When evaluating the merits of a business acquisition, one of the shortcuts taken too often from both a time and cost perspective is a thorough due diligence investigation of the seller and their information. The fundamental purpose of a buyer’s due diligence is to gather information that will help assess the value of the target business, in light of all the facts and circumstances, including special skills and attributes the buyer may possess or lack thereof. This information allows the buyer to determine whether the proposed purchase price is acceptable or the transaction is worth finalizing.
Generally, the value of a target business to a potential buyer depends primarily on three factors:
- • Its true condition (financial, physical, and otherwise).
- • The buyer’s business plans (considering all the buyer’s personal positives and negatives).
- • Risks affecting the target’s financial condition and operations.
If the results of the due diligence investigation show that the target business appears to be worth at least as much to the buyer as the negotiated purchase price, the acquisition can go forward. If not, the buyer should either attempt to negotiate a lower price or look for another potential acquisition. A due diligence investigation is concerned with uncovering facts that may affect the value of the target business under any valuation method or approach utilized.
Although it sounds obvious, no matter how good the business, the buyer must be careful not to pay too much. This is especially true if the acquisition will be financed largely with borrowed money. Numerous businesses with respectable operating profits struggle to meet its financial obligations due to unreasonable or irrational financial expectations. This did not occur because the businesses were simply poor investments in the first place. Rather, the failures were the inevitable result of debt loads created when unwarranted purchase prices were paid with borrowed funds. If you plan to use a significant amount of debt to acquire a business, getting a good deal on the purchase price is not a matter of greed, but a matter of financial survival.
While due diligence investigations should always rely upon their own creativity and ingenuity when planning for this process, a standard checklist can be handy as a starting point. Below is a list of areas that experience has proven to be problematic in due diligence investigations and can distort the financial information and value of a business.
- • Accuracy of seller representations and potential issues in the business environment.
- • Trends the business and industry are experiencing.
- • Revenue recognition policies and consistency in reporting revenues.
- • Inadequate accruals and allocations of overhead.
- • Improper identification or treatment of non-recurring items.
- • Verification and reserves for inventory, receivables and other operating assets.
- • Lack of or unenforceable employment contracts for key people.
- • Assignability and stability of key contracts and customers.
- • Excessive related party transactions.
- • Off balance sheet debt or commitments.
- • Compliance with covenants and regulatory oversight.
A due diligence investigation should not strictly follow the preceding list or any other checklist, as each acquisition is unique and the due diligence investigation should be distinctively tailored to each target. The goal in a due diligence investigation is not to generate an impressive report. Instead, the objective is to uncover potential problems and issues in a deal before it closes. Thus, the due diligence team should always rely upon their own resourcefulness and intuition. To accomplish this, the buyer should assemble a team of employees and professionals to contribute their unique perspective and skills to identify the areas of concern and unknown risks. The team should then discuss the risks associated with each matter, identify the procedures to be performed and assign responsibility for the performance of each item.
While a thorough due diligence investigation will take time and require financial resources, the significance of making an informed decision cannot be overstated. Even if the investigation does not uncover any new concerns or issues to address, the value of knowing you have made an informed decision is of significant importance. If the investigation uncovers unknown or new information, the time and cost of the investigation could be substantial.
Our recommendation is that whenever you are buying a business or asset, do your diligence thoughtfully and thoroughly. If you need assistance with developing or performing a due diligence investigation, please contact us to assist in this process.