Typical questions to ask a consultant in M&A deals

Financial due diligence is frequently mistaken for audit. While both audit and due diligence play an important role in any successful M&A deal, they serve distinct purposes and should not be viewed as interchangeable.

Audits provide assurance that the target company’s financial statements fairly reflect the company’s financial position and performance. Accordingly, the availability of audited financial statements provides a greater level of confidence in the figures that investors rely on when evaluating and determining the value of a business.

However, audits specifically focus on how well a target’s financial reporting complies with the requirements of applicable financial reporting framework (e.g. IFRS or UNAS), whereas due diligence focuses on analysing these financial statements to assess the sustainability of financial indicators and presenting adjustments to these indicators to take into account one-time, non-recurring, and other transactions.

Unlike financial due diligence, an audit will not delve into the factors driving a business’ performance and position, nor will an audit address EBITDA sustainability or offer negotiation points to support the buyer or seller in the transaction.

That being said, audited financial statements can help avoid significant discrepancies between seller and buyer interpretations of a business’ financial results, which can bring both parties' positions closer together.

There is a common misconception, often prevalent in the Ukrainian M&A market, that enterprise value is the same as the amount that the buyer pays to the seller. The “enterprise to equity value bridge” illustrates how a business' value translates into its purchase price.

This bridge provides a comprehensive overview of the purchase price, breaking it down by key components and items of influence. It demonstrates how a business' value (determined using multiples or the cash flow model) can be adjusted for deficits or surpluses in working capital, cash, debt, and other potential items identified during the due diligence process. In the case of deals involving a locked box mechanism, an enterprise to equity value bridge includes adjustments for profit/interest factors and known leakages. In a nutshell, a value bridge is the natural outcome of the due diligence process which monetises identified issues, risks, and opportunities.

The buyer typically prepares the bridge to support their bidding price. However, cases where a seller will want to provide its own perspective on the purchase price first are not uncommon (especially in European practices).

The contents of an enterprise to equity value bridge are typically one of the key negotiation points between parties and ultimately flow into the SPA.

The general understanding in the M&A market is that a sale and purchase agreement (SPA) is prepared by legal advisors. However, an SPA naturally always contains, among other things, financial and tax components and information. Legal advisors are therefore usually responsible for the general wording and adaptation of the proposed financial, tax, or other concepts to the applicable law, and specialists from other areas provide recommendations on the wording specific to the target company. Accordingly, the involvement of specialists from other areas that are critical to the transaction (e.g. financial, tax, etc.) is an integral part of the SPA preparation process.

Typical financial components of an SPA include:

• Warranties in respect of the reliability of financial information: the cornerstone of any deal is the ability of a seller to guarantee the veracity of any financial statements and other information that have served as that basis for the due diligence and any decision making by the buyer.
• Purchase price composition: The components and calculation mechanism for the purchase price should be clearly written in the SPA.
• Accounting policies for completion accounts: When the completion mechanism is chosen by the parties to the deal, an SPA should define the policies to be applied at the completion date in the preparation of completion accounts. These are policies that flow from observations made in the financial due diligence and the enterprise to equity value bridge.
• Leakages: potential leakages are normally identified during the due diligence process. Leakages are reflected in the SPA based on the agreements between the parties to the deal. The actual analysis for leakages is conducted at specified date or dates following the execution of the SPA and in accordance with its provisions.

Financial aspects should be clearly defined in the SPA to avoid misunderstandings between the parties regarding the calculation of the transaction price. Uncertainty about financial aspects inevitably leads to conflict between the parties to the transaction.

The seller should prepare for the transaction in the same manner as the buyer. Unfortunately, this practice is relatively undeveloped in Ukraine and sellers are typically in a position to protect their own interests.

Prior to acquiring a company, a buyer will carry out a due diligence investigation to assess relevant risks, devise mitigation strategies, and determine transaction details. The seller can also carry out the same exercises, typically conducted through vendor assistance involving external consultants.

These preparatory steps significantly simplify the negotiation process for both parties, enabling the seller to form their own position on problematic issues even before the buyer's due diligence begins.

It is also common practice to conduct vendor due diligence as part of international M&A transactions. In this case, an independent consultant prepares a vendor due diligence report that potential buyers can use to make their own investment decisions. Consultants representing the buyer typically engage with the seller's advisor to discuss the contents of their report and additional questions that simplify and facilitate the buyer's due diligence.

Certain tax-related issues are commonly flagged by investors as significant risks or potential deal breakers for M&A transactions. These include: 

• Complex or Opaque Business Structures: A target company having a complicated or opaque business structure raises concerns about potential hidden liabilities and the company’s overall governance. This complexity can inhibit making an accurate assessment of a target company’s tax obligations and risks. 

• Strategies for Tax Optimisation: The use of tax planning tools aimed at optimising a target company’s tax position can cut both ways, in that while they may provide short-term financial benefits, they can also attract scrutiny from the tax authorities and lead to reputational risks, compliance issues, or significant penalties. 

