It's all about the employees
Personnel expenses account for a large portion of a company’s income statement. Personnel expenses highly vary between different industries and so does the employee structure. Think about consulting vs. manufacturing.
During a financial due diligence, high attention is paid to personnel expenses. Personnel expenses contain many potential adjustments. This includes, for example, recruiting costs, headhunter fees, or severance payments.
Personnel expenses comprise all components related to employees and their respective payments. Salaries and wages, bonus payments, overtime or weekend compensation, and social security contributions.
The aim of the financial due diligence is to understand the development in personnel expenses. This requires understanding how the employee base developed over time.
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Ideally, you are able to analyze employees on an full time equivalent basis (FTEs). There might be a difference between headcount and FTE. If you are working part-time (50%), then you are ONE headcount but only HALF FTE. This is crucial when it comes to calculating average salaries. Taking FTEs will then correct for the lower payment due to lower workforce.
When analyzing the employees, it is ideal to get all information on an FTE basis. But what if this data is not available? Then you need to state that only data about headcounts was available. This is important, because this lack of data can distort the average salary per headcount. This is because the salary considers your working time and if you only work 50% you only receive a 50% salary.
Employees are analyzed by nature and by function. By nature refers to the different departments that exist (Finance, Production,…). By function relates to the rank (Management, Head of XYZ, Assistant). This allows for conclusions on the remuneration per area and function. Also, it allows to understand developments in the individual areas better. And it also helps potential investors identify any adjustments. Take, for example, a production company with 100 FTEs. 30 of them work in Finance. A potential investor will want to know why there is this relatively high number of FTEs in finance.
Further items of the employee analysis include fluctuation, sickness days, and average tenure.
Bonus and other extra payments
Apart from the fixed monthly compensation, there are other items within personnel expenses. A company needs to pay social security contributions. And some companies even have a bonus system in place. This could relate to a performance bonus, christmas or holiday bonus. There are three aspects related to the bonus topic. First, how they are being treated in accounting. For example, does the company accrue them throughout the year. And when does it pay the bonus. Second, who is entitled to receive these payments. This could be management only, or every employee. Third, how are bonus payments calculated. Often, the bonus is based on revenue, EBITDA, and individual achievements.
Owner — manager
In owner-managed firms, the owner is also the manager. This means, that the compensation does not always reflect market standards. Hence, there is a gap between the compensation for the owner and an external manager. Sometimes, owners do not pay themselves a remuneration but take the net income at the end of the year. In this case, the management compensation wouldn’t be reflected in EBITDA and an adjustment is necessary.
The new investor would probably hire an external management. Also, the salaries for the external management would reflect market standards. To create this comparability, a pro-forma normalization for is included.
Potential one-off costs
Understand that there are often interim managers, severance payments or extra bonuses that don’t occur each year. So, personnel expenses offer a rich set of potential items for adjustment. Don’t adjust any item, always check what’s a recurring level and only adjust for the portion beyond the recurring level.
Also a long leave due to sickness could be part of the adjustments. Assume, another employee is replacing the sick person in the meantime. This means that the company is paying two salaries for one job. This situation is then reflected within the adjustments.
- Perform a detailed employee analysis and understands trends
- Understand which additional personnel expenses beyond salaries and wages are paid
- Understand whether owners pay themselves a remuneration reflecting market standards
- Analyse for potential one-off items
Personnel expenses are a major focus of any due diligence. There are many challenges that need to be addressed. For example, employee turnover, severance payments, joining bonuses.
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