By Brandon Frederics, CPA | AGP Advisory, Leader
Our journey thus far has taken us through understanding what a quality of earnings (QofE) entails, how we define and assess the “quality” within earnings, and our work around the earnings and Net Working Capital (NWC). This leads us into the next topic that helps bring these projects all together—the adjustments. Let’s define the typical adjustments we can expect to see during the process.
- Management Adjustment -These adjustments typically relate to non-recurring expenses, noncash events, and perhaps excess compensation. For a potential buyer, verification of all adjustments should be a part of the QofE project. Best practices would entail the adjustments having support evidence and not simply relying on an estimate. Furthermore, sound judgement should support each adjustment and assumptions should be challenged during the normal course of due diligence.
- Due Diligence Adjustment -These adjustments are defined by those adjustments identified during our quality of earnings work. Adjustments might include overlooked onetime expenses, unique or non-reoccurring revenue streams, restructuring charges, related party charges, changes in accounting policies and/or errors, incorrect application of GAAP standards, effects of unrecorded or under recorded liabilities, or even a reversal of management adjustments that fail to hold up to scrutiny. As a buyer, the volume of the adjustments can be telling. The most straight forward impact of the identification of the adjustment provides the financial implication to the transaction itself. But more importantly, the adjustments should also provide key insights into the quality of the earnings and the strength of the overall finance team.
- Proforma Adjustments -Lesser known and frequently misunderstood, these adjustments are present to normalize and address the sustainability of the business on a go-forward basis for a potential buyer. Keep in mind, as most deals are done with some type of trailing twelve-months, adjusting the financial statements in a manner that more accurately reflects the company moving forward is key. For example, an increase in pricing for a supply agreement may be annualized and adjusted to better account for the actual cost structure moving forward. Similar scrutiny should be applied to these during the due diligence process.
It is important to note these adjustments go beyond just earnings. As we have previously discussed, NWC plays a significant role in almost every deal. Thus, understanding seasonality issues facing the business, normalizing one-time matters, financing situations is also key in the adjustment process. With many deals having some type of earn-out or ‘peg’ attributable to NWC, spending the appropriate amount of time on NWC due diligence can pay dividends.
In closing this segment, understanding each of the adjustments is key to place yourself in a better negotiating position. Whether you are the buyer, the seller, or a part of professional service teams serving one of the former, having a sound basis on all adjustments should be a required objective of all prior to finalizing the deal.