1. Introduction: A Practical Financial Approach Built for Small and Mid-Sized Deals
There is no shortage of commentary on financial practice in M&A. Most of it, however, assumes the kind of reasonably polished financial statements and management infrastructure that large financial advisory (FAS) firms are used to working with. Apply theory developed for listed companies and large enterprises directly to a Japanese small or mid-sized enterprise (SME), most of which are owner-managed, and you will often find it doesn’t fit what you see on the ground.
In many Japanese SMEs, the owner’s personal living expenses are mixed in with company expenses, and accounting and internal controls are not always fully developed. Focusing on finance and accounting, this article walks through the points that overseas investors and CFOs considering an acquisition should keep in mind across the entire process: valuation, financial due diligence (financial DD), price adjustments, and closing.
Of course, M&A does not begin and end with financial DD. Tax, legal, and labor matters all require their own specialists, and the work has to be coordinated among them. Those performing financial DD, in turn, need to look beyond their own area of expertise and stay alert to where it meets other disciplines.
For overseas investors in particular, reading the financial information of a Japanese SME requires an understanding of Japan-specific business customs and the characteristics of owner-managed companies. We hope this article helps you understand such businesses as they really are, including what lies behind the numbers.
2. Pre-DD and Valuation: Don’t Take the Financial Statements at Face Value. Establish Normalized EBITDA and Real Net Assets
The first task in the early stages of an M&A transaction is not to accept the target’s financial statements as they are, but to determine its true earning power and net assets. The key concept here is “Normalized EBITDA” (also called Adjusted EBITDA).
In owner-managed companies, the compensation paid to the representative director can differ significantly from what a post-acquisition manager would be paid, or from the cost of hiring a replacement. In such cases, earning power should be assessed after adjusting compensation to an appropriate level, based on the management structure you expect to have after the deal.
The same goes for entertainment expenses, vehicle costs, and similar items booked as company expenses: confirm their connection to the business and whether they will continue after the acquisition. Costs that can reasonably be expected to disappear after closing, or expenditures with little connection to the business, may be candidates for adjustment when determining normalized earnings. Compensation paid to family-member directors who do not perform real services is treated in the same way.
What matters is not simply to “add back anything that is an expense.” It is to examine, one item at a time, whether each cost is truly necessary to keep the business running and whether it will still be incurred after the acquisition.
Another point to check is surplus and non-operating assets. Assets not directly required to run the core business, such as idle real estate, golf club memberships, and insurance reserves, should be separated from enterprise value (EV) and dealt with in the bridge from EV to equity value.
This work cannot be handled with textbook formulas alone. You need to confirm the story behind each number, one by one, taking into account the target’s industry characteristics and the owner’s management style.
Calculating Normalized EBITDA is more than a mechanical exercise in correcting numbers.
Why did the owner choose that level of compensation? Why does a particular expense recur year after year? Understanding the reasons is useful not only for the valuation negotiation that follows, but also for thinking through the management structure after the acquisition.
In SME M&A, it is especially important to adjust the numbers while also understanding the background that produced them.
3. Financial DD: Setting Priorities in a Limited Timeframe and Testing for Off-Balance-Sheet Risks
In SME transactions, the time and personnel available for investigation are often limited compared with large-company deals. In financial DD, therefore, the practical key is not to comb through every account line by line, but to start with areas that have a large monetary impact and with issues that raise concerns in interviews with management and accounting staff.
For example, if monthly sales are plotted and one particular month stands out, or if terms with a major customer change only near period-end, such irregular movements can prompt suspicion of revenue recognition timing differences or period-end channel stuffing. In one actual engagement (described here in general terms for confidentiality), a manufacturer’s sales in its fiscal year-end month were nearly 1.5 times those of other months. When we matched shipping records against payment records, we found that returns and price reductions after the start of the following fiscal year were higher than usual. Focusing on what drove the change, rather than on the number itself, is what opens the door to further investigation.
Inventory is similar. Looking only at the book balance will not reveal missed write-downs or slow-moving stock. You need to review trends in inventory turnover period and movement by item, and quickly narrow down to stock that has not moved for a long time.
It is also important to recognize that the risks addressed in financial DD are of different kinds. Obligations that have already arisen but are not reflected in the books (off-balance-sheet liabilities) are treated differently from liabilities such as litigation or labor disputes, where it is itself uncertain whether they will ever materialize (contingent liabilities). The former can be estimated and are relatively easy to reflect in a price adjustment. The latter, because both occurrence and amount are uncertain, are more likely to call for treatment through contract provisions. Some obligations, such as the restoration obligation on leased premises (an asset retirement obligation), come to light only when the contract is read, and cannot be fully identified from the financial statements alone.
