DUE DILIGENCE - DIG DEEP

Due diligence is the process whereby the buyer satisfies himself that he is in fact buying what the seller proposes to be selling. It is an investigation (not an audit) of a potential acquisition to confirm, to the buyer’s satisfaction, whether to proceed with the transaction or walk away.

By Bob Power

While the extent of the buyer’s investigation depends on the size of the transaction, regrettably, as a result of poor corporate governance, the investigation for small/medium deals can be more complex than bigger deals. Poor corporate governance, which includes a lack of legal compliance, poor accounting systems and shortcuts with the tax man, is the reason buyers of small/medium businesses are encouraged to dig deep.

In conducting a due diligence, apply the “keep it simple and practical” rule. By focusing on the areas highlighted below you can build a clear understanding of the state of the business and the purchase and sale transaction.

• Why is the business for sale? If the answer is not clear and/or if you are not able to verify claims made by the owners/management, walk away.

• Other offers on the table. Don’t get caught in an auction. Secure a commitment from the seller that he/she will not entertain other offers while the due diligence is ongoing.

 Legal and financial compliance. Is the business compliant or are there legal cases pending with the potential to affect the image and financial stability of the business?

• Financial statements. If possible, go back three years to determine that the information is accurate and that the business is solvent.

• Cash flow. Is there a positive cash flow? Guaranteed monthly income is the prize.

• Looking forward. Consider the possible future performance of the business.

• Stock. Is it in a saleable condition?

• Assets. What is the condition and real value of the assets? Be sure that valuations are market related and watch depreciation.

 Opportunities. Ascertain what opportunities are available to increase revenue and profits.

• Business risks. Is there new technology available in the market that threatens the continued existence of the business?

• Existing contracts. Will they remain in place with the change of ownership?

• Employees. Is there an ongoing commitment from employees and are they motivated?

• Understand the industry and know your competitors. What is the future of the business and its competition?

• Sales and marketing. How strong are these functions in the current set-up?

• Price and payment terms. What are they and are they justified? Tax is an area which needs specific attention.

A due diligence investigation can be frustrating, time consuming and expensive, but the risks inherent in not following through are significant. Remember that locating the skeletons is the job of the buyer, so avoid being penny wise but pound foolish and, if necessary, engage the services of an experienced and knowledgeable third party adviser. As this can be a potentially cost exercise ensure that your agreement with the professional adviser is in writing, setting out what is to be delivered, when delivery will be made and the cost involved.

Forming a clear picture of the business requires that the buyer assesses the findings of the lawyers, accountants and other participants, but all too often poor communication delivers an incomplete picture of the business, resulting in a wrong decision being made. If the investigation reveals anything “negative” about the business, this information can be used to negotiate a reduced purchase price.

LEGAL INVESTIGATION

The purpose of the legal investigation is to satisfy the buyer that the legal affairs of the business are in order, particularly the ownership of assets. It should also satisfy that the business complies with statutory requirements and that the main contracts affecting the business are in order.

FINANCIAL INVESTIGATION

The major components of the financial investigation centres around confirming the quality of the accounting system, comparing budgets with actuals, ascertaining whether forecasts are realistic and checking business trends. Auditor’s qualifications, for example, “Circumstances which are so serious as to affect a significant difference from the transaction so as to make the buyer uncomfortable with concluding it” can be a deal breaker.

HUMAN RESOURCES INVESTIGATION

From a human resources position, matters such as salary levels, restraints of trade, pension rights and terms in the employees’ contracts (especially notice periods) must be considered.
 I leave you with this last thought, don’t be rushed. Remember, only fools rush in. It is no use being wise after the event. Check first and avoid problems later.
While this article is written from the traditional perspective of the buyer conducting a due diligence on small/medium business he hopes to acquire, in a later chapter we turn the tables and consider the seller’s due diligence.

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