FOCUS YOUR FINANCIAL PICTURE FOR IMPROVED OUTCOMES.

Originally posted on November 10, 2015 by Jeanne Goulet

Be sure to focus your financial picture before an audit, exit talks or IPO, because you get one chance to make a great first impression with your financial statements, and you can improve your outcomes as a result.

Tomasz Tunguz – a venture capitalist at Menlo Park, CA based Redpoint Ventures characterized financial statements as “A Rosetta Stone for startups.” He went on to observe in his blog “They reveal the strategies and the tactics of how to bring a product to market.”

Tunguz identified ten key metrics he looks at when sifting through a startup’s operational model, whether he is considering an investment or in a board meeting. They ranged from revenue growth to net income, gross margin to customer acquisition payback period and sales efficiency.

Consider the massive downside financial valuation impact of poorly prepared financial statements, as seen from the Groupon fiasco of April 2012.

Groupon offers deals and coupons for restaurants, retailers and service providers. It made a big splash back in 2011 when its IPO was issued raising $805 million. Investment banks, including Goldman Sachs, made millions in fees.

After an audit revealed “material weaknesses” in its internal controls over financial reporting, specifically in terms of accounting for customer refunds, the company’s stock dropped a precipitous 17% in one day.

The company was then forced to restate its 4th Quarter 2011 financials, and in the end the stock tanked by 44% and $350 million in equity valuation simply vaporized. Groupon’s equity valuation has never fully recovered.

Could this have been avoided? Certainly yes, had these problems been rectified prior to the financial audit by engaging in thorough pre-audit preparation.

Here are some key areas to examine in terms of your company’s financial statements, in order to maximize your selling price and to minimize potential hold-backs.

Hold-backs occur when there are issues with your business that potentially have not been properly managed. As a result the buyer may be interested in setting aside money in the event that these risks materialize, and result in tax liabilities and penalties that will potentially need to be paid out.

These business issues of concern to a potential buyer usually come out during the due diligence process. They can include: failure to file federal, state, local and foreign tax returns – with potential taxes being owed; failure to collect and remit sales tax; and improper characterization of independent contractors. These are are all common triggers for hold-backs.

It is extremely important to work with a qualified CPA to rectify these potential problems prior to exploring exit options, so the issues can be corrected and the valuation of the company can then be optimized.

Another important task is to evaluate your company’s valuation under alternative structures and then prepare a negotiation position.

For example, explore the potential consequences of selling assets vs. stock. Buyers often prefer to buy assets over stock because it allows them to avoid taking on liabilities and business issues or risks facing your company. And buyers can then step up the valuation basis of the assets and then depreciate from a higher level, usually reducing their tax liability in the process.

As the seller, you may face a high tax rate (65% rate) that you can perhaps negotiate and have the buyer pay part of the tax bill. If the buyer is willing to buy the stock and then can’t get the lower tax rate, they may in turn offer you a lower price. There are also tax-deferral strategies, including installment sales and earn-outs.

So it pays to take all these variables into consideration, and develop an exit strategy that will work best for you.

You will also need to identify the information requirements for potential buyers and their respective due diligence process, as different buyers will likely have different requirements. Consider the view of Venture Capital or Private Equity firms who want a company that can stand alone, versus a strategic buyer who plans to integrate your business into their existing business structure.

It’s important to have all the relevant information a buyer may need readily available in advance, because good first impressions are important to help foster the best exit negotiation outcomes.

“Be prepared to discuss detailed and pointed questions about company information, strategy, growth plans and operations, as the buyer will pick through your balance sheet and income statement” as Tomasz Tunguz points out.

Identify and highlight major deal issues from an accounting and financial perspective, and either remedy or prepare a response for the issues for the buyer’s due diligence inquiry. Examples include revenue recognition methodology, aging of accounts receivable, unfavorable contract terms with significant customers or system limitations. Develop potential solutions that will help minimize the impact of these issues on your exit negotiations.

On the positive side, be sure to identify and highlight potential upside indicators for the business that can enhance the value. If you have expansion plans, or the buyer has a particularly good fit with your business model that will enhance the growth trajectory of both companies – this is the time to bring it up.

Also consider impediments that might slow down the deal – for example if you need to transfer key contracts to the new owner you may need customer approval to do so. Transfer of outstanding loan liabilities may require the lender’s approval as well. You may even need to deal with structural issues for the company that will help facilitate the sale. Any number of these issues can and will have an impact on the final valuation of the company.

If you are selling at a multiple of earnings, say for example 10X, any significant reduction in the company valuation can have a big material impact on the final sale price of the company.

In other words, any problems with your financial statements can cost you plenty in the end!

Reprinted and used with permission from Marks Paneth LLP

This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.