Depending on the nature of a labor issue, confirmation from a licensed labor and social security consultant (shakai hoken romushi) may be needed, and for the legal evaluation of disputes, an attorney. The role of financial DD is to recognize that such issues exist and to judge their monetary materiality. Judging the legal merits themselves is done in collaboration with the relevant specialists.
Identified financial risks have little value if they are merely listed one by one. Each needs to be estimated in terms of how much it affects future cash flows and real net assets, and then carried into the price negotiation and the design of contract terms.
When conducting site visits and interviews within a limited period, it can also be effective to speak not only with accounting staff but also with the heads of the sales and manufacturing departments. Practical realities that the books do not show, such as the balance of power with customers and the causes of seasonality, often sharpen the accuracy of risk assessment. Whether you can secure these multiple perspectives within a tight timeframe largely determines the quality of financial DD.
4. Contract and Price Adjustment: Turning Identified Financial Risks into SPA Terms and Price Adjustments
The risks and adjustments identified in financial DD inform the investment decision only once they are properly reflected in the transaction price and the share purchase agreement (SPA).
That said, there is no uniform rule that says “this risk must always be handled this way.”
The actual method of adjustment also depends on how price is determined: a Completion Accounts mechanism, which uses the financial figures at closing, or a Locked Box mechanism, which fixes the price by reference to the financial figures at a set reference date.
One typical approach to price adjustment is the bridge from Enterprise Value to Equity Value.
After calculating EV based on Normalized EBITDA and similar measures, you adjust for cash, interest-bearing debt, and debt-like items to arrive at equity value.
The important point here is that what counts as a debt-like item is not necessarily clear-cut.
For off-balance-sheet liabilities found in financial DD as well, you consider their nature, the certainty of the amount, and the terms of the deal to decide whether to adjust the price as net debt, treat them as another price adjustment item, or make them subject to contractual indemnification.
Likewise, when an asset turns out to be overvalued, it is not automatically deducted from the price by a set method. You need to work out the effect on equity value according to the nature of the item, for example whether it affects normalized working capital, or whether it affects the very assumptions underlying the EV calculation.
Another important element is representations and warranties and indemnity provisions.
For risks identified in financial DD whose occurrence or amount is hard to pin down, one option is not to try to resolve them through price alone, but to address them through representations and warranties in the SPA or through specific indemnity clauses.
Which risks go into the price and which are covered by contract is a matter of negotiation in each deal. Drafting the legal provisions naturally requires close collaboration with an attorney.
In addition, under the Completion Accounts mechanism, working capital adjustment is also important.
You set the level of “normalized working capital” needed to run the business as usual, based on historical performance and similar data, and reflect the difference from actual working capital at closing in the transaction price.
A 12-month average can serve as one reference point, but for highly seasonal businesses or fast-growing companies, a simple average is not necessarily appropriate. The benchmark should be set in light of the target’s business characteristics.
In this way, deciding where to reflect the information obtained in financial DD (Normalized EBITDA, the EV-to-Equity Value bridge, working capital adjustment, representations and warranties, indemnities) is what gives the price negotiation its real substance.
5. Conclusion: Financial DD That Goes Beyond Writing the Report
In financial DD, organizing the identified risks and delivering them in a report is certainly an important role.
In SME M&A, however, that alone does not necessarily complete the job of financial DD.
What is the Normalized EBITDA?
Given that, how should we think about enterprise value?
How much will the identified risks affect equity value?
Should we adjust the price, or protect ourselves through the contract?
Only by connecting this chain of questions do the results of financial DD translate into a concrete investment decision.
In Japanese SMEs in particular, there are often circumstances and business practices peculiar to owner management that are hard to grasp from the numbers alone. Understanding that background, it is important to connect the findings of financial DD consistently to valuation, price negotiation, the SPA, and the settlement of funds at closing.
The earnings structure and management issues identified in financial DD also provide important input for more than the purchase price. They inform the post-acquisition management structure and post-merger integration (PMI) planning.
For overseas investors and domestic acquirers alike, financial DD is not merely an exercise in “identifying risks.”
It is one of the key decision-making processes in M&A: understanding the true condition of the target and weighing appropriate price and deal terms.