Ask Me Anything Summary

Chris Barrett, Managing Director of Midwest CPA, joined the EBIT community to share insights from his extensive experience helping acquisition entrepreneurs navigate deals. With his firm completing 61 Quality of Earnings (QoE) reports last year and currently supporting 70 successful buyers post-close, Chris offered valuable perspectives on what makes deals work – and what causes them to fail.

The Three Deal Killers

Early in the discussion, Chris identified the three biggest deal-breaking issues his team encounters:

1. Net working capital disputes

2. Revenue recognition problems

3. Tax complications

"I've seen people sink six figures into deals only to have them blow up a few weeks from close because they waited too long to have the working capital discussion," Chris emphasized. This led to one of the session's most practical insights: calculating the cash conversion cycle and multiplying it by average daily sales can give searchers a rough working capital estimate before they even sign an LOI.

Demystifying Working Capital

The working capital conversation sparked significant interest from the community. Chris shared a comprehensive framework for what typically should and shouldn't be included:

Typically Included:

• Accounts receivable

• Inventory

• Certain prepaid expenses

• Accounts payable

• Accrued salaries and wages

Not Included:

• Cash

• Debt

• Investment accounts

• One-time events

• Unearned revenue

• Aged receivables/inventory

Importantly, Chris noted that about 70% of deals his firm sees include working capital in the enterprise value calculation. This challenges the common broker narrative that working capital should always be added to the purchase price. As member Mike O. pointed out, "The idea is that the value of the purchase includes NWC. If seller isn't willing to leave it in terms of cash, their cash received at closing falls accordingly."

Revenue Recognition Red Flags

Chris shared compelling visuals demonstrating how improper revenue recognition can mask underlying business performance issues. The before/after charts he presented showed how dramatically different a business's performance can look once revenue is properly recognized - transforming erratic revenue spikes into more predictable patterns that better reflect business reality.

Key warning signs include:

• Significant month-to-month gross margin swings (what should be relatively stable in most businesses)

• Inconsistent revenue patterns in project-based businesses

• Mismatched timing between revenue recognition and expense booking

• Early or premature revenue recognition

• Large end-of-period adjustments

• Unclear percentage of completion tracking

The solution requires a systematic investigation of:

1. Current invoicing practices

   • When invoices are generated

   • How deposits are handled

   • Whether progress billing is used appropriately

   • If revenue is recognized at invoice or completion

2. Payment terms and cash flow patterns

   • Standard payment terms

   • Actual collection cycles

   • Deposit requirements

   • How progress payments align with work completion

3. Project completion tracking

   • Methods used to track % complete

   • Who determines completion status

   • How change orders are handled

   • Documentation requirements

4. Systems integration

   • Whether invoicing happens in the accounting system

   • How project management software interfaces with accounting

   • Manual vs automated revenue recognition

   • Controls around revenue recognition timing

Chris shared an example where proper revenue recognition analysis revealed that what appeared to be a seasonal business with dramatic revenue spikes was actually much more stable once recognized properly. For project-based businesses, he emphasized examining percentage of completion calculations, treatment of deposits, timing of cost recognition, and change order handling - all of which affect not just valuation but also understanding true working capital needs post-acquisition.

Deal Structure and Tax Implications

The discussion revealed several layers of tax complexity that can materially impact deal economics. "You'd be surprised how many sellers don't talk to their accountant before they go to sell," Chris noted, explaining how tax surprises often derail deals late in the process.

Key considerations include:

• Asset vs. stock sale implications

  • Stock sales benefit sellers through capital gains treatment

  • Asset sales give buyers depreciation and amortization benefits

  • Many buyers pay zero tax in year one through proper structuring

• Hidden liability risks

  • Sales tax obligations can follow the business even in asset sales

  • Chris shared a recent case where $400k in sales tax liability was discovered

  • Required creative escrow structuring to protect the buyer

• Deferred revenue treatment, especially in SAAS businesses

  • Traditional treatment as debt-like item doesn't always make sense

  • Chris recommends considering the incremental cost to service

  • Can negotiate based on gross margin impact rather than full value

The discussion highlighted how early tax planning with both buyer and seller counsel can prevent late-stage deal friction. Chris emphasized that understanding these implications early helps with both initial pricing discussions and final deal structure negotiations.

Due Diligence Best Practices

Chris emphasized how quality diligence can transform the acquisition process from an exercise in risk management to a roadmap for future success. His framework for effective diligence revealed several key dimensions:

1. Balancing Information Asymmetry

• Focus on validating rather than just collecting data

• Look for inconsistencies between financial and operational metrics

• Document explanations for any unusual patterns or trends

• Cross-reference customer and vendor relationships

2. Identifying Critical Success Factors

• Understand customer concentration and relationship depth

• Validate key employee roles and tribal knowledge

• Review systems and processes for scalability

• Assess competitive position and barriers to entry

3. Financial Validation & Analysis

• Compare P&Ls to tax returns and bank statements

• Review revenue recognition policies and implementation

• Analyze working capital cycles and seasonality

• Validate add-backs and one-time adjustments

4. Operational Assessment

• Evaluate management team depth and capabilities

• Review employee agreements and compensation structures

• Assess vendor relationships and supply chain risks

• Understand regulatory and compliance requirements

5. Strategic Positioning

• Analyze market trends and competitive dynamics

• Identify growth opportunities and constraints

• Evaluate pricing power and customer relationships

• Assess technology and capital investment needs

Chris shared how this framework helped uncover critical issues in recent deals, from undisclosed tax liabilities to revenue recognition problems that materially impacted valuations. "Quality diligence isn't just about finding problems," he noted, "it's about understanding how to create value post-close."

Key Takeaways for Searchers

1. Address working capital discussions early in the process - Chris recommends using the cash conversion cycle calculation for initial estimates

2. Verify proper accrual accounting, especially for project-based businesses where revenue recognition can mask underlying performance

3. Ensure alignment on estimated seller exit proceeds to avoid late-stage deal friction

4. Consider tax implications from both buyer and seller perspectives, particularly around asset vs stock sale decisions

5. Plan for post-close success by implementing robust tracking systems - Chris strongly advocates for a 13-week cash flow forecast, noting "this report is what allows clients to sleep at night"

6. Document deal assumptions and rationale during diligence to inform post-close priorities

7. Build relationships with key employees and customers during diligence to smooth transition

For searchers looking to learn more about Midwest CPA's approach to deal support and quality of earnings, visit midwest.cpa and follow Chris on X @CBarrett_CPA.

EBIT Community

Our community gained actionable insights from this week's AMA with Chris Barrett of Midwest CPA, who shared hard-earned wisdom from completing over 60 quality of earnings reports last year. The conversation quickly moved beyond basic accounting as members dug into real deal challenges - from working capital negotiations to revenue recognition red flags. When member Kyle H. raised a question about evaluating cash-heavy businesses, it sparked an invaluable discussion about deal structuring and tax implications, with experienced buyers like Mike O. and members of the community sharing their own lessons learned. These kinds of practical, granular discussions happen daily in our growing community of searchers. Click below to join the conversation.