M & A for smaller companies.

Over the past several years, and especially in 1995, merger and acquisition activity has heated up substantially in both the public markets and the middle market. The increased dealmaking in businesses selling for $1 million to $50 million has created opportunities, but it has also called attention to the special problems of working in this market. With little or no public information available, few comparables and fewer financial controls than in large corporations, the value of a company in this category can rise or fall dramatically according to the findings of a financial due diligence evaluation. Indeed, entire deals can sink or swim based on the due diligence process and on the steps taken in advance to ensure success. This article offers some background for CPAs who have middle-market employers or clients and who are called on to advise them on a possible sale or purchase.

MIDDLE-MARKET DIFFERENCES

The buying and selling of companies of all sizes has been fueled by a combination of pent-up demand, favorable interest rates, improved corporate profitability and access to financing as a result of new lending strategies spurred in part by an easing of federal regulations on highly leveraged transactions. For small and intermediate middle-market companies, two additional factors have fueled the increase: the sheer number of businesses in this category and the rising population of displaced executives seeking new ways to earn a living as owners of their own businesses.

The differences between these transactions and larger M&A deals pose special challenges for accounting, tax and legal advisers.

First, there is the problem of lack of information. It's impossible to check an approximate valuation against the daily newspapers for market prices and price comparables because these companies aren't publicly traded. Business and nonbusiness costs may be commingled in company ledgers. As a result, the buyer and seller may have widely different perceptions of value. The practitioner's skill in closing this gap can help make or break a deal.

Another difference lies in the options for financing and structuring acquisitions for closely held companies. Stock-for-stock swaps are rare, and access to initial public offering funds or other large pools of money is limited. As a result, creative financing is imperative and the best asset is a friendly banker. It is no coincidence that middle-market companies began to change hands at a faster pace after the lending climate thawed and competition among financing sources started to mount.

There are also issues of emotional attachment to the business that aren't encountered in larger transactions. Many middle-market companies are owned by founders or founders' families, and a sale is often fraught with personal biases and concerns that may have little to do with making a sound business decision.

With all these minefields, success in middle-market M&A depends on two processes: laying the proper groundwork and conducting thorough financial due diligence.

LAYING THE GROUNDWORK

It's possible to avoid problems by preparing the buyer or seller for a long process (typically, 6 to 24 months from the time a business goes up for sale) and helping plot strategy and identify goals beforehand, whether working with the buyer or the seller. Setting sales and acquisition criteria, in particular, results in a cost-effective search because it minimizes the time wasted looking at undesirable deals.

If working with the seller, the CPA can help

* Clean up the financial records, particularly if the records haven't been audited.

* Develop a sales strategy by identifying which parts of the business to sell, what price to accept and the circumstances under which the sale can be made. Is the idea to sell a certain division to raise cash or redirect the core business or to sell the whole company because of retirement, owner disputes, poor health or operating losses? Does the seller want all cash or is he or she willing to take deferred payments? Will the seller continue working in the business? Must employees be retained or provided with severance packages?

Inadequate financial resources, unwillingness to negotiate with a competitor and potential environmental liabilities can kill a deal in the early stages.

* Secure a business valuation to identify ballpark figures and help set realistic goals - or assist in finding a reliable appraiser.

* Eliminate side interests or hobbies such as car collections, miscellaneous real estate holdings or other unrelated items.

* Identify and engage other outside advisers, including attorneys and investment bankers.

* Increase the likelihood of completing the deal by encouraging a willingness to include stock or deferred payments in the purchase package.

If working with the buyer, the CPA can help

* Identify goals and evaluate the expected benefits. It is important to develop a comprehensive business plan that documents goals.

* Develop an acquisition strategy by identifying the appropriate industry, company size, location, price range, timing, profitability, growth and technology. Is the buyer a corporate purchaser who wants to expand, increase market share or add product lines? Is he or she a displaced executive or manager interested in a business in his or her field? Is the goal to expedite international expansion? Acquire new technology? Generate certain shareholder returns? These questions - and an examination of industry trade data, publications and directories - can help establish criteria with which to evaluate potential target companies and eliminate all but the most likely candidates for purchase.

