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Analyzing a Target’s Customer Base – A Vital Step in the Due Diligence Process

Due Diligence

Revenue and value are of paramount importance to successful business owners, as well as potential acquirers of companies. However, without a strong customer base, target companies would be incapable of generating revenue or driving value as desired. Fortunately, by analyzing the target’s customer base, potential buyers can account for post-transaction risks or customer exposure in the due diligence process. This allows them to evaluate areas of concern and determine whether or not it is a deal breaker.

During customer due diligence, six areas in particular can be reviewed, analyzed and discussed with the owners and management of a target company, which are summarized below.

1. Customer Revenue/Purchasing Trends and Customer Concentrations: It is important for a buyer to understand the purchasing patterns of the target company’s customer base. To do so, consider asking the following questions about the target’s top-10 customers:

  • What led to a significant increase or decrease in customer purchases year-over-year?
  • Did the company experience any significant one-time purchases from a customer or multiple customers?
  • What does the target company expect in terms of customer purchasing trends over the next 12 to 24 months?
  • What products are being sold to the customer?
  • Does the target company currently have a customer concentration, both individually and/or for the top five to ten customers?

The answers to these questions can provide meaningful insight into revenue stability, customer growth opportunities and risk of post-transaction customer attrition of the business.

2. Contracts: Another vital piece to the customer puzzle is determining whether the target company has contracts in place with their current top customers. The following questions are frequently addressed during the course of customer due diligence:
  • What customers currently have contracts in place?
  • For how long are these contracts in place?
  • Do the contracts have automatic renewals or automatic expirations?
  • Is the target company already in negotiations with customers regarding their respective renewals?
  • Do the contracts have minimum purchase commitments included?
  • What is the pricing on these contracts, and is it similar to others?
  • Does the pricing change based on the amount of annual purchases?

Contract-based revenue can have a significant impact on the likelihood and reliability of revenue results post-transaction, so it is important for buyers to gain an understanding of major customer contracts of the target.

3. Margins: Whether it is pricing, product/sales mix or other key factors, it is essential to review margins by customer to uncover variances and fluctuations in gross margin by customer each year. Once again, a review of the top customers of the target can provide insight. Consider addressing the following questions:

  • Which customers result in the top gross margins and why?
  • Are the revenue trends for the top gross margin customers increasing or decreasing over the periods analyzed?
  • What will these margins look like in the next year?
  • How can the buyer improve margins with lower margin customers and maintain or increase higher-margin customers?
  • Does the company budget or target certain gross margins with customers?
  • If the margin is too low, will the target company not sell products to certain customers?

The answers to these questions can inform the buyer of opportunities to pursue post-transaction, such as efforts to adjust product mix or pricing changes.

4. Lost Customers: Analyzing the target company’s lost customers, especially top customers, is vital to ensuring the value of the customer base being acquired. Ideally, this analysis will uncover consistent customer performance (i.e., “stickiness”). However, asking tough questions about customer turnover can certainly help the buyer assess risks and opportunities in the transaction. Consider:
  • Why did the target company lose a top customer?
  • Did they go to a competitor?
  • Was it due to pricing?
  • Was it due to the quality of the products or work performed?
  • Does the buyer have the ability to gain the customer back in the future?

Once again, the answers to these questions will assist the buyer in prioritizing post-transaction revenue-related activities.

5. Customer Acquisition: Oftentimes, acquisitions are the result of a buyer’s desire to acquire certain key customers. As such, sellers and buyers have to ask themselves, at what price am I willing to sell or pay for the customers? If the buyer is willing to pay a premium, that premium should be evaluated against the potential risk of customer attrition post-transaction. On the other hand, the seller should analyze their ability to demand a premium for these customers.

6. Customer Relationships: It is common for employees of a company to maintain relationships with key customers. Whether that is an owner, sales representative or a manager, customers tend to be loyal to that specific company representative at the target company. A buyer must determine whether or not that person will remain with the company post-transaction and what can be done to entice that person to stay on board to maintain the customer relationship. If not, what is the likelihood that the customer will remain with the new company? If the buyer is unable to retain the key employee, the buyer must determine how to backfill that lost customer, revenue and value Customer relationships are central to most business transactions, and the ability to maintain or even enhance those relationships post-transaction can unlock significant value embedded in the deal.

If you seek to acquire a business or are exploring the sale of your business, it is important to analyze the company’s customer base and determine how that customer base impacts revenue, gross margin and EBITDA. You’ll want to ensure that the financial results that support the value that you are acquiring or selling are confirmed and vetted so that you can protect and enhance that value post-close.

Freed Maxick Can Help 

Do you have additional questions about customer analyses and how it relates to due diligence or other transaction advisory-related matters? Please contact Freed Maxick at 716.847.2651 or fill out our contact form.

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The Impact of Revenue Recognition on M&A Transactions—What You Need to Know

Rev Rec M&A

Acquisitions are often priced based on earnings, which are directly impacted by revenues. During the course of financial due diligence for a potential acquisition, there are several considerations that merit close attention. One area in particular is the reporting of revenue by the target company. In this case, it is critical to understand how a business recognizes revenues and how its process aligns with industry standards and norms.

