When you're paying a multiple of earnings for a company, you can't be too sure that revenues and expenses are normalized and reflect a full year's operations. Why would a seller invest in deferred maintenance right before closing if it would reduce proceeds from the sale? We have seen overpayments in excess of $15MM to $20MM, simply due to the specific day of the month or year that a deal closed. Once the discrepancies were discovered in these cases, the buyers' only remedy was litigation. Needless to say, they did not end up whole.

To protect yourself from timing discrepancies, and to ensure a remedy for your Reps & Warranties, we suggest structuring a seller's note. The note should remain in place until post-acquisition diligence is completed and all Reps & Warranties fulfilled. Barring the ability to negotiate a seller's note, your only alternative is to conduct as much diligence as possible, right up to the closing bell. A month, week or even a day can make a multi-million dollar difference.

Whether conducted immediately prior to or post closing, due diligence should cover:

• Accounting Practices: search for patterns of accounting that may be considered acceptable, but are aggressive or marginal in nature.
• Sales: examine sales cutoff, channel stuffing, evaluate sales returns for improper shipping at or near transaction close, analyze sales returns and discounts as a percentage of sales and compare to historical periods, identify bill and hold transactions, corroborate sales mix percentages, stratify sales terms and match to cash flow projections/forecasting.
• Cost of Sales: test gross margins at product category level, identify SKU level loss leaders, identify variable vs. fixed costs contributors to COS.
• SG&A: test validity of business vs. non business related expenses, test number of paid people to actual headcount, identify non recurring items.
• Reps & Warranties: determine if all items are as disclosed, if undisclosed items are an issue and/or negatively impact working capital and/or possible contingent liabilities.
• Contracts: evaluate contingent liabilities, "evergreen" provisions, "kickbacks."
• Cash: examine aged reconciling items, inquire about remaining terms of restricted cash, evaluate cash management and banking relationships.
• Accounts Receivable: examine new customer credits, match customer write-offs with bad debt expense, evaluate new aged debtors for improper sales.
• Inventory: evaluate in-transit receipts for validity, review sales cutoff for "bill and hold" transactions, investigate obsolescence amounts, test inventory pricing consistency, evaluate cycle count procedures, consider possible purchase commitments, examine ABL lending terms and reconcile to recent compliance certificate.
• PP&E: evaluate asset control procedures (e.g., tagged office equipment), evaluate UCC filings, compare capitalization amounts with stated policy and or for reasonableness.
• Other Assets: verify security deposits and validity of prepaid expenses, verify expiration of NOLs, evaluate intangibles with new accounting standards, look for and challenge miscellaneous debits.
• Accounts Payable: examine payment terms and working capital requirements, update approved vendor listing.
• Accrued Expenses: compare accruals between periods, evaluate deferred revenue, inquire about contingent liabilities, verify accruals for quarterly taxes (e.g., sales and property taxes).
• Debt: examine credit agreements for debt covenant compliance and any cross default provisions, cure remedies & requirements, calculate debt service requirements.
• Leases: evaluate current lease obligations (i.e., bargain purchase option), assess the discounted cash flow of the lease(s).

A senior, experienced professional conducting this final-hour or post-closing diligence brings a healthy dose of skepticism to the process. As a result, the buyer can be more assured that their best interests are protected.

Brandlin & Associates is an exclusive provider of investigative accounting, financial consulting and strategic consulting services. We pride ourselves on offering superior technical expertise, years of practical experience and unparalleled service to decipher financial and operational performance metrics. As a result, our clients are able to make informed decisions in a timely manner.

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