Do the small businesses a public company buys need audited financials?

When does a public company need audited financials for a business it buys?

Only when the purchase is significant to the buyer. Rule 3-05 of Regulation S-X applies once an acquisition has closed or is probable, and it measures significance with the "significant subsidiary" tests. A small holding company that reports to the SEC, or files a registration statement, is covered. My view is that most first deals by a micro-cap holdco are small enough to avoid the rule, but the second and third deals often are not.

Three tests run side by side, and the highest result decides:

• Investment test. The price paid, including the fair value of shares and contingent payments, against the buyer's market value of common equity. If the buyer has no market value, total assets are used instead.
• Asset test. The target's share of total assets against the buyer's total assets.
• Income test. Both pre-tax income and revenue must be exceeded; the lower of the two results is used. The revenue part is skipped if either company lacked material revenue in each of its last two fiscal years.

The market value in the investment test is an average over the last five trading days of the month before the deal is announced or agreed. A thinly traded stock can swing that denominator.

What are the 20% and 40% thresholds?

• No test above 20%: no acquiree financial statements.
• Any test above 20% but none above 40%: the most recent audited fiscal year plus the most recent interim period.
• Any test above 40%: the two most recent audited fiscal years plus required interim periods.

The fiscal-year statements must be audited. Interim statements need not be.

Worked example (assumptions, not a real company). A holding company has an average market value of $20.0M. It looks at three targets using the investment test alone:

• Price $3.0M: 3.0 / 20.0 = 15%. Under 20%, no acquiree financials.
• Price $5.0M: 5.0 / 20.0 = 25%. One audited year plus interim.
• Price $9.0M: 9.0 / 20.0 = 45%. Two audited years plus interim.

The asset and income tests could still push a deal into a higher bucket. A target with thin assets but high income often fails the income test first.

What about several small deals?

Rule 3-05(b)(2)(iv) adds up deals whose statements were not required or are not yet required, counting from the date of the buyer's most recent audited balance sheet. This test applies when the buyer files a registration statement or proxy statement, not to the Form 8-K itself. If the total exceeds 50% on any test, the filing must include pro forma information showing the combined effect of all of those deals. Audited statements are then needed only for businesses above 20% individually whose statements have not yet been filed, such as a pending deal or one still inside its filing window. Loss-making and profitable targets are aggregated separately on the income test.

Using the same $20.0M example, four deals of $3.0M each total $12.0M, or 60%. That crosses the 50% line even though no single deal reached 20%, so a registration statement filed then would need pro forma information for all four. None of the four needs its own audited statements, because none exceeds 20% alone. Three such deals total $9.0M, or 45%, which does not cross the line.

Is a smaller reporting company treated differently?

Partly. Rule 8-04 tells a smaller reporting company to apply Rule 3-05, substituting the Article 8 form and content rules for the general ones. The significance thresholds are therefore the same. Since the 2020 amendments, no buyer, large or small, has to provide more than two fiscal years of acquiree statements, so the two-year limit is not special relief for small companies. The difference is in content. SEC staff guidance says a buyer under Rule 8-04 may let a non-reporting target use scaled smaller-reporting-company disclosure, while a buyer under Rule 3-05 needs the target's full statements. Pro forma information for smaller reporting companies follows Rule 8-05, which points back to Article 11.

What are the deadlines?

A closing that involves a significant amount of assets is reported on Form 8-K under Item 2.01. The form's instruction treats a deal as significant if the price paid, or the net book value acquired, exceeds 10% of the buyer's total assets, or if the business acquired is significant at the 20% level under Article 11. That closing is reported on Form 8-K within four business days. If the target also exceeds 20% on a Rule 3-05 test, its financials and pro forma information can follow by amendment under Item 9.01, no later than 71 calendar days after the date the first 8-K was due. The same deadline applies to the pro forma information. Separate statements can stop once the target's results sit in the buyer's audited consolidated statements: after nine months for a deal in the 20% to 40% bucket, after a full fiscal year for one above 40%.

Does the acquiree audit have to be by a PCAOB-registered firm?

Not for a private target. SEC staff guidance says a non-issuer's audit under Rule 3-05 does not need a PCAOB-registered auditor, and an audit under U.S. generally accepted auditing standards is acceptable. Compilation reports are not accepted in any filing. Confirm independence and report wording with your auditor before engaging one.

Where these numbers come from: Thresholds, periods, aggregation and omission rules are from 17 CFR 210.3-05 (Cornell LII copy). The significance tests and five-day market value are from 17 CFR 210.1-02 (Cornell LII copy). Smaller reporting company mechanics are from 17 CFR 210.8-04 (Cornell LII copy), 17 CFR 210.8-05 (Cornell LII copy) and SEC Financial Reporting Manual, Topic 2(section 2030.5). The two-year cap is noted in SEC Release 33-10786, and the post-2020 treatment of individually small deals is summarized in the Katten client advisory on the 2020 amendments. Item 2.01 (Instruction 4), Item 9.01 and the 71-day period are from SEC Form 8-K. Auditor guidance is from Topic 4(sections 4110.5 and 4430). The $20.0M figures are illustrative. Confirm the application to your deal with securities counsel and your auditor.

Related questions

Does a private holding company that does not report to the SEC need this?

Rule 3-05 applies to SEC registrants. A holding company that is not an SEC filer is not bound by it, though a lender or investor may ask for audited statements anyway.

Can a quality of earnings report replace the audit?

No. A quality of earnings report is a diligence tool, not an audit, and an SEC filing needs the audit when the rule applies. See whether you need a quality of earnings report.

Do I need audited statements if I pay only in stock?

The form of payment does not change the test. The investment test counts the fair value of the shares, so a stock deal is measured like a cash deal.

What comes next

If the target has never been audited, read how a public company buys a business that has never had an audit.

Related articles

• How does a public company buy a business that has never had an audit?
• How can a holding company use public stock to buy private businesses?
• What finance team does a public holding company need?
• Do you need a quality of earnings report to buy a small business?
• How do you pay a seller with stock instead of cash?

Meraki Dealmakers is a service of Meraki Partners, LLC, an advisory firm. It is not a broker-dealer, investment adviser, business broker, law firm or accounting firm. This article is general information, not legal, tax or investment advice.