By Ross Vozar and Adam Berebitsky, BDO USA, LLP
FINANCIAL DUE DILIGENCE 101
M&A deals can be time-consuming and complex, especially if one of the parties hasn’t vetted the many financial components that factor into such a transaction. For a deal to progress as smoothly as possible, both buyers and sellers must have a clear understanding of the financial operating results of the company being sold. Typically, this understanding is confirmed through the financial due diligence process, which takes into account both pre-close and post-close financial considerations.
Understanding the Key Financial Metrics
Pro forma store-level EBITDA
Pro forma store openings & closings
Temporarily closed stores
Temporary agreements to reduce franchise fee for remodels
Post-close lease costs – opco/propco
Above store-level costs
GAAP vs cash rent
It is common for a seller to underestimate the usefulness of presenting a thorough picture of the historical operating results. Performing sell-side financial due diligence can bridge a great divide when it comes to valuation expectations, ultimately enabling a smoother and quicker deal process.
A seller should represent a recurring earnings stream that offers transparency into its financials—what, for example, may be affecting profit margins, such as store openings and closings, above store-level expenses, and GAAP versus cash rent. For a buyer, understanding what is driving the seller’s earnings will lead to a more confident (read as higher) initial valuation that isn’t discounted for the unknown.
Most growing restaurants are opening new locations and closing less profitable ones on a regular basis. A buyer will want to eliminate such noise from the financials to understand the fundamentals and determine whether the earnings stream is not only profitable, but sustainable. A prospective buyer should look at the seller’s operations as if all of the stores were open: for example, if a store opens in June, a buyer will likely consider a pro forma adjustment to give credit to the seller for annualized earnings.
On the other side of the table, a seller should consider the impact of pre-opening costs and temporarily closed stores and get a credit from the buyer for the non-recurring nature of these expenses.
Another financial component to examine is the company’s capitalization policy. In a tax-driven approach, a company is often motivated to expense amounts less than $5,000 in an effort to decrease taxable income, while the seller may have a policy to capitalize amounts greater than $2,500. This difference could result in a significant difference in earnings.
The Metrics behind the Move
In 2018, restaurant M&A multiples ranged from 8–12x EBITDA, according to Citizens Financial Group. In a high-valuation environment, a seller will want to have a clear idea of the growth and value drivers of the pro forma entity. The rationale behind a deal can range from portfolio diversification—a brick-and-mortar-based business acquiring a company that specializes in food delivery services, for example—to portfolio reinforcement (buying more of the same business), economies of scale, or a talented executive team.
When entertaining a franchise deal, for example, most buyers begin with four-wall EBITDA to calculate store-level operating profit. If a buyer owns 100 stores and wants to acquire 20 more, the buyer will likely compare the prospective 20 stores to the current 100 to determine the incremental value the buyer’s operating model will provide, which is above and beyond what a seller can provide and expect to get paid for.
Lease costs can also be a value driver. If a seller is only three years into a contracted five- or ten-year below-market lease, a buyer may find this to be an attractive short-term cost savings. Conversely, if a seller’s lease is ending, a buyer should weigh the potential impact of signing a new lease on the pro forma earnings stream.
A buyer should also consider how complementary the composition of a seller may be: Is there some kind of infrastructure already in place to absorb the new business? If a buyer is making a foray into the restaurant industry, it will also have to look at the kind of human infrastructure needed to support that purchase—the corporate office, for example: accounting, finance, and the leaders who continue to keep operations flowing through and beyond the transaction.
Don’t Overlook Tax Liability
When evaluating a deal, it’s common for both parties to be thinking about the big questions, like whether the various puzzle pieces of their businesses will fit together. An often overlooked, but essential, component to a restaurant deal is understanding potential state and local tax liabilities. These alone can determine a transaction’s success. How a deal is structured, whether it’s an equity- or asset-level transaction, and how the buyer will finance the purchase, may subject the buyer to different kinds of tax exposure, such as sales tax or payroll tax. As a buyer, not knowing the tax liability of the pro forma business can be detrimental to its ongoing operations.
Furthermore, in the post-tax reform era, how to structure a deal is becoming increasingly important on both the buy- and sell-side. On the buy-side, there are new depreciation rules to consider, and on the sell-side, the net gains from a sale may be affected by the change in the tax rate, which fell from 35% to 21%.
Tax liability is an especially timely consideration in light of the 2018 Supreme Court decision in South Dakota v. Wayfair. The ruling, which overturned decades of precedent, allows states to require a business to collect and remit sales and use taxes, even if the business has no in-state physical presence. Though much of the media coverage and tax analysis in response to the ruling has focused on the effects on the retail industry, interstate restaurant transactions may also succumb to taxation. Among other requirements, restaurants will need to determine whether the volume of sales they complete across state lines will meet each state’s economic nexus threshold.
Be Mindful of the Chaos Factor
Introducing a potential transaction into the day-to-day responsibilities of employees is usually accompanied by a certain chaos factor. These employees may be asked to support the transaction in various ways—by providing financial and operational documents, for example, and managing extra duties on top of their business-as-usual tasks. From beginning to end, closing a deal can take upwards of six months on the sell side. It is important for both a seller’s expectations and the expectations of all employees to be mindful of the lengthy timeline. Preparing the deal team and communicating with them on an ongoing basis to help manage workflow and expectations will also be critical to a harmonious close.
Having an advisory team that understands the current market and how to guide a buyer or seller through the process is essential. The right team of investment bankers, lawyers, and accountants is key to help navigate options, scrutinize financials, and guide toward a satisfactory close.
OPERATIONAL DUE DILIGENCE 101
Sixty percent of transactions fail to achieve the goals they set out to, either because the gears of the integration process jammed or the post-acquisition strategy, if one was in place, petered out in the absence of guidance and reinforcement.
The roadmap to a smooth transaction starts with both parties having a thorough look under the figurative hood in the planning process. Proper operational due diligence truly sets the stage for success because it establishes and sets into motion the processes by which the pro forma company will operate—processes that have been streamlined and optimized for two discrete entities as they sync up to do business as one.
Identify the Risks and Drivers
Operational due diligence focuses primarily on three areas: value drivers, operational risks, and integration risks. In consolidation or scale-type transactions, a deal’s value drivers often center around cost synergies—consolidating back office operations, integrating the supply chain, or upgrading IT systems, for example. Cost synergies not only provide the justification for the deal, but a roadmap for its execution. This is different from strategic growth-type transactions in which buyers are generally looking to extract value through revenue synergies like cross-selling or product integration. Operational due diligence is where these value drivers are uncovered and proved out.
On the flip side, there are risks to the value drivers. A due diligence team will assess a restaurant’s exposure to vulnerabilities, such as whether a succession plan is in place for a small family-owned-and-operated shop, whether the menu is heavily dependent on a commodity that is forecast to experience significant volatility, or what the makeup of the competition might be if a restaurant is being introduced to a new location. On buy-side carve-outs—when acquiring corporate-owned restaurants from a franchisor, for example—a due diligence team will also analyze the stand-alone recurring costs or the costs of running the restaurants post-close. This will entail assessing the allocated costs, which represent the corporate or shared services provided by the parent to the restaurants, and can range from IT and human resources to finance and accounting services.
Integration risks are just as important to consider. Are there cultural differences between how the restaurants are run? For example, is one management’s style command-and-control while the other’s is based on consensus building? Culture and brand, especially, can be sensitive issues—a buyer should be wary of bulldozing a beloved brand or forcing its own culture on the acquired company’s employees.
A good operational due diligence team will assess these types of risks and will keep them front of mind as they draw up and carry out an integration strategy.