Hi, it’s CJ Gustafson and welcome to Looking for Leverage.

If we’re being real, every dollar of your diligence budget wants to go to the P&L. It’s a magnetic pull, since it’s where you’re applying an EBITDA multiple. The balance sheet merely receives a working capital peg, a cash confirmation, and a polite how ya doing on the way past. No fraud here! Pass go…

Today’s topic: the stuff lurking on a target’s balance sheet when it’s a founder owned company that’s never been audited. And how to figure out what is clean up vs meaningful dollars before it nukes your own statements via osmosis.

The founder still owned most of the company after eighteen years. It was profitable, but had never been audited, since it had never taken real professional money, just checks from family and friends over the years.

I pulled the leases first, which from prior experiences I knew could be a rats nest. There were two offices the company rented. One had been straight-lined, while the other was booked at whatever rent got paid that month. And unfortunately for me, the people who set each of them up were long gone.

My spidey senses went off because usually when two leases are booked differently inside the same company, it means no one applied a policy to anything. They were just taking the numbers as they came. And now I couldn’t help but wonder if anything on that balance sheet had a rhyme or reason to it. This was the canary in the lease coal mine, if you will.

You probably know how balance sheet diligence goes down. First you tie out the cash, then confirm the debt, block out a bunch of time to argue about the working capital peg, and finally check if AR is hiding a collections problem. 

All of that treats the balance sheet as a record of what happened to the company. However, if the book keepers changed multiple times over the years, and there isn’t a folder containing specific balance sheet policies, you’re only scratching the surface.

The whole thing comes down to how information got to the person doing the books. Because there’s a litany of items that may never have reached the person recording what went down.

That might include side letters with the founder’s uncle who put in $50K in 2013, warrants attached to a term loan, or escalation language on a lease. In many respects, the founder’s email folder is the real general ledger, and the accounting system is what someone bothered to type in.

But the gaps are predictable, which is the good news. Here are the most common balance sheet land mines I’ve seen on founder owned company balance sheets when you are looking to acquire:

As you probably deduced, they don’t all cost you (or the seller) in the same way

Some land above the line, where you pay a multiple for them. That includes straight-line rent, PTO, and a blown commission cutoff.

Some land in the bridge, where you argue dollar for dollar, since it directly impacts purchase price. That includes unrecorded sales tax exposure, deferred tax liabilities, and  anything else you (or your lender) is going to call debt-like.

And some are just frustrating cleanup, which costs you audit fees and grey hairs when you try to close the books for the first few months. This includes stock comp, warrant accounting, and deferred tax completeness. These won’t change the purchase price but will potentially change who gets paid and how it’s recorded.

Let’s use the lease example. Say the headquarters lease ran ten years with 3% annual escalators.

The company was three years in, and writing checks for $848,720. They were also booking that number.

So EBITDA was overstated by $68,390 for every year they’d been in that space. At 7x EBITDA, one lease booked the way it felt natural to book it moved the purchase price by $478,730.

So that was a lease accounting example, but the real gut punch were the warrants that turned up eleven days before close.

Years back the company took a growth facility from a mezz lender, because the founder wanted to expand and didn’t want to sell equity to do it (once again, no professional capital was taken). The loan got repaid, and everybody moved on after retiring the debt. However, the lender had also taken a warrant for about 1% of fully diluted, and warrants don’t get repaid… They just sit there until there’s a liquidity event.

And nobody had booked it or put it on the cap table (they didn’t have cap table software, only a wonky spreadsheet that the owner saved to his desktop).

Our counsel found it in the payoff letter while working the closing checklist, which was lucky, because there was no version of financial diligence that was going to surface this, because it was never in the financials.

It cost $180K out of seller proceeds and pushed the close two days while we rebuilt the funds flow. The seller was obviously pissed, and I wasn’t happy having to wrack up more legal fees. But what was really infuriating is that I’d spent four months in that data room and the thing that moved the close date was buried in some archaic email attachment.

Wishing you an acquisition target whose lease policies agree with each other,

CJ

Looking for Leverage breaks down one PE term, clause, or mechanic each week, written for the CFOs and finance leaders who actually have to live with these things. If this got forwarded to you, subscribe at lookingforleverage.com. If there's a term you want broken down, reply and tell me. I read everything.

Thanks for reading, and make sure to check out our sponsor, Netsuite.

Readers of Looking for Leverage can try NetSuite Next for free.