Improving value through financial and tax due diligence

The aim of any deal is not only a successful close, but (certainly from a vendor perspective) one that achieves the valuation expected at the start of a deal. Not laying the ground work increases the risk of chipping away at the valuation during the critical negotiation stage.

Due diligence is a means by which acquirers mitigate overall transaction risk by identifying, validating and quantifying value drivers. It can be used to identify deal breakers, better analyse financial and operational health, identify negotiation aspects, challenge synergy and valuation assumptions, and assess risks. However it should also be used to uncover potential upsides, unlocking value through cost savings, revenue optimisation and increasing efficiency opportunities. Whilst acquirers may not want to share any synergistic ‘marriage benefit’ with the vendors, they will certainly want to mitigate any downsides, generally by means of a price reduction.

Ahead of any deal a business should have its house in order which will include:-
➢ Up to date filings with Companies House and HM Revenue & Customs
➢ A clear and simple ownership structure, identifying the ultimate shareholders
➢ A clean and complete balance sheet
➢ Accurate management accounts and robust financial systems
➢ Sound working capital management, including clarity on the cash cycle and the troughs and peaks in the business
➢ Transparent accounting policies in particular around key areas such as revenue recognition and provisioning
➢ Details of future commitments and off balance sheet liabilities (such as leases)

This may sound simple, but it is surprising how often businesses are unprepared for the rigours of due diligence. Areas that frequently arise surround directors remuneration (dividends being taken rather than salary, which means profits are effectively being overstated), the use of director loan accounts with a lack of a clear trail of the transactions in the loan account, details of any official terms (such as interest) and how it is has historically been settled.

In preparing for due diligence, any risk areas should be considered internally and mitigated proactively. As an example, PAYE health-checks are great for businesses which have scaled-up in numbers over a short period of time. A PAYE health-check will pre-empt any potential hidden liabilities, as an example in freelancers vs. employees or incomplete reporting of employee benefits.

VAT is another complex area where a health-check is beneficial as it is constantly changing as a result of case law developments, changes in legislation and HMRC guidance. A simple mistake in assessing a VAT liability can lead to significant exposure which can be compounded by the fact that HMRC can assess for errors for the previous four years. The recent (1 January 2015) change to the place of supply rules for electronically supplied services is an example of such new legislation. Under the new rules, if a business provides such a service from the UK to a private individual in another EU member state it has to charge them VAT at their local EU VAT rate rather than UK VAT. A digital business that supplies EU consumers over the internet may have had an exposure to VAT penalties in many EU member states if unaware of the changes.

Taking practical action in the areas highlighted above will give the business time to rectify any problem areas arising as opposed to being brought to light during negotiations, with zero lead time.
Preparing for the due diligence process will also ease the discussions around warranties, indemnities and disclosures in a sale. Warranties are statements made by the seller that certain facts in relation to the business are true. Should the buyer later discover that a warranty was not true this could give rise to a claim for breach of warranty entitling the buyer to damages. Indemnities arise in respect of specific issues generally discovered during due diligence and are given on a £ for £ basis.

A tax indemnity is an indemnity from the seller in favour of the buyer against any tax liabilities falling on the company prior to completion, apart from liabilities shown in the last financial statements of the company and those arising in respect of ordinary business after the date of those accounts. The intention is that the indemnity covers surprise tax liabilities which do not arise from normal business.

So, if there is a risk of PAYE being due on a freelancer for example, to the extent this risk crystallises the vendor will be required to reimburse any payment made to (and fine from) HMRC in the future. Clearly, the more risk you can mitigate before due diligence starts, the less indemnities you will end up on the hook for. Buyers want to see warranties and indemnities included in the sale agreement in any event, but more specifically in instances where their due diligence findings uncover areas of a business of which they are unable to gain a complete knowledge and understanding. Warranties and indemnities re-allocate risk between the seller and the buyer and are potential price-adjusters.
In response to the warranties the seller and its advisers carry out a disclosure exercise which results in the preparation of a disclosure letter. The disclosure letter acts as a collection point for information disclosed to the buyer about the business being sold; and it records exceptions or qualifications to the warranties contained in the sale agreement.

A company will only be aware of the matters requiring disclosure if it has prepared itself for the due diligence process internally and with the assistance of its advisers. Generally, disclosures made will reduce a buyer’s right under the warranties and limit a seller’s liability. This is a critical document for a deal and requires close and frank liaison between the company and its advisers. However the company should bear in mind that certain disclosures may trigger attempts by a buyer to renegotiate the purchase price.

This comes full circle back to the importance of a company making its own preparations for the rigorous due diligence process ahead of a deal as a way of increasing value – giving itself time to put right any financial inconsistencies, unreported tax liabilities or incorrectly reported matters whether that is to HMRC or in the way it accounts for its revenue and costs.

By Tony Walford, Partner Green Square and Natasha Frangos, Head of Creative, Media and Technology, haysmacintyre.