Bearer of bad news

This month's case study sees a chief executive who is eager for an acquisition, but his accountant has plenty of reservations to bring to the board

In the eyes of its main rival, Selerino Ltd was a highly attractive acquisition. A leading manufacturer of digital vending machines, Selerino had effectively cornered the Irish and UK markets. In addition, its managing director, Paul Robinson, was believed to be negotiating the renewal of an exclusive supply contract with a large European retailer.

IBW Technologies Ltd had had Selerino in its sights for a long time. Although IBW's product range was every bit as strong as Selerino's, it had failed to capture the market in the same way. While the family-run IBW had established itself as a competent number two in both the domestic and UK markets, Selerino had leap-frogged to pole position by forging relationships with a number of blue chip clients.

To the ambitious chief executive of IBW, Barry Murray, acquiring Selerino offered the opportunity to seize market share, expand the product range and grow revenues far beyond the limits of the company's existing platform. What's more, Murray believed that the transaction could be funded from IBW's extensive cash reserves which had been significantly boosted by the sale and leaseback of the company's premises in Sandyford the previous year.

Negotiations between Selerino and IBW started after receipt of the information memorandum from Cygnum Corporate Finance. Heads of terms were signed in October 2006 and both parties agreed to work towards a deadline of January 12th, 2007. On advice from its solicitor, IBW included a clause making the acquisition dependent on completion of successful legal and financial due diligence.

Having reviewed a number of quotes from accountancy firms for conducting due diligence, Murray saw it would save a lot of money to keep it in house. After all, IBW would not need to borrow to buy Selerino and board approval was a certainty, so hiring external accountants for due diligence seemed to be an unnecessary expense.

Instead, he asked the company's management accountant Chris Johns, to conduct an internal financial review. In Murray's mind the risk was minimal; he had tracked the growth of Selerino from its beginnings in a small IDA unit in Ringsend. He was familiar with key staff members and he always reviewed Selerino's published accounts at the end of each year. Although Johns had no formal financial accounting background, Murray knew him to be a competent management accountant with a keen eye for detail.

Johns had never been asked to take on an assignment like this before. Cygnum was managing the process, providing an online data room followed by an online Q&A forum. Initially flattered by the chief executive's trust in him, Johns soon realised he was out of his depth. He felt an experienced transaction services team was needed. But Murray was quick to dismiss his misgivings, saying that they had more than enough experience between them to carry out the financial review.

The information provided in the data room was limited. Selerino management produced audited financial statements for three years, management accounts to October 31st, 2006 and forecast figures for the two months ending December 31st, 2006. It also presented a copy of the company's strategic overview, a series of supply contracts and a summary of Selerino's key revenue streams in the past. Limited taxation and insurance information was made available.

Johns met Murray to discuss what they should concentrate on in the review. Murray stressed that the focus should be on turnover, revenue streams and gross profit. It was agreed that the board would meet in three weeks to review Johns' findings and to assess the acquisition opportunity.

Selerino's financial statements presented strong growth figures, particularly in the company's UK and European markets. As far as Murray was concerned, these figures did the talking. Compound annual growth rates exceeding 20 per cent, backed by iron-clad contractual agreements, could only mean success.

However Johns was less optimistic. He acknowledged the strong growth in revenues in the period under review, but he was worried about the company's deteriorating margins.

The data room and online Q&A platform provided no explanation for this decline. Murray maintained that the Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA) margin would improve with a boost in business after the acquisition. Furthermore, the sales channels that Selerino would open up to IBW would ensure the viability of the transaction in the long term.

To Johns, Selerino's sale appeared to be motivated by necessity rather than choice. The company's net debt position had deteriorated dramatically since 2003. He questioned the value of the company's intangible assets at October 31st, 2006 and the existence of Selerino's "iron-clad" supply contracts.

In preparation for his presentation to the board the following week, Johns spent a late night in the office reviewing the key issues for discussion:

1. The supply contracts contained a change of control clause, yet Selerino had failed to discuss the proposed transaction with the relevant parties.

2. Selerino's premises was partly owned by its managing director, Paul Robinson, and the rent charged was substantially less than market rates. The lease was subject to rent review in March 2007, which would result in an annual increase of approximately €100,000.

3. When IBW reviewed Selerino's most recent stock take, it found that, given the high level of obsolescence, the stock provision was inadequate. The resulting write off and restocking requirements would reduce the company's overall profitability.

4. Debts outstanding for 90 days or more were equivalent to one month's sales - yet the bad debt provision in Selerino's accounts was significantly lower than this. Johns believed that after the acquisition many of these debts would prove to be irrecoverable.

5. The management accounts at October 31st, 2006, capitalised research and development costs to be amortised over three years, resulting in a significant inflation of the period's profits.

6. On further analysis, it was discovered that a number of unused environmental provisions had been released in the periods reviewed, distorting the company's underlying profitability.

7. Despite the substantial increase in turnover in the 10 months to October 31st, 2006, Selerino had fallen out of favour with a key customer who had accounted for approximately 11 per cent of the previous year's turnover.

As Johns stood outside the sixth-floor boardroom at one minute to three, he rehearsed how he was going to describe the cumulative effect of the above items on Selerino's underlying earnings. He knew Murray was not going to be happy.

Taking a deep breath, Johns knocked on the door and went in to face the board.

What should Chris Johns be recommending to the board?