When buying a business, due diligence refers to the process validating the information presented by the vendor and that all matters pertaining to the business are in order. Given the investment of time and money, a purchaser needs to be satisfied with the feasibility of the proposed transaction. These investigations should provide a clear picture of where the business is today, how it can grow and whether the asking price is fair. And more importantly, they can ensure there are no unpleasant surprises to cause the purchaser to walk away from the transaction.
The scope of due diligence will depend on the nature of the transaction. It is often a team effort with the purchaser being supported by accountants, lawyers and transaction advisors. When professionals are engaged early on, the transaction will have greater success when a due diligence plan is defined.
In general, due diligence is divided into three major components: operational and commercial; financial; and legal.
Operational and commercial: Many purchasers will lead their own operational and commercial due diligence. The investigations made here will vary considerably depending on the type of business. Ultimately, the focus is on understanding the company’s business model and ensuring the existing operations are sustainable and capable of growth.
Typical items to consider include:
- Operational processes – are procedures documented? Can the purchaser effectively take over the operations?
- Market position – how does the business compare to its competitors? What options exist to diversify and grow?
- Customer details – is there any customer concentration? How strong are the customer relationships?
- Supplier details – is there a diversity of suppliers, or reliance on a select few?
- Employee details – who are the key employees?
- Equipment – what is the condition of the equipment? Will the equipment and infrastructure support continued growth?
Financial: Financial due diligence should be closely related to the commercial due diligence, as findings here will help guide the other. The focus of financial due diligence is to analyze historical financial information to help forecast future profitability. Purchasers will often engage accountants who specialize in due diligence to prepare a quality-of-earnings report, or other assessments.
Typical items to consider include:
- Historical financial statements – what are normalized earnings based on the historical results?
- Sales and gross margin by key categories – how does the financial information regarding key customers, products, services, geography, etc. match with the commercial due diligence findings?
- Wages by employee – how will the wage structure need to change based on the commercial due diligence findings?
- Working capital – how much profit needs to be reinvested to support continued growth?
- Forecasts and budgets – how will profitability be impacted by planned changes?
Legal: Legal due diligence should be led by the purchaser’s lawyer. The purpose is to identify any legal issues that may impact the business. Any legal issues identified will often be incorporated into the representations and warranties within the purchase agreement.
Typical items to consider include:
- Contracts and agreements - are the material agreements satisfactory for the business? Are they transferable to the purchaser?
- Intellectual property – does the business have the rights to its intellectual property?
- Licenses and permits – does the business have necessary licences and permits to operate?
- Litigation – is there any current or potential litigation?
- Due diligence is a critical part of a sale or acquisition of a business – it represents the transaction scorecard, as deals often fall apart if not properly managed.
As loss of trust, lack of supporting information and delays are key factors for a transaction to fail, prudent vendors need to be prepared for the due diligence process.
The role of a transaction adviser is to maintain clear and direct communications between all parties, anticipate roadblocks, propose solutions and eliminate friction between parties. With all parties working together, a mutually beneficial transaction can be accomplished.
Arthur Klein is a merger and acquisition adviser with Smythe Advisory, serving clients across Western Canada and beyond. Visit smytheadvisory.com
