Managing Partner RSM Poland
Let's say I purchased a company and...
... not everything is quite as I had assumed, although nobody was trying to cheat me. Does that sound familiar? I fear it does. In my job I work with people who are in charge of deciding whether to acquire another company, and if so – for what price. In the course of negotiation the price is usually established as a multiple of EBIT/EBITDA/net profit. I am personally not a supporter of this method. In my opinion it is much better to evaluate a company using the DCF methods in three scenarios: positive, neutral and negative. But who has time for such things these days? Due to its simplicity the multiple method is gaining many supporters among decision-makers.
Many M&A experts and transaction advisors believe the EBITDA multiple to be the primary indicator of good purchase price (if the index is low) or good selling price (if the index is high). In times of crisis we tend to purchase offering a triple EBITDA value; in times of prosperity – offering a value of eight-fold EBITDA. On Friday, January 16th, 2015 during the Going International conference in Turin, a colleague from the United States was referring that in 2014 the EBITDA multiple for transactions in the States was 12-14. So far for the crisis in the USA that Frank LeBiahn, a colleague from RSM McGladrey, believes to nearing its end.
It's decided: I'm buying a company, tough decisions are on the horizon
Imagine the following, not all that rare situation. Place of action: Poland. Company X (purchaser) finds company Y (target) or vice versa; in any case company X want to purchase company Y. Both companies are well-based on their markets, experienced in making business, confident about their branch-specific know-how and business competences in general. Both companies are lucky to have professional and experienced management that decides they will manage the process on their own.
And so they negotiate, sign their NDA (Non-Disclosure Agreement), negotiate further, and finally agree on the price as being the eight-fold of normalized EBITDA (with one-time events excluded from the result). Terms of transaction are established, LOI (Letter of Intent) is signed, and the Sale and Purchase Agreement (SPA) is concluded. Company X (to remind you – this is the purchaser) resolves not to have due diligence performed to confirm the carrying amounts of company Y (target of the acquisition). The CFO of company X supports the decision by explaining that the parties trust each other, the acquired company Y has all necessary tax clearance and social security contribution clearance certificates and moreover the target's financial statements were reviewed in the last 3 years by a renown audit firm. In a nutshell – the transaction is costly enough, why add more expenses.
Is this the right decision? Let's look deeper into the key arguments item by item.
- Trust comes first. Trust is certainly required between both parties of the transaction, but it is never enough. Sometimes the other party does not necessarily want to cheat us; it simply makes its own mistakes and when this happens we are being unintentionally misinformed.
- Certificates come next. Social security contribution and tax clearance certificates confirm that company Y has paid the Social Insurance Institute (ZUS) and the Tax Office the amount it had previously declared. But had it declared the right amount? What if the accountant made a mistake, the accountancy office missed some business event in the books, or what if the computerized accounting system had not been configured properly? Formal certificates won't prove nor deny this had been the case. Such certificates are only there to prove that company Y was supposed to pay a certain amount on basis of previous declaration and that this has been done.
- And now for financial results. The company's financial statement have been confirmed by a well-known auditing company, so what else do you want? Nobody questions the reliability of a professional audit firm, do they? Perhaps I need to elaborate on this matter in more detail.
Bone of contention
Not questioning the work quality nor the approach of company Y's auditor, it is important to stress the difference between reviewing a financial statement and due diligence, which may stick in the purchaser's craw. Two things are to consider, to be precise: materiality and the multiple.
The multiple as valuation method has already been described above. On significance, cutting a long story short as possible: the auditor when reviewing a financial statement confirms that it is correct to a material extent. Which means it is not necessarily perfect, but differences are insubstantial and negligible.
Company Y has a profit of PLN 200 million. Total debts in the financial statement are PLN 40 million. EBITDA is PLN 10 million. Materiality of debts in this case is PLN 0.5 million. In other words, even if 0.5 of the PLN 40 million debt of company Y towards its transactors is outdated and should be written off, the auditor is still going to state (as is good practice) that the financial statement is clear, reliable etc. The auditor did a good job, and there can be no reservations to his work. But what does that mean in terms of our transaction?
The parties agreed that company Y's sale price depends on its EBITDA and equals 8 x EBITDA. EBITDA, after excluding one-time events, is PLN 10 million, which is in line with the financial statement reviewed by a statutory auditor. The price of company Y is therefore PLN 80 million.
And now consider that if company X decided to have due diligence performed and was able to confirm thanks to the service that debts should be PLN 0.5 million less (assuming no other differences are revealed), EBITDA would be at PLN 9.5 million, which means that the final price of the acquired company would have been … PLN 4 million less.
But, alas, the CFO would rather save.