* Evaluate financing options, including the usual requirement for 15% to 30% equity in today's market, based on the authors' experience.

* Identify and engage other outside advisers.

CONDUCTING DUE DILIGENCE

Once the acquisition plan has been developed and the first match found, the next step is to conduct the financial due diligence evaluation. Usually, this is a joint effort of management, legal counsel, CPA and tax adviser and the banker or investment banker.

The scope of a due diligence analysis with vary according to management experience, timing, size and complexity of the deal (see the exhibit on page 73 for a general rundown.) It also will be influenced by the significance of seller warrants and representations and by confidentiality requirements that may be imposed by either side.

A management buyout or purchase by related parties, for example, win require less investigation. A prospective purchase by a competitor, on the other hand, win require extra precautions. The seller will place a limit on a competitor's access to company records for obvious reasons.

Due diligence has two stages: preliminary and expanded. Preliminary due diligence focuses on market and valuation issues and the buyer seller fit. The adviser's mission is to determine the reasonableness of the transaction and whether buying or selling is a good match with the client's or employer's business strategy.

When representing the purchaser, the usual starting point is a fact-finding mission in which the CPA and other advisers - such as attorneys and bankers - and the prospective buyer or his or her designated representative tour the targeted company, ask some general questions and analyze the financial statements.

CPAs representing the seller will be looking at the prospective buyer's, anticipated financing structure, banking source and personal and business background. In the case of an unfamiliar corporate buyer, it's also necessary to obtain a historical background and check the company's industry reputation. With a competitor, it's important to establish extra ground rules for dealing with confidentiality.

Many acquisition talks die at this stage. The potential buyer may be disqualified because of inadequate financial resources or the seller's unwillingness to negotiate with a competitor. Or the buyer may withdraw because the targeted company turns out to have potential environmental liabilities, unattractive financial performance, a different customer base than expected or myriad other problems.

Expanded due diligence is a more in-depth investigation conducted by the buyer if the deal is still alive after the preliminary examination. Its purpose is to assess the potential impact of the target company's strengths and weaknesses. It involves four basic elements:

1. Detailed market assessment. The team analyzes historical trends, customer base and key competitors. Does one customer account for 30% of sales, for example, or is the customer base diversified? This step includes using information from the business valuation about the industry found in periodicals and Value Line, Securities and Exchange Commission filings and other reports if there are comparable public companies in the marketplace. This can be done either by a CPA-adviser, the potential buyer's marketing department or the buyer himself or herself. If the seller has an investment banker, much of the needed information would have been provided in the banker's investment and background document.

2. Review of historical and current data. Some of the items to review include cash flow forecasts; financial statements; interim reports and budgets; corporate, partnership and proprietorship tax returns; property and equipment data; and salaries and fringe benefits. Receivables, inventory and general accounting records and policies must be examined closely for accuracy and unrecorded liabilities. Is some of the inventory on the books unsalable because it is an old product line? Should some of the parts counted as assets be written off because manufacturing specifications have changed? Is the business seasonal? Have vacations been accrued properly? If the company is 3 years old and offers 20-year product warranties, is there a sufficient accrual to reflect potential warranty costs? Are reserves for pending lawsuits reflected? Is the pension plan under- or overfunded? What are the debt and lease agreements?

3. Operations review. This includes the management information system and its requirements, organizational structure, compensation programs, facilities, capital requirements, maintenance issues, layout, tooling and production issues. The company's control systems - including management integrity and the quality of the accounting staff - should be discussed. Has a top salesperson or engineer taken his or her talents to a competitor? Is there a union contract that is up for renewal or hasn't been signed? Is expensive new machinery needed? Have salaries been frozen for three years? Frequently, such problems lead to the decision to sell in the first place and have a significant impact on company value.

