Primer on Business Due Diligence
Due diligence is
the process of finding out the undisclosed information and confirming the
information provided is accurate. For a business buyer, it is the process of
running all the details provided by the business seller. During the due
diligence condition, the business buyer must access all the business books,
financial statements, and other records. The due diligence phase provides the
business buyer with a shutter to determine if the information provided is
accurate. The process can take several days or a month. The Due diligence
process is broad and must include financials, marketing, and strategy amongst
different things. Financial due diligence also includes business-valuation,
identifying undisclosed liabilities, and a lot more.
DUE DILIGENCE STRATEGY
Due diligence is the process of systematically evaluating the target company’s documents and extra artifacts. If significant disparities are found it can result in being a breaker or result in the deal being re-negotiated. Overall, due diligence can be classified in the following categories:
§ Management Due Diligence
§ Legal Due Diligence
§ Financial Due Diligence
§ Marketing Due Diligence
§ Operational Due Diligence
Information required in each category needs to be acquired through interviews, financial statements, and legal and other documents. The person managing the due diligence may need to contact the target business lawyers, bankers, accountants, customers, and suppliers to gather details about the business.
FINANCIAL DUE DILIGENCE
Financial due diligence requires the business buyer to look into the financial health of the company. It provides the business investor or acquirer knowledge on the liability of the company, the capacity to expand, and more. Understanding the capital structure of the business is a crucial element of financial due diligence because too much liability or poor cash flow can prevent the growth and sustainability of a business.
Typically, financial due diligence involves the following documents:
§ All published financial statements for the last 4-5 years including balance sheets, income statements, and cash flow statements. This includes interim financial statements for the current quarter.
§ All tax returns and tax payment schedules
§ Appraisals on tangible assets including real estate owned by the business
CASH FLOW (FINANCIAL) DUE DILIGENCE
Cash flow is the amount of cash being generated or spent during a specific period of time. It is the change in cash position or in the cash account due to revenue, expenses, operating costs, and investments. Cash flow is typically impacted by:
§ Accounts Receivable (AR)
§ Accounts Payable (AP)ç
§ Capital Expenditures (CAPEX)
§ Debt Servicing
§ Tax Payments and other timing issues
Managing the Cash flow of paramount importance in operating a business on day today basis. Accounting rules govern the creation of financial statements which is used to measure profit and loss. Therefore, Balance Sheets and Income Statements do not provide an accurate and timely view of a company’s cash position. For example, if cash is blocked in accounts receivables (AR) and investments, a business can find itself in a cash crisis even though the balance sheet is healthy. Cash flow can be classified as:
§ Cash from Operations
§ Investment cash flow
§ Financing cash flow
A Cash flow statement is a financial statement that shows companies incoming and outgoing cash for a specific duration. When buying a business, studying the business cash flow statements (3 to 5 years) plays an important role and must be completed during the due-diligence process.
MARKETING DUE DILIGENCE
Marketing Due diligence involves the review of the overall marketing strategy and marketing plan of the business being acquired. Typically, a summary of the marketing plan is provided in the investment proposal.
During the Due diligence process, the investor or the acquirer must review the underlying market research including the size of the market, market segmentation, competitive pressures, threat of new entrants into the market, a threat from substitutes, and more. It is important to understand the overall size of the market (industry) the business operates in, the size of the market for the business, and more. Reports provided by external agencies provide significant credibility to the marketing plan.
§ Review marketing plan and marketing strategy documents
§ Marketing material for the last few years
§ Interviews with the marketing manager or the person involved with marketing
§ External and internal research data
LEGAL DUE DILIGENCE
Under legal due diligence, the business buyer needs to make sure that the business doesn't have any legal issues and is being perfectly operated. Legal Due diligence requires the business buyer to review all legal contracts and agreements made by the firm. Several legal artifacts must be evaluated including:
§ Review all contracts. A company in business can have several contracts in place including contracts with suppliers, customers, employees, and others.
§ Agreements with employees
§ Corporate charter and bylaws
§ Non-Disclosure Agreements (NDA) with employees
§ Patents, copyrights and other assets in the company
§ Minutes and consent from the board of directors and shareholders
§ Litigation related documentation and summary of current and pending disputes
§ Review tax documentation from a legal standpoint
§ All artifacts related to the issuance of securities
There are several checklists available online to guide you through the process of conducting legal due diligence.
NON-FINANCIAL DUE-DILIGENCE (BUSINESS BUYER)
The following are a few non-financial due-diligence considerations a business buyer must account for:
ESTABLISH CUSTOMER CONCENTRATION
An important component of business due-diligence is to determine customer attention. Customer attention may be defined as the percentage of revenues coming from an individual customer. For example, a business may hold 5 great customers accountable for 60% of its profits.
Customer attention is directly associated with the purchase amount and the cash at a close component of the proceeding structure. Let’s say there are two similar companies with equal profits, margins, and net revenue. The business with lower customer attention will demand higher prices and higher cash at close as compared to a business with lower customer attention. A business buyer should always mold the business losing a few customers when ownership changes. If customer attention is high, losing vast customers when the business changes hands can hurt the business significantly.
When a business changes hands the former business owner still has a relationship with all customers. This relationship becomes a critical element of the due-diligence process if the customer concentration for the business is high. It is possible that after the selling business the previous owner may restart the same business in the same area. The business buyer can protect himself from such behavior through non-compete agreements. If the former business owner could be a competitive threat, the business buyer must work with his lawyer to draft a non-compete agreement and get it signed as a part of the deal. The article on due diligence and covering various topics related to due diligence.