When businesses are aiming to grow, there are two main paths. The first is organic growth and the second is inorganic growth. If you actively pursue inorganic growth, you may have the chance to acquire a struggling business.
Although these “turnaround acquisitions” can offer significant long-term benefits, they can also come with higher risks compared to acquiring a financially stable company.
Organic growth, involves internal efforts like increasing sales, entering into new markets, developing new products or services, and enhancing operational efficiency. Inorganic growth, is achieved through external activities such as mergers and acquisitions (M&A), and strategic partnerships.
Due diligence
Generally, successful turnaround acquisitions begin by identifying a floundering business with hidden value, such as untapped market potential, poor (but replaceable) leadership or excessive (yet fixable) costs.
But be careful: You’ve got to fully understand the target company’s core business — specifically, its profit drivers and roadblocks — before you start drawing up a deal. If you rush into the acquisition or let emotions cloud your judgment, you could misjudge its financial condition and, ultimately, devise an ineffective course of rehabilitative action. This is why so many successful turnarounds are conducted by buyers in the same industry as the sellers or by investors, such as private equity firms, that specialize in particular types of companies.
During the due diligence phase, pinpoint the source(s) of your target’s distress. Common examples include excessive fixed costs, lack of skilled labor, decreased demand for its products or services, and overwhelming debt. Then, determine what, if any, corrective measures can be taken.
Don’t be surprised to find hidden liabilities, such as pending legal actions or outstanding tax liabilities. Then again, you also might find potential sources of value, such as unclaimed tax breaks or undervalued proprietary technologies.
Cash management
Another critical step in due diligence is identifying cash flows, both in and out. Determine what products or services drive revenue and which costs hinder profitability. Would it make sense to divest the business of unprofitable products or services, subsidiaries, divisions, or real estate?
Implementing a long-term cash-management plan based on reasonable forecasts is also critical. Revenue-generating and cost-cutting measures — such as eliminating excessive overtime pay, lowering utility bills, and collecting unbilled or overdue accounts receivable — can often be achieved following a thorough evaluation of accounting controls and procedures.
Reliable due diligence hinges on whether the target company’s accounting and financial reporting systems can produce the appropriate data. If these systems don’t accurately capture transactions and fully list assets and liabilities, you’ll likely encounter some unpleasant surprises and struggle to turn around the business.
Buyers vs. sellers
Parties to a business acquisition generally structure the deal as a sale of either assets or stock. Buyers usually prefer asset deals, which allow them to select the most desirable items from a target company’s balance sheet. In addition, buyers typically receive a step-up in basis on the acquired assets, which lowers future tax obligations. And they’re often able to negotiate new contracts, licenses, titles and permits.
On the other hand, sellers generally prefer to sell stock, not assets. Selling stock simplifies the deal, and tax obligations are usually lower for sellers. However, a stock sale may be riskier for the buyer because the struggling target business remains operational while the buyer takes on its debts and legal obligations. Buyers also inherit sellers’ existing depreciation schedules and tax basis in target companies’ assets.
Reasonable assurance
For any prospective turnaround acquisition, you’ve got to establish reasonable assurance that the return on investment will likely exceed the acquisition’s immediate costs and ongoing risks. We can help you gather and analyze the financial reporting and tax-related information associated with any prospective M&A transaction.
We Can Help
If you have any questions about turnaround acquisitions, or would like to discuss individual tax planning strategies that apply to your situation, do not hesitate to contact your Rudler, PSC advisor at 859-331-1717.
RUDLER, PSC CPAs and Business Advisors
This week's Rudler Review is presented by Alyssa Monson, Staff Accountant and James Ray, CPA.
If you would like to discuss your particular situation, contact Alyssa or James at 859-331-1717.
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