As a business valuation expert, I am often called in to assess the true value of a business that is the target of an acquisition. In many such deals, there’s an intricate dance between financial reality and manipulated appearances, which may present a glossier, more appealing image of a company’s financial health than what reality might reveal. In a recently reported case between two private equity firms, the acquirer alleged the seller employed multiple accounting gimmicks to inflate the earnings of a software company, Mobileum, prior to its $915 million sale. By prematurely booking revenues and masking expenses, they claim the target’s profits were artificially inflated by over $250 million.
While the allegations remain in dispute, they underscore risks I regularly highlight to clients. As we evaluate the financials of an M&A target, here are some manipulative techniques that our team looks for.
Premature Revenue Recognition
Illegal yet common, this ploy involves recording future anticipated revenue as current-period income, inflating top-line figures before a sale. Sellers may book forward years of subscription revenue, excessive sales to partners, or less commonly, fictitious sales from shell companies to portray accelerated growth.
This tactic converts regular operating expenses into long-term capital expenditures, enabling costs to be depreciated over years instead of impacting the income statement immediately. By reclassifying expenses as assets without proper documentation, companies reduce reported expenses, inflate reported assets, and subsequently increase profits and net worth.
A risky tactic, channel stuffing involves shipping surplus products to distributors and retailers to temporarily inflate revenues, distorting current-period sales figures. This maneuver borrows from future earnings potential and leads to lower true valuation multiples once the excess inventory diminishes post-deal.
Exaggerating the growth potential of new products, expanded markets, and cross-selling opportunities often leads to an inflated valuation. This optimistic scenario building ignores market constraints, competitive challenges, or unforeseen obstacles that could significantly impact the projected growth trajectory, creating an overly optimistic portrayal of the business’s future prospects.
Other less common tactics used to inflate valuations include:
- Inadequately setting aside funds to cover future liabilities.
- Intentionally making accounting extremely complicated across merged entities to introduce ambiguities
- Extending payment terms to customers to incentivize more oversized orders
Our team of business valuation experts and forensic accountants specializes in meticulously examining various areas prone to manipulation in M&A valuations. By methodically assessing these facets, we uncover nuanced inconsistencies within meticulously constructed financial presentations.