• Quality of Tax and Accounting Functions: The strength of a target company’s tax and accounting practices is essential to any deal. Poorly managed tax functions and inadequate accounting records can indicate underlying financial problems that may require significant improvement post-acquisition. This can lead to unexpected post-deal costs and challenges. 

• Compliance with Tax Laws and Practice: A history of non-compliance with tax laws or a controversial local tax practice, including unpaid taxes, penalties, or ongoing disputes with the tax authorities, can be a major red flag. Such issues can affect valuations while also posing the risk of legal complications and financial burdens post-acquisition. 

• Future Tax Liability Exposure: Potential future tax liabilities, such as those arising from unresolved tax disputes or claims, can significantly impact the attractiveness of a deal. Investors need to assess the likelihood and the scope of impact should such liabilities materialise. 

Investors can adopt several strategies to mitigate risks associated with identified tax issues during M&A transactions. These strategies can help ensure a smoother transaction and protect investor interests. Here are some key approaches:

• Request a Full-Scope Tax Audit: Prior to finalising the deal, investors could consider requiring the target company to apply for a full-scope tax audit by the relevant tax authorities. Having this audit performed by the tax authorities adds an additional layer of credibility and thoroughness, revealing any hidden tax issues that may affect the transaction. 

• Negotiate Protective Clauses in the Sale and Purchase Agreement (SPA): The SPA should include specific clauses that protect the buyer from future tax liabilities arising as a result of company actions taken during the period prior to the acquisition. These can include warranties, indemnities, and representations related to tax matters. Such clauses ensure that any subsequent tax liabilities discovered after the transaction can be claimed back from the seller, thus safeguarding an investor’s financial interests.

• Elect for an Asset Deal: Choosing an asset deal over a share deal can provide significant tax advantages and risk mitigation. In an asset deal, the buyer can selectively purchase assets and avoid inheriting the target company's liabilities, including potential tax liabilities. This type of transaction allows for greater flexibility in structuring the deal to reduce exposure to a seller’s past tax issues. 

• Regular Monitoring and Compliance: Post-acquisition, it is vital that investors implement a robust system for ongoing tax compliance and monitoring. Regular reviews and updates to tax compliance strategies should be made so as to align with current laws and regulations, minimising the risk of non-compliance and associated penalties.

Tax structuring is a critical component of M&A transactions, involving several complex elements that need careful consideration:

• Complex Group Structures and Lack of Clear Functional Distinction Among Companies: In many cases, a target group of companies may have a complex organisational structure with blurred lines between the different entities' functions. This level of inter-group complexity can create challenges when assessing tax liabilities and operational efficiencies. Clearly understanding and potentially simplifying these structures is critical to ensuring compliance and optimising tax obligations.

• Existence of 'Empty' or 'Inactive' Companies with Unknown Tax Histories (Including Abroad): The presence of dormant or inactive companies, especially those in foreign jurisdictions, can be a red flag for potential hidden liabilities. Conducting a thorough investigation of these entities' tax histories is crucial for uncovering any undisclosed liabilities or compliance issues.

• Dynamic Legal and Tax Environment in Ukraine: Ukraine’s legal and tax landscape is continually evolving which can have an impact on the tax regimes under which a business operates. Staying up to date with these changes and understanding their implications is essential for strategic planning and compliance. 

• Potential Use of Special Tax Regimes: Special tax regimes offer opportunities for tax savings. Evaluating the applicability and benefits of these regimes can provide significant tax advantages and should be considered during the structuring phase.

• Tax Aspects of Exiting the Business: The tax implications of a business sale, particularly concerning capital gains tax, must be carefully analysed. This includes understanding the tax impact on both the selling and buying parties, as well as planning strategies to minimise tax liabilities.

Addressing tax issues comprehensively within a deal is vital to maintaining deal transparency. Here are some additional key areas to focus on:

• Disclosure of Information: Striking a balance between providing enough information for a transaction while not overwhelming the process with unnecessary details can be tricky, especially when also prioritising tax issues that could directly affect the deal's outcome and lead to significant repercussions for the buyer.

• Approach to Controversial Tax Treatments: Controversial tax treatment of transactions necessitates careful tax planning, thorough documentation, and (in certain cases) proactive engagement with tax authorities. It is therefore crucial to determine the most effective strategy for evaluating such transactions in the context of risk assessment and the overall deal. 

• Risk Mitigation Plan: In M&A transactions, protecting the investor from historical risks while also supporting the target company in rectifying past issues to avoid reputational damage is a top priority. A balanced risk mitigation plan should include comprehensive due diligence, negotiated indemnities, and a collaborative correction strategy. This approach ensures legal and financial safeguards for the investor and assists the target company in addressing compliance discrepancies, thereby fostering a positive relationship post-deal and maintaining both entities' reputations. 

• Transactional Documents and Negotiations with the Buyer: Deals should seek to maintain a fair balance between protecting the interests of the buyer while ensuring that the seller fulfills their obligations without undue burden. This balance should be reflected in the negotiation process and, ultimately, in the final transactional documents.