What is Due Diligence?
A question sellers often have is what is due diligence? Due diligence is the process that takes place after a letter of intent (LOI) is signed, but before the closing of the deal. It is a detailed investigation into the potential investment in order to verify the assets and liabilities and to make sure that the buyer understands what it is acquiring. Normally, it entails a complete review of the business, products, customers, facilities, background checks on the management, technological reviews, etc.
If the due diligence process is not comprehensive, then the buyer runs the risk of serious financial losses. It is imperative for the buyer to understand how the business operates and the potential risks before closing the deal no matter how big or small that acquisition may be. Due diligence is a way to ensure that neither party involved in the transaction was misled so the deal can be closed successfully.
Three major areas of financial due diligence
Most often the three most important areas of the financial diligence are; (i) the quality and accuracy of the financial statements and related information, (ii) the sustainability of the cash flows, and (iii) a thorough understanding of the tax issues that may arise due to a possible change of ownership. Prior to a sale, owners can significantly improve the value of their business by focusing on these three areas to make sure there are no issues.
Most buyers prefer audited financial statements; however, in the middle-market, a majority of the companies do not have audited statements, primarily due to the high cost. If a seller does not have audited financial statements, the most important thing is to have accurate financial data that is prepared in accordance with GAAP. Sloppy or inaccurate accounting data always makes buyers nervous about the value of the assets and the possibility that liabilities are under-reported.
The sustainability of the seller’s cash flows is very important to potential buyers as this information provides excellent visibility into the possible future performance of the target company. Buyers also like to know which products and services generate the highest margins and have the greatest growth potential in order to better recognize how they can integrate these products and services into their strategic plans and current product offerings. Buyers tend to pay higher multiples when there is a strong, diversified customer base from which they can grow the company.
It’s important that a seller understand that if the diligence doesn’t go well, the buyer may elect not to close the transaction or may ask for a price reduction. For that reason, sellers should make sure that their accounting records are up to date and accurate. Furthermore, to the extent possible, sellers should think about the most important parts of their business and make sure that they are ready to withstand the scrutiny of someone else’s due diligence.
