non-cash reserve reversals to income; and perhaps the earnings impact from lost customers or other such pro-forma adjustments. The financial due diligence advisor's mission is to report on the target's historical run-rate earnings. This quality of earnings analysis is critical to establishing an accurate, normalized run-rate earnings base.

The goal in any value-added due diligence exercise is to evaluate the target's projected run-rate earnings and free cash flow, both of which drive the value of the transaction. Such an analysis is done by using the target's historical run-rate performance as a basis for evaluating the assumptions in the projections. Thus, it is essential to bridge the gap between the target's historical performance and expected future performance. Frequently, a large gap exists and it must be reconciled. Moreover, when the seller presents its view of the buyer's synergies, the gap can become even wider (sellers typically look to participate in the value created by these synergies.). Accordingly, the historicalto-projected run-rate earnings bridge should focus on the assumptions driving the change in earnings and cash flows. Relatively small changes in certain key assumptions (i.e. the assumed EBITDA margin or discount rate) can have a material impact on earnings and cash flows and, consequently, the value of the deal.

It is also essential during financial due diligence to reconcile the target's earnings (EBITDA) and its cash flows from operations, investing and financing activities. This reconciliation will highlight the cash impact of net working capital changes, capital expenditures, cash taxes and debt service charges on the target's free cash flows. Too often investors will use EBITDA as a proxy for operating cash flow of a target and not address the cash impact of net working capital requirements and capital expenditure outlays, taxes and financing costs. The cash flow impact of all of these items must be fully understood in evaluating the value of the deal.

The quality of a target's assets is another key area to focus on during the financial due diligence process. Although many target companies have audited financial statements, circumstances might have changed since the last audit. The target may also use an accounting standard or interpretation thats is different from the buyer. In addition, it is imperative to understand what comprises each asset/liability account and to what extent these accounts impact the cash flows of the target.

Net working capital value implications
Many assume that net working capital is computed simply by subtracting current liabilities from current assets. However, it is essential to look at specific line-items that make up a target's current assets and liabilities, as well the structure of the deal. For example, certain current assets and liabilities relating to taxes, financing and hedging activities may not be relevant if the deal is structured as an asset sale, or if the debt in place is being refinanced rather than assumed. Even in a stock purchase deal, the value of certain tax and financing-related assets and liabilities may be impacted by change in control limitations. Figure 1 illustrates how working capital can vary by the structure of the deal.

In an asset deal, the buyer will do three things: establish a new stepped-up basis in the assets for tax purposes, usually refinance the outstanding debt and remit existing cash balances to the seller. Accordingly, any income tax and/or debt-related current assets and liabilities would be excluded. However, though cash is typically excluded in an asset deal, we believe that to the extent that deferred revenue represents cash deposits from customers, an equivalent amount of that cash collected should remain in the business since the buyer will be expected to perform in order to earn that cash or return the cash to the customer.

In addition to the components of net working capital, a buyer must determine the appropriate level of net working capital to run the business upon closing the transaction. A shortfall generally results in a reduction to the purchase price and any excess generally results in an additional purchase price payment made to the seller. Accordingly, it is important to assess the appropriate net working capital bench How much working capital should be left in the business at the closing date? We recommend the amount be sufficient to enable the buyer to run the business without an additional infusion of cash to fund working capital items. To project the amount of net working capital required at closing, an advisor typically evaluates monthly historical net working capital and considers monthly projected working capital based on the impact of sales growth on accounts receivable and days sales outstanding, inventory requirements and pricing trends, and accounts payable and days payables outstanding.

Skimping on capital expenditures
We have seen instances where the seller, knowing full well that the business they own will be sold in the near term, dramatically cuts back on planned or even necessary capital expenditures in order to conserve cash and leave the outlay for the buyer to eventually make. Accordingly, it is important to assess historical and future capital expenditure requirements, and their impact on projected free cash flow in determining the value of the deal. It is useful to compare capital expenditures to depreciation expense over the recent historical period to see if the seller has been under-investing in the business as follows. mark before signing the purchase and sale agreement.

Figure 2 shows that capital expenditures have been decreasing in recent years and have dropped below the amount of annual depreciation expense. If the seller has been curtailing capital expenditures in an attempt to take money out of the business (or to avoid putting more money in the business) before the sale closes, then consideration should be given to adjusting the purchase price for the cash flow impact of the deferral.

Electing Section 338 (h) (10)
As noted above, it is possible to structure a transaction as a stock deal or as an asset deal. A seller usually prefers to do a stock deal, as the seller is then able to transfer any historical obligations or liabilities associated with the business to the buyer. On the other hand, a buyer usually prefers to do an asset deal for the opposite reason (i.e. to avoid inheriting any historical obligations or liabilities of the business).

Beyond the legal considerations in structuring a deal, there are significant US tax considerations that may impact the value of the deal. An asset deal allows the buyer to step-up the basis in the assets acquired to fair market value (i.e. the purchase price is allocated to the assets acquired and liabilities assumed, for both book and tax purposes) and the related depreciation and amortization expense provides a tax shield resulting in additional cash flow in the earlier years. In a stock deal, the buyer retains the seller's tax basis in the underlying assets and liabilities of the seller ? unless the buyer and seller agree to make a Section 338 (h) (10) election.

When a Section 338 (h) (10) election is made, the buyer and seller agree to treat the sale of the business as if it were an asset sale and the buyer is then able to step up the basis of the assets received from the seller. Generally, the buyer will have to pay the seller for the related tax benefits in order to get the seller to agree to a Section 338 (h) (10) election, especially if the seller will incur a greater tax liability in an asset sale rather than a stock sale.

Conclusion
Value-based due diligence is the only way to add real value as a transaction advisor. This requires the advisor have a strong working knowledge of financing, accounting, valuation and tax expertise. By focusing on the key value drivers of the target's business and reconciling the gap between the target's historical normalized run-rate and its projected run-rate, a transaction advisor can assist a buyer in performing value-focused due diligence and provide the grist for value-related negotiations.

The net working capital or net worth adjustments (and, thus, what comprises net working capital or net worth) are a key component of the purchase and sales agreement and will usually impact the final purchase price. Accordingly, it is essential that the benchmark be set at an appropriate amount and the components of the benchmark be clearly defined. There should be no misunderstanding as to what is included and excluded from the computation of net working capital or net worth.

A detailed analysis of the target's historical and projected capital expenditures may also have a significant impact on the purchase price, either in terms of reducing the price for the under-investment itself or reducing it if the projections provided cannot be met without additional capital investment by the buyer (i.e. the future cash flows will be lower than projected). Finally, don't forget about the possible tax-related cash flow implications and choices that exist when structuring and negotiating a deal.