4. Pro forma analysis and projected results. For the buyer, these projections will answer a key question: What will the business look like after it's purchased? The answer will help determine whether to buy, reach a purchase price, establish earnouts and get financing. It may be necessary to run several scenarios based on different assumptions or changing circumstances, such as a decision not to buy one division or a new tax or legal structure. Typically, these projections are prepared by the buyer's CPAs, but the seller and the funding source may also develop their own figures.

DEAL MAKERS AND BREAKERS

Vigilance in the due diligence process has multiple benefits. First, it saves time and money by answering basic questions at an early stage and by uncovering skeletons in the buyer's or seller's closet. Second, it helps set an accurate value on the company to be purchased and establish terms. Third, it can help the buyer obtain financing because it gives the bank solid support for his or her request.

In addition, due diligence sets the stage for a smooth transition because it gives the buyer a good understanding of the company's strengths and weaknesses, permitting the establishment of an informed business plan. It also minimizes the risk of later litigation by identifying any "smoking guns" before anyone signs on the dotted line.

Still, no deal goes without a hitch. Some things to remember:

* Sometimes a deal can be saved if outside advisers are sufficiently creative in coming up with terms to resolve differences. If the sticking point is purchase price or payment terms, for example, it's time to explore the feasibility of options such as seller notes, owner consulting agreements or employment contracts, earnouts based on future performance, enhanced warranties and representations and carefully structured escrow accounts.

* Sometimes a deal deserves to die. Watch out for buyers or sellers who oversell synergies or projections that seem too rosy. One of the important roles of a third party is to challenge assumptions.

* The deal's not over till the last paper is signed. Acquisitions can fizzle at the last minute because the financing falls through or the seller's financial performance deteriorates during negotiations. Conversely, deals that seem to be dead may be suddenly resurrected. Persistence pays off.

EXECUTIVE SUMMARY

* There is increased dealmaking in businesses selling for $1 million to $50 million, but working in this market presents special problems of which CPAs should be aware if their employers or clients are affected. With little or no public information available, few comparables and fewer financial controls than in large corporations, the value of a company in this category can rise and fall dramatically according to the findings of a financial due diligence evaluation.

* For CPAs helping to lay the groundwork, the job involves preparing the client or employer for a long process and helping plot strategy and identify goals before the process starts. Setting sales and acquisition criteria, in particular, minimizes the time wasted looking at undesirable deals.

* The scope of a due diligence analysis will vary according to management experience, timing, size and complexity of the deal, among other details. Preliminary due diligence focuses on market and valuation issues and the buyer-seller fit. The next step - expanded due diligence - has four basic elements: a detailed market assessment, a review of historical and current data, an operations review and pro forma analysis and projected results.

ROBERT B. MOORE, CPA, is senior manager, PAUL H. FLOYD, CPA, is a partner, and RONALD M. KORABIK is a senior manager at McGladrey & Pullen, Schaumberg, Illinois.

Examples of Resolving

Differences in Valuation

When differences in buyers' and sellers' valuations threaten to derail a deal, a variety of strategies can get things back on track. Here are 1 few real-life examples:

* Contingency. A buyer was interested in an asset purchase, but the due diligence investigation found the inventory book value was significantly higher than market value. The seller conceded certain inventory was unlikely to be used over the next year and agreed to reduce the purchase price by $500,000 with the stipulation that if the buyer needed any of this inventory, he would buy it dollar for dollar. Inventory unused after a year was to be scrapped, with the proceeds going to the seller.

* Earnout. A seller was forecasting significant growth, but the buyer's due diligence team found the forecast to be highly optimistic. To address the issue, an earnout was structured in which the seller would receive additional funds if conditions and contract renewals resulted in the forecasted sales. The three-year earnout provision enabled the deal to close.

* Seller financing. A buyer and seller agreed on a $5.5 million purchase price, but the local banker offered financing for only $4.5 million based on the seller's $500,000 of equity and seller notes of $2 million. The seller, eager to complete the deal, ultimately agreed to an additional $1 minion of deferred seller financing, with the deferral to be paid beginning in five years based on a percentage of sales.