The following areas frequently impact the way in which a buyer may look at a potential transaction:

1. Cash vs. Accrual Basis of Accounting

Under accrual basis accounting, revenues are recorded when they are earned regardless of when the money is received. The cash basis, on the other hand, records revenue when cash is received (and expenses when cash is paid). Although GAAP (Generally Accepted Accounting Principles) financial statements require companies to use accrual accounting, many small and middle-market businesses operate under the cash basis for various reasons (e.g., small or no accounting department exists within the business, it’s more easily understandable, it allows for more simplified entries).

If a company uses cash basis accounting, this means it will not report receivables or payables, which can impact profitability, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), working capital, etc. When performing a due diligence engagement, the cash basis may not fairly reflect the true profitability of a business year after year. Furthermore, the target company’s financial results may not be consistent with the industry, which is important for pricing the deal. For example, say your business pays an annual fee of $6,000 in June for a one-year subscription. Under the cash basis, the month of June will reflect a higher expense level than all other months ($6,000 of expense is recorded in June, and $0 is recorded in the rest of the year). Under the accrual basis, the $6,000 is evenly spread over the 12 months the subscription is utilized ($500/month). Additionally, a trailing twelve-month period may pick up additional expenses or not capture an expense, which could create a distorted view of the financials.

2. FOB Shipping Point and FOB Destination

FOB shipping point and destination indicate the point that the title of the goods transfers from the seller to the buyer. FOB shipping point transfers to the seller when placed in delivery, whereas FOB destination transfers to the seller once the goods reach the seller. These milestones, depending on the contract between the buyer and the seller, are frequently utilized in the recognition of revenue.

From a due diligence perspective, it is important to understand if the company is applying its selected method consistently. If not, there may be revenue cutoff issues from one period to another, resulting in distorted revenue results. It is also essential to understand if the company’s revenue recognition policies are followed each month or less frequently (e.g. quarterly or annually). For example, if a business has an FOB destination agreement with a customer and the goods are shipped on the last day of the month, but not delivered until the following month, they should not be relieved from inventory until the goods have been delivered to the destination because risk of loss still resides with the seller until delivery. If the company does not consistently apply this method on a monthly basis, financial adjustments may be necessary.

3. Percentage of Completion

Percentage of completion is a common accounting method in the construction industry, which recognizes revenue and expenses of long-term contracts as a percentage of work completed during the period.

One potential diligence issue is that this method is susceptible to misuse in the interest of boosting short-term results (e.g., a project is actually only 10 percent complete but reported as 80 percent complete so that revenues are inflated in the current period). Revenues and expenses that are accounted for in an incorrect period could skew profitability and create unreliable numbers. Understanding the appropriateness of estimates historically and the review process of the company’s WIP (Work-in-Process) schedule will help to better understand if revenue and expenses are being recognized correctly.

As discussed above, due diligence procedures can be designed to evaluate the consistency of application of accounting methods, cut-off between periods, accrual accounting, etc. In addition, as the new revenue recognition standard moves into effect, the issue of revenue recognition will be crucial in evaluating potential deals.

If your business, or the business you are looking to purchase, has not adopted the new standard, you should assess the implementation costs to be incurred as well as the time and resources needed. It is also important to look at how the new model will affect contracts with customers or shifts in pricing or marketing strategies. These changes may impact performance metrics, working capital adjustments, EBITDA or even earnouts and debt covenants.

Contact Freed MaxickDo you have questions about revenue recognition and how it relates to due diligence, or other transaction advisory-related matters? Please contact Freed Maxick at 716.847.2651, or click on the button for a contact form. 

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Balance Sheet Due Diligence—Where Does It Stand When Determining Financial Position?

Balance sheet due diligence

When conducting a quality of earnings analysis as part of a due diligence process, a company’s balance sheet may seem like a secondary consideration when compared to income, expenses and normalized EBITDA. Yet, to help ensure that the benefit stream and EBITDA generated by a target company are dependable, it is important to consider the significance of the balance sheet when measuring a company’s annual earnings. Indeed, due diligence procedures related to the balance sheet are vital components to the current and future financial health of a target company.

In order to validate both the quality of earnings and the balance sheet, the following accounts are typically considered, analyzed and discussed with the target’s management during the course of financial due diligence:

  • Cash and short-term investments: While transactions are commonly structured on a cash-free, debt-free basis, it can be important to understand a target company’s cash management and treasury function, including deposit and disbursement practices, banking relationships, reconciliation process and more. In addition, performing proof of cash analyses, analyzing financial derivative contracts, understanding and reviewing cash flow and operational funding capabilities also play an integral part in understanding the target company’s overall cash and short-term investment techniques.
  • Accounts receivable/accounts payable: It is important to review aging and bad debt statistics, especially balances aged 90 days or greater, as this will uncover any historical issues with receiving payments from customers or vendor disputes. In addition, due diligence procedures related to accounts receivable and accounts payable include:
    • Inquiries into the collectability of large overdue balances prior to closing dates
    • Billing and credit policies
    • The basis for, adequacy, and consistency of reserves for bad debts, returns, discounts and other allowances.

