In today’s fast-paced and competitive M&A environment, business owners that are considering a sale or other liquidity event need to be as prepared as possible before they go to market in order to foster long-term success. But, what does it mean to be “transaction ready”? For financial advisors who work with businesses, this generally includes having historical financials and key performance indicators (KPIs) that are as investor-friendly as possible. When done successfully, transaction readiness can minimize delays, reduce the risk of errors, and enhance credibility and trust with your future buyer.

The first step a business owner should take in order to become transaction-ready is to prepare investor-friendly financial statements by first evaluating historical financial performance.

Evaluation of historical financial performance

An early evaluation of your businesses’ historical financial performance can assist with several areas around transaction readiness:

1. Enables the identification and creation of key performance indicators that will be attractive to a potential investor
2. Allows for the creation of accrual financial statements on a monthly basis that financial investors will be familiar with and expect to see
3. Provides the opportunity to identify issues and resolve them before you start a liquidity process
4. Helps speed up the overall timeline once an M&A event has commenced, providing bankers with historical financials that are ready to be incorporated into materials to investors

Establishing business-specific KPIs

As a leader, you’re often pulled in many different directions and don’t have the opportunity to take a step back and explore how you’ve been measuring success. However, to begin the process of a transaction, a leader must evaluate, or in some cases establish, their company’s KPIs; a measurable value that demonstrates how effectively an individual, team, or company is achieving their business objectives. KPIs help companies understand whether they are on track to meet their goals by providing clear, quantifiable metrics that can be measured and trended to understand how a business is performing over time. It's important to note that KPIs are very business and industry-specific, and what works for one business may not work for another. By engaging with an outside advisor who is familiar with evaluating KPIs, you can get recommendations for what your business can measure against based on your industry, revenue, and growth goals.

Creating investor-friendly financial statements

Although they usually are not required for internal or audit purposes, investor-friendly financial statements will likely be required as part of the diligence process for a transaction. Effective investor-friendly financial statements generally have the following characteristics:

1. GAAP/accrual basis: Rather than reporting revenue and expenses on a cash basis (i.e. when invoices are billed or collected, and when expenses are paid), investors will want to see financials on an accrual basis (i.e. recording revenue when earned and expenses when incurred). This is known as an “accrual basis” of financials and aligns with US GAAP.

2. Consolidated results: For businesses with multiple entities, transactions between those entities (known as intercompany transactions) can cause “noise” in the financial statements that need to be eliminated or removed for the investors to get a sense of the true consolidated results. Investors will want to ensure that intercompany activity is not improperly inflating or deflating consolidated profitability.

3. Normalize historical EBITDA: Investors will want to view EBITDA (Earnings Before Interest Tax Depreciation and Amortization) on a fully normalized basis, with adjustments made to remove:

a. Non-recurring items: These can be legal and professional expenses associated with settlements or other unusual items, compensation items (e.g. signing bonuses, severance, etc.), one-time inventory adjustments, expedited freight charges, and other revenue or expense items that are not considered recurring in nature.

b. Personal/owner expenses: Several businesses record expenses for their owners (e.g. travel and entertainment, insurance, tax expenses, etc.) within the historical financials. These items are generally removed when presenting to investors.

c. True-ups to accruals and reserves: Even if companies do record their financials on an accrual basis, periodic changes in these accruals and reserves may result in out-of-period income and expense items that need to be normalized to their respective period.

d. Changes in EBITDA run-rates: Many businesses experience constant changes in customer or vendor pricing, employee turnover, and other operational changes that impact EBITDA. These items can be normalized to represent an “apples-to-apples comparison” in the historical financial statements.

While the above adjustments are important, there are several other areas that accountants can look at to normalize historical EBITDA and working capital so that they are in a format that investors will recognize and appreciate.

Once the foundation of investor-friendly financial statements and KPI’s are created, the business owner can start thinking about the next steps of the transaction readiness process: implementing recommendations and analyzing the performance of the business on a go-forward basis until they are ready to begin a formal M&A process.

It’s not too early to start

While the evaluation phase can continue indefinitely, the business owner gets to make the decision on what areas of improvement they want to make. By starting the evaluation process early, leaders can help ensure they have the opportunity to identify issues, determine if those issues are worth correcting, and allow adequate time to fix anything they desire.

Doing this work early will better ensure a quick and efficient sale process for the business and its advisors, and maximize the return in any potential liquidity process. CohnReznick is here to be your financial inspector early on in any potential liquidity process.