Proactively Preparing for Transactions: Unlocking Value with Pro Forma Considerations

Our financial due diligence teams are often asked to quantify pro forma adjustments or addbacks that capture the impact to historical earnings for transactions that either did not occur or that would have occurred differently due to large or unusual events (e.g., tariffs, natural disasters, work stoppages, etc.). In an environment of high valuation multiples buyers are increasingly skeptical of giving full or partial credit for pro forma adjustments to EBITDA.

Often times this skepticism is caused by lack of detailed, tangible support for the adjusted operating results, which reduces credibility and could distract from an otherwise healthy business. In our experience, the ability to succinctly identify, articulate and support pro forma adjustments increases buyer confidence, creates a more defensible story and can result in a successful purchase versus a derailed transaction.

The World Health Organization identified COVID 19 (commonly referred to as the coronavirus) as a public health emergency of international concern on January 30, 2020. The coronavirus outbreak is an ongoing epidemic impacting nearly 70 countries resulting in lower production, work stoppages, reduced or halted travel and a spike in health-related costs. As many U.S.-based businesses rely on fulfilling production orders from Chinese and other foreign-based manufacturers, the coronavirus could continue to disrupt operations and impact earnings growth.

Below are some suggestions to proactively address future adjustments that could be presented in a quality of earnings report, board and lender reporting packages and investment banker presentations. These suggestions could apply to a broad array of unusual events, whether an event is specific to a business (e.g., facility damage) or widespread (e.g., coronavirus).

• Lost Revenue – Lost revenue may occur from orders that could not be fulfilled due to lack of available inventory or from orders that a customer could not undertake. In certain cases lost sales orders could be easily identified, such as cancellations, but could also be more difficult to identify. Remember to speak with and obtain evidence of discussions with customers to ascertain this impact.
• "Make-Up Orders" – Companies are often unable to determine whether lost revenue during an event is "madeup" in subsequent months. In other words, did sales shift from one period to the next, or did the company forego sales altogether? In the former case, the adjustment to revenue and EBITDA would be intended to adjust for outof-period recognition of revenue and gross profit, whereas the latter would be an adjustment to increase revenue and EBITDA for the lost revenue.
• Inflated or Depressed Gross Profit Margin – Customers may demand a lower unit price in order to help businesses move product. Conversely, businesses may be able to charge a higher rate for goods or services in the event of lower supply and higher demand. DHG recommends keeping track of the average selling price on a monthover-month basis before, during and after the unusual event.
• Changes in Unit Costs – The cost of overseas or domestically sourced goods could increase during the event due to periods of lower supply and higher demand. DHG recommends businesses keep track of average inventory cost at the SKU level to support the impact to margins.
• Other Considerations – Depending on the extent of the event and its geographic reach, businesses should consider the impact due to consumer activity, lost production time, continued supply chain disruption, inventory risk and even higher health costs if companies are self-insured. Fluctuations to inventory, accounts receivable and accounts payable that are outside of normal business conditions should also be considered for assessing working capital needs on an operational basis.

Examples of detailed supporting documentation might include (i) a complete listing of transactions separately identified that were impacted, (ii) month-over-month analysis of key performance indicators demonstrating the anomalies and (iii) written documentation from vendors or customers indicating a short-term or one-time impact related to the events.

For more information, contact one of your trusted DHG advisers.