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Comprehensive, accurate, and well-presented financial documentation is critical to capturing the interest of prospective buyers and to completing the due diligence process that precedes the negotiation of the purchase agreement.
Owners who are new to selling a business may question what financial documentation they should have ready and why it is necessary.
To understand the ins and outs, we spoke with Michael Poole, the founder and president of PCE Investment Bankers of Winter Park, Florida. Poole has been involved in many business transfers as a corporate executive, private equity investor, and investment banker. Below, we explore some of the most commonly asked questions.
Q: Business owners are often advised to normalize the books before they sell the business. Sometimes the phrase is “dress up the books.” What does this involve?
A: It’s really making sure the numbers are accurate, add up, and appear in the right place. “Dressing up” is another way of saying the documentation should help the business look its best. It doesn’t mean covering things up. You don’t want to hide issues.
Think of financial documentation as being the language of value. Any mistakes a potential buyer sees will gnaw away at their trust in the seller. Diminished trust can impact the value of the business and may result in a lower offer or no deal at all. (Calculator: Business value)
Q. What type of financial documentation are buyers looking for?
A. Typically, they’re looking for income statements and balance sheets that use accrual basis accounting. An income statement will display business revenue and expenses for a period of time, while the balance sheet will be tied to a specific date. It’s best to have three years of income statements and balance sheets available to help a buyer understand any seasonality in your business.
Q. Are bank statements necessary? And if so, what period should they cover?
A. Bank statements are used in the due diligence process, which takes place after the seller and buyer have signed a Letter of Intent (LOI). You can think of the due diligence process like the inspection of a home after the purchase agreement has been signed.
Bank statements are examined as part of a multi-step due diligence process that focuses on all aspects of the company, including the accounting, legal, real estate, and human resources practices. The entire process usually takes 60 to 90 days, depending on the size of the company being purchased.
Q. Where do I list tangible and intangible business assets?
A. Tangible assets, such as inventory, receivables, and real estate, appear on the balance sheet. Intangible assets, such as brand names, patents, and proprietary processes, rarely appear on the balance sheet. Intangible assets are treated separately because the value of intangibles is often in the eye of the beholder, and depend on what the buyer sees as the company’s future direction. Intangible assets are often referred to as the “goodwill” in a business and are often what makes a business most attractive to an acquirer.
Q. What are add-backs and how are they documented?
A. Add-backs are expenses that are added back to the profits of the business to understand the true cash flow of the company. Because these expenses are one-time costs or personal expenditures of the seller, they would not continue with the buyer. For example, your business may have one-time costs associated with a lawsuit or expenses related to personal real estate not used for business purposes. Your salary wouldn’t be an add-back if the buyer will need to hire someone to do that same job. In contrast, the deductions you take for a company car, travel or entertainment will qualify as an add-back.
Generally, a buyer will want to see an itemized list of add-backs and proof that the expenses are extras. For example, you’ll want to show receipts that document that your trip to Utah was for business and not a ski holiday.
Q. That brings up another question: What’s the best way to package and present all this information?
A. How you communicate the information is crucial. Make it as easy as possible for a potential buyer to review and understand. Handing a buyer a 3-inch stack of financial statements isn’t the best way to present your information. It is preferable to have your controller put everything in an Excel spreadsheet. If you don’t have a controller, then organize your financial statements in files by date and send them digitally.
Make sure you review them several times for accuracy, and be sure to correct any mistakes and explain inconsistencies. View your company’s finances holistically, and be sure that they accurately communicate your story. The 30,000-foot panorama and detailed views should complement and support one another. (Related: Ways to increase the value of your business)
Q. Should I have my financial statements audited?
A. If your business is small, there’s really no need to take this step. But if you’re doing more than $20 million per year, for example, then you’d be well advised to have a professional CPA review or audit your financial statements.
Q. Any final thoughts on the subject?
A. Owners often wonder whether they need pro forma projections. I think they’re a good idea for one important reason: buyers are reviewing past performance but what they’re really buying is the future. If you view the future optimistically and can substantiate your optimism, then go for it. State your profit projections in terms of earnings before interest, taxes, depreciation, and amortization (EBITDA), and explain how you arrived at the numbers. Click here to calculate your EBITDA.
MassMutual and our team of professionals can help you achieve your business goals – whether you’re growing, selling or have your business comfortably on cruise control. Talk to us today to learn more.
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This article was originally published in February 2021. It has been updated.
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