M&A deal momentum in the Government and Defense sector continued to grow in the first quarter of 2022 after a record-breaking year in deal volume in 2021. Strategic and private equity buyers continue to have a strong appetite for platform and add-on acquisitions.

Whether you are an established mid-sized contractor with a strong backlog supported by full and open contracts, or a small business contractor with sought-after capabilities, there are things you can and should do today to help ensure success when the time comes to sell. In our Government and Defense practice, we see how these issues commonly impact prospective buyers’ view of your business and valuation. They also impact the ease or difficulty of the due diligence process, and the likelihood of closing the deal.

Financial reporting – getting your house in order

All else being equal, businesses with accurate, transparent financials will be more attractive to buyers, as having this information readily available reduces both real and perceived risks. Buyers want to be confident that the financials you disclose are an accurate reflection of your business’s performance, and they will almost always go to great expense to confirm it by engaging an independent CPA firm to perform a quality of earnings analysis.

Government contractors already have to meet a high standard for complying with financial record keeping deadlines. But getting your financial house in order doesn’t mean paying to have your financials audited: The truth is, few lower middle businesses (less than $100 million annual revenue) have audited financials. It does mean ensuring that all revenues and expenses are accurately and consistently reflected in your financial statements so your results can be analyzed over a multiyear period.

Human resources – your most valuable assets

 In a service business that encompasses the large majority of government contractors, employees are your most valuable assets. They perform your service and interact with customers on a daily basis; your long-term success or failure hinges on them and buyers know it. Not surprisingly, buyers will want to closely examine your relationship with employees and who is critical to maintaining strong client relationships. These are just a few of the employee-related due diligence issues you should be prepared to address.

Contract waterfall – tell a compelling growth story

A prospective seller’s contract waterfall is a key valuation driver. Buyers look for a backlog that can support revenue into the foreseeable future and a history of repeat competitive wins. For businesses with a significant portion of backlog supported by set-aside contracts, it is imperative to define your competitive differentiations and a plausible path to one day competing for full and open solicitations.

Small business set-aside work provides a great opportunity for early-stage firms to build their performance and scale comfortably, but there ultimately comes a time when the business must make the jump to compete for full and open work. Buyers will key in on this growth strategy and will want comfort that your business has identified specific opportunities that it is well positioned to win.

Investing back into the business – building a sustainable organization

 In the years leading up to the sale of your business, it can be tempting to delay or forgo investments. Why invest when you will be soon turning the keys over to someone else? Unfortunately, this almost always shows in your performance.

Whether it’s investing in a proposal writing staff, technology systems supporting service delivery, or employee training and development, today’s savvy buyers will sniff out organizational deficiencies during due diligence. They will lower their valuation of your business to account for the investments they will need to make after the deal closes.

Set-aside contracts – A manageable concern for buyers

Government contractors in the lower middle market almost always have a component of set-aside work in their contract waterfall. In the years leading up to an M&A transaction, you should actively manage the total amount of set-aside work in your backlog. Depending on the amount and quality of set-aside work in the contract waterfall, buyers can be expected to apply their own discount on overall valuation. And yes, while there are a few select buyers that can acquire businesses and continue to compete for set-aside solicitations, there is no guarantee this will equate to a valuation premium. All things considered, most buyers are familiar with set-aside work, and it will not deter buyers from for pursuing the right acquisition opportunity.

Every transaction is unique, so you can never prepare for every contingency, but the issues described here are ones we see over and over again. Bottom line: A little up-front preparation can pay huge dividends when you are ready to sell your business by making it more attractive to a larger number of prospective buyers and ensuring a smooth due diligence process.

Barry Calogero, a FOCUS Managing Director, brings more than 30 years of executive management and consulting experience, with an emphasis on driving operational excellence and improving the enterprise value of companies around the world.