There has been considerable consolidation in the marketplace over the last 18 months. Covid has created challenges causing owners to consider earlier exits than planned, PPP and other government subsidies have infused some firms with excess cash and Private Equity firms are buying smaller professional services firms and rolling them into a larger platform. If your company has a potential deal or if you have closed a deal, what should you be thinking about from a valuation perspective before year end?
From diligence to performing your own quality of earnings analysis on your financial statements so there are no surprises throughout a transaction, to understanding the tax implications for the buyer and seller, the structure for what’s being acquired, and how that’s going to impact the accounting and potentially any existing or future bank covenants, we cover the questions you should be asking before year end. If you have acquired another firm and the dust has now settled there are a number of things that have to happen in a relatively short period of time, including potentially a whole new set of reporting requirements, covenant considerations, opening balance sheet preparation, purchase price allocation values, earnout calculations and rollover equity considerations.
Listen to Scott Duda, Leader of Cherry Bekaert’s Professional Services Industry practice and Anna Townsend, a partner in the Firm’s Valuation Services group, as they discuss what you need to think about as you go down the diligence and deal path.
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SCOTT DUDA: I'm Scott Duda, a partner with Cherry Bekaert, and I lead our professional services group. We're recording a podcast to discuss valuation considerations for professional service firms. With me is Anna Townsend; Anna, please tell the audience about yourself.
ANNA TOWNSEND: I'm Anna Townsend, a partner in the valuation services group for Cherry Bekaert. I focus on financial reporting valuations, particularly purchase price allocation, and I'm looking forward to discussing this topic.
SCOTT DUDA: One reason we're here today is the amount of activity we've seen over the last 18 months. There has been substantial liquidity, and private equity is consolidating across many industries, including A&E, professional services, fire suppression, and pool cleaning.
SCOTT DUDA: We want to discuss what to consider from a valuation perspective if you have a potential deal, and what to consider after closing before year end. Anna, if you have an interested buyer, what should you be thinking about?
ANNA TOWNSEND: We are seeing roll-up strategies acquiring smaller professional services firms. If you're approached by a buyer, assemble your advisors early. Consider deal-structure impacts on personal taxes and bring in tax, diligence, and valuation specialists to determine whether the offered price is fair in the marketplace.
ANNA TOWNSEND: Think through the purchase price and what will be required during diligence, because buyers will request many documents and may uncover issues. If you are interested in being acquired, prepare in advance by performing your own diligence and a quality-of-earnings review so you know the issues before the buyer finds them.
SCOTT DUDA: Deals that go well are those where sellers disclose red flags upfront. For example, if you have not written off aged accounts receivable, disclose that and either record an allowance or communicate the issue.
SCOTT DUDA: Discovering issues during diligence suggests there may be more undisclosed problems and creates complications. Also, if you've never gone through this process, do not assume the deal is closed until everything is signed; either party can walk away at any point.
SCOTT DUDA: Continue to do the work and push to the finish line rather than planning for post-close too early. We've been engaged when clients prematurely focused on year-end consolidation and covenants while the deal later fell apart; perform the blocking and tackling throughout the process.
ANNA TOWNSEND: Clients sometimes get so wrapped up in the transaction and the volume of information that they lose sight of running the business. Revenues and earnings can decline as a result, so remain focused on operations so the business performs well if the transaction closes.
SCOTT DUDA: If you have a potential deal, bring in a tax advisor to understand tax implications for all parties, and understand the structure, what is being acquired, and how it will affect accounting and covenants. If you've already been acquired or you have acquired another firm, what should you consider between close and calendar year end?
ANNA TOWNSEND: After closing, you cannot let the dust settle. Continue operations and prepare for a new parent company's reporting requirements and bank covenants, and be ready to provide an opening balance sheet as of the acquisition date.
ANNA TOWNSEND: Work on the opening balance sheet while transaction details are fresh. Engage a valuation specialist to perform the purchase price allocation, value tangible and intangible assets, and assess components of purchase consideration such as earnouts and rollover equity.
ANNA TOWNSEND: If you are under audit, completing this work before year end will ease busy season when closing year-end books. As you prepare the opening balance sheet, consider whether to elect the PCC (Private Company Council) election for acquisition accounting and the intangibles you must record.
SCOTT DUDA: Earnouts and rollover equity increase transaction complexity. Consider both the audit perspective—whether you have a GAAP audit requirement or covenants—and the tax perspective.
SCOTT DUDA: From an audit perspective, materiality provides flexibility on GAAP audit matters. From a tax perspective, however, there is no concept of materiality; issues addressed in audit discussions may reappear during tax provision calculations and filings for both buyer and seller.
SCOTT DUDA: You need to consider valuation from the GAAP perspective, materiality for audit, and purchase price allocation for tax, understanding that materiality does not apply in the tax context. Anna, you mentioned the PCC election; what are the pros and cons when considering that election versus a straight GAAP approach?
ANNA TOWNSEND: The PCC election can simplify financial reporting for many clients. For a straightforward deal—cash only, no rollover equity, no earnout—it removes the need to separately value customer relationships and non-compete agreements, which are often among the hardest intangibles to value, and subsumes them into goodwill.
ANNA TOWNSEND: With the PCC election, goodwill is amortized, and if the business continues to perform well, goodwill impairment testing can be simpler, often allowing a qualitative assessment with no further testing. The downside is that if you anticipate going public or require a PCAOB audit or a public filing in the future, you cannot take the PCC election, and you may need to redo the accounting later.
ANNA TOWNSEND: The PCC election does not preclude valuing rollover equity and earnouts. We often see rollover equity in private equity transactions, where sponsors use preferred shares while rollover equity is common; the preferred position affects the common's value. Earnouts must be valued each reporting period, whether quarterly or annually.
SCOTT DUDA: That is helpful information. You can reach out to us; contact information is included in the podcast information where you access this episode.