These procedures ensure that revenues recognized previously are truly collectable. They also help the buyer understand the target’s collection patterns, and they reveal any disputes on invoices that need to be resolved prior to closing.

  • Inventory: When acquiring a company that maintains inventory, it is essential to analyze the historical, current and expected levels of inventory on the target’s books. Inquiries related to aging help identify any excess or obsolete inventory, which can often overstate acquired inventory levels and subsequently affect net working capital target amounts. Ultimately, inflated inventory may adversely impact the company’s ability to meet product delivery post-transaction. Moreover, analyzing the historical and expected levels of primary components of inventory (e.g., raw materials, work-in-progress, finished goods) helps a buyer understand the inventory turn cycle and identify seasonal or cyclical variations.
  • Related party assets/liabilities: For working capital purposes, identifying and analyzing amounts due from or due to officers, directors, stockholders, employees, affiliates or other related parties is important to understand. Typically, the goal is to present the target company’s financial position as if it were on a stand-alone basis, or to be consistent with what is expected on a go-forward basis subsequent to the closing of the transaction. Many privately-held companies utilize shareholder loans or receivables for a variety of reasons, so it is important to understand the nature of these accounts and determine if an adjustment should be made. Often, these types of assets or liabilities are in plain sight, while in other cases these items might be buried in other assets or liabilities. Discussions with management by your due diligence provider can help identify these and ensure they are treated properly in the transaction terms.
  • Prepaid expenses/accrued liabilities: It is common for privately held middle-market companies to only review and adjust prepaid expenses and accrued liabilities at year-end as opposed to doing so more frequently (e.g., monthly or quarterly). In most cases, this approach is the result of the limited time and resources available to smaller companies that would allow them to complete a formal monthly “hard close.” As such, a due diligence engagement performed as of an interim period may create exposure due to unreported prepaid expenses and accrued liabilities. In these cases, additional analysis may need to be performed to ensure that the interim period EBITDA is complete and accurate, incorporating proper adjustments to these balance sheet accounts. Typical due diligence procedures related to prepaid expenses and accrued liabilities consist of:
    • Inquiries surrounding the accounting policies
    • Timing of the conversion of these balances into cash
    • The basis for and adequacy of accruals
    • Consistency of the prepaid expenses and liabilities
    • The nature, movement and impact on earnings of significant accrued liabilities and reserves
  • Fixed assets/capital requirements: When evaluating a target company, it is also crucial to consider the fixed assets and capital investment requirements of the target company that are necessary to properly operate the business. A company’s book value may not fairly reflect the market value of its real or personal property. Furthermore, the target may require immediate additional investment to continue to generate the cash flows the company has realized in the past.
    As such, due diligence procedures related to fixed assets identify these potential issues or unknown items. For example, those procedures may include inquiries surrounding accounting policies for fixed assets (e.g., capitalization, depreciation, impairment), the date and results of the last physical counts, excess or idle property (including property that has been written off or requires replacement sooner than originally anticipated) and significant gains or losses on dispositions. Moreover, it is important to make inquiries related to capital expenditure history and projected capital investment requirements such as historical budget-to-actual analyses, individually significant capital projects and any related purchase commitments. This analysis can provide a better understanding of the company’s fixed asset position along with a preview into what expenditures might be necessary on a go-forward basis.
  • Debt: As previously discussed, transactions often are structured on a cash-free, debt-free basis. That said, due diligence procedures related to an analysis of a target company’s debt position are also important with respect to understanding the company’s current leveraging capabilities. Procedures and inquiries related to debt can consist of:
    • A review of debt agreements to identify any significant change of control, prepayment or other significant provisions
    • Past due amounts
    • Actual or potential covenant violations (including consideration that a proposed transaction could have)
    • Terms of debt agreements (such as future payment requirements).
Insight into future payment requirements can be of particular import to a buyer, as quantifying the post-transaction cash flows provides valuable decision-making information in terms of how operations will look going forward. It can also help determine the capital available for additional reinvestment, distribution to owners or other options.
  • Other assets, other liabilities, and off-balance sheet items: It is important to identify and analyze any additional non-operating assets and liabilities, as well as perform inquiries to determine if any material off-balance sheet items exist, including operating leases and outstanding litigation which impact the target company’s cash flows post-transaction.

A fundamental understanding of a company’s balance sheet can provide important insight in evaluating the feasibility of a transaction as it ensures the whole picture of a company’s financial health is known and understood. Whether you seek to purchase a business or explore sale opportunities, you should be cognizant of the impact that balance sheet components can have on the value of a business and its EBITDA.

Freed Maxick Can Help

Contact Freed Maxick

Do you have questions about the balance sheet and understanding its role in evaluating a company’s annual earnings, or other transaction advisory-related matters? Please contact Freed Maxick at 716.847.2651, or click on the button for a contact form. 

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