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For government contractors considering a transaction, readiness begins well before a formal sale process. Buyers will look beyond revenue, customer/project profitability, EBITDA and backlog to understand the financial reporting, contract compliance, systems, processes, and management infrastructure supporting the business.
Preparing early gives management time to identify gaps, address issues that may require longer-term remediation, and build the documentation needed to support the company's position during diligence. This is particularly important in government contracting, where contract terms, indirect rates, cybersecurity requirements, and other compliance matters may not be resolved quickly once a transaction is imminent.
Look at the business through a buyer's lens
A buyer will want to understand not only the company's financial performance, but what is driving it and whether it is supportable. For government contractors, that assessment can extend from revenue, profitability and backlog to the contracts, accounting practices, and infrastructure supporting those results.
Private equity buyers also consider what it will take to operate the business after close. The maturity of the finance function, quality of books and records, internal controls, and ability to produce timely and reliable financial information can help a buyer assess whether the business can support additional growth, acquisitions, and new reporting requirements, or will require significant investment after the transaction.
Know what buyers will examine
Government contracting diligence can extend into the contracts, accounting practices, and compliance requirements underlying the company's financial performance. The diligence process may focus on several areas.
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- Financial diligence. Buyers will examine the quality and consistency of the company’s financial information and whether it supports the story being presented. That can include revenue recognition, adjusted EBITDA, and the underlying financial results, as well as projections, backlog, and pipeline that support expectations for future performance. For government contractors, revenue recognition can warrant particular attention because accounting for fixed-price contracts may affect reported revenue and adjusted EBITDA, which can impact transaction value.
- GovCon contracts and performance. Buyers may review awards, modifications, Contractor Performance Assessment Reporting System (CPARS) ratings, claims, and requests for equitable adjustment (REAs) as they evaluate the contract portfolio and validate backlog. Performance history can also affect expectations for future awards. A negative CPARS rating, for example, may require further diligence to determine whether it reflects an isolated issue or a performance concern that could affect follow-on work.
- Rates, billings, and government submissions. Indirect rate structures, billing support, provisional rates, and incurred cost submissions can provide insight into the company's cost accounting practices and potential exposure. For contractors subject to incurred cost submission requirements, significant underbillings or overbillings may raise questions about what could occur when contracts are closed out. Changes in indirect rate structures should also be documented and supportable.
- Policies and internal controls. Buyers may examine timekeeping, procurement, cost allowability, and other controls that support the company's accounting and contract practices. These controls can affect indirect rates, project profitability, and the reliability of the financial information being evaluated during diligence.
- Transaction-specific compliance considerations. Change-of-control requirements; organizational conflicts of interest (OCI); foreign ownership, control, or influence (FOCI); Cybersecurity Maturity Model Certification (CMMC) requirements, and other security considerations may affect the transaction itself. Understanding these requirements before diligence allows management to identify issues that could influence deal structure, timing, or buyer interest.
Understand how findings can affect the deal
Buyers may evaluate diligence findings through both a financial and transaction lens. Issues that create uncertainty around financial performance, contract compliance, or future revenue can affect buyer confidence and the value a buyer places on the business. Depending on the nature of the finding, buyers may seek additional diligence, protections in the purchase agreement or escrow arrangements, and unresolved issues may extend the transaction timeline.
Buyers expect to identify issues. The more important question is whether management understands the risk, has documentation supporting its position, and can demonstrate a credible path for addressing it. An issue management has already identified and can explain creates a different diligence conversation from one the buyer uncovers and management cannot support.
The benefit of preparing early is having time to address these issues before they become diligence findings. A phased approach can help management prioritize that work, moving from assessment to remediation and, ultimately, preparation for the diligence process.
Build readiness before diligence begins
24 months: Assess the foundation
At approximately 24 months, evaluate whether the company's financial and compliance infrastructure has kept pace with the size and complexity of the business. Growth, acquisitions or new lines of business can introduce requirements that existing processes, systems and controls were not designed to support.
From a financial perspective, assess whether the accounting books and records provide consistent, supportable information, and whether the chart of accounts allows management to understand performance at a meaningful level. For government contractors, that includes tracking revenue and profitability at a meaningful level, as well as understanding the bifurcation of direct and indirect costs and the allowability of costs.
The compliance assessment should examine contract clauses and administration, policies and procedures, cost accounting practices, indirect rates, and cybersecurity requirements.
Management should also review the contract portfolio for small business set-asides, consent requirements, teaming agreements, organizational conflicts of interest, and other contract provisions that could affect a transaction.
At this stage, the objective is to identify gaps while there is still time to address them through process improvements, system enhancements, training, or documentation.
12 months: Remediate and document
At approximately 12 months, the focus shifts from assessment to remediation. Gaps identified earlier should be actively addressed through stronger policies and procedures, improved contract documentation, enhancements to timekeeping, labor charging, and other controls.
Contract documentation should also become a priority. Buyers will want to understand contract types, periods of performance, and the backlog supporting future revenue. Awards, modifications, and other supporting documents should be organized and complete, and contract briefs should be current. Management should also assess whether the organization has the capacity to support due diligence efforts while continuing to run the business. Reliance on a single CFO, controller, or other key individual can create a bottleneck as the finance team balances ongoing reporting responsibilities with buyer requests.
Basic financial reporting capabilities can provide an early test for the seller. A company should be able to close its books on a monthly basis and produce requested financial information in a timely manner. If a relatively basic financial report takes weeks to produce, a buyer may begin to question the underlying finance function and the reliability of the financial story being presented.
6 months: Prepare to support diligence
At approximately six months, the seller’s focus should shift to producing and organizing the information buyers will use during diligence. Significant gaps identified earlier should largely be resolved or supported by a clear explanation of the remaining issues, if any.
On the contracts and compliance side, the data room should include complete contracts, task orders, and modifications, including changes that affect funding or contract requirements. Relevant government audit reports and business system matters should also be addressed and organized so management can present its compliance position alongside its financial performance.
On the financial side, management should be prepared to produce monthly trial balances, monthly income statements and balance sheets, monthly reporting packages, and information about the systems supporting the finance function. If gaps remain, management should be able to identify them, explain their significance, and describe what has been done or remains to be done. This transparency gives buyers a clearer view of the business and areas that may require attention after close.
Use time while you have it
Transaction preparation adds to the day-to-day demands of running the business, often with a limited number of people involved because of the confidential nature of a potential sale. For government contractors considering a transaction within the next 12 to 24 months, using that time to assess, remediate, and organize the business can help accelerate the transaction process, limit management distraction and operational disruption during the due diligence process, and minimize purchase price erosion.
For a deeper dive, watch our webinar: Before the buyer calls: GovCon transaction readiness
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