Due diligence is probably the most critical stage in the buying process. Many prospective buyers incorrectly identify this period as strictly a financial review, but it goes far beyond that. Due diligence encompasses a far greater project - that being the complete investigation and review of the business. In this article, we have covered an overview of Due Diligence concept along with the basic process to be followed in the assignments of Due Diligence.
One of the keys to buying a good business comes from your ability to learn the intimate details of the business, to identify the strengths, weaknesses, pluses, minuses, growth opportunities and areas of concerns. If you do not do a flawless job of gathering information, you will not be able to pull the trigger and complete the transaction since you’ll be uncertain about too many components of the business.
When to Start the Due Diligence?
The investigation process begins the moment a business becomes of interest to you. Your goal is to make certain that you uncover everything about any business BEFORE you buy it. You don’t have to meet the seller or even visit the business for your research to begin. The Internet is an incredible tool that will allow you to investigate the business, the industry, the competition, the marketing, the suppliers, and on and on.
The importance of beginning your investigation early on cannot be emphasized strongly enough. This way, you’ll position yourself to ask the proper questions to the seller. Once you progress to the stage of an accepted offer, you will commence the inspection or financial due diligence. This period usually lasts 10-30 days. This is the time when you’ll have access to all of the company’s books and records.
Once you are looking at a particular business, you’ll find a thousand things crossing your mind regarding the acquisition. Keep a notepad handy at all times and log your thoughts. You’ll have many thoughts about things “I need to check out”. Write these all in one place. Don’t trust your memory; these little things are the ones that can come back to haunt you down the road. Begin to put together your checklist of what you need to investigate and how you’re going to do it, along with the materials you may need from the seller to accomplish it.
Allow Yourself Enough Time
Many sellers and some brokers will press for a very short inspection period; sometimes just days. Don’t get bullied into this - give ample time to complete this part of the process. You should allow for, negotiate and not settle for less than a 20-business-day inspection/due diligence period.
Since you’ll have some time restrictions (you’ll only have x number of days per the contract), provide the seller with a listing of all of the materials required for you to complete this exercise. No matter what you’re told, do not begin the process until they have everything ready for you.
Dealing with Surprises
You’ll probably find some surprises; don’t panic, it’s normal. Work through them. Get clarification. Build your case. Don’t run to the seller or broker every time you find an inconsistency between what you’ve seen versus what you were told. No business is perfect. The rule to follow is, do not treat any incidents as catastrophes or any catastrophes as incidents. If you find a major problem, get your facts in order and you can then decide the appropriate action to be taken with the seller (i.e. renegotiation, walking from the deal etc.)
According to industry statistics, nine out of ten people who begin the search to buy a business never complete a transaction.
While there are many reasons for this dismal figure, a lot has to do with the inability of people to “pull the trigger”. This gun-shy reaction is related specifically to uncertainty: if you have not gathered the right information or failed to investigate the business thoroughly, you will not be 100% certain of what to do. And so, you’ll drop the project. Conversely, if you do a flawless job of investigating the business, and everything else adds up right, then making the final decision is simply one more step in the process!
Due diligence services are typically provided to a buyer in connection with company mergers and acquisitions. Engagements are generally fact-finding and include:
• A study of financial information and accounting practices
• Analysis of historic financial statements
• Review of independent auditors' or accountants' work papers
• Inspection of tax returns
• Discussions with target/buyer management and their independent auditors or accountants
• Assistance preparing or assessing pro forma or prospective financial information.
The extent and nature of the services are generally tailored to the needs of the client. The engagement may contain aspects of consulting, agreed-upon procedures, examination, and/or review engagements.
As organizations go through any merger or acquisitions, the leadership in both entities hopes for quick and efficient integration, accurate financial reports, open lines of communication, and much more. And establishing an experienced Project Management Office (PMO) is critical for success.
Financial Due Diligence
“The basic purpose of due diligence is to enable the prospective purchaser or investor to make an informed judgment as to whether to proceed with the proposed transaction or not.”
Within the overriding objective of a due diligence, there are a number of purposes to the exercise:
Confirm net assets
Support the price
Enable future management
Acquisition of a business or company is the most common situation requiring due diligence but other situations include investment by venture capitalists, pre-lending reports for bank finance, initial public offerings (IPOs), or ‘sell side’ due diligence where the vendor commissions a due diligence report.
The Process of conducting the Due Diligence is discussed as under:
A detailed briefing meeting with the client is the foundation of an effective due diligence exercise. The different areas of expertise required for a particular due diligence investigation will dictate the makeup of the due diligence team. The above basic data discusses the areas of expertise that may be required and how the team can be managed to avoid duplication of effort.
Letters of engagement are covered as are other preliminary matters such as the nature and use of the report, contacting the target, and obtaining clearance to talk to the target’s auditors.
Information gathering and verification forms a substantial portion of the factsheet. This is a crucial stage of the process and must be carried out systematically and with care. The factsheet covers:
Taxation is an area where the investigating accountant may require an external specialist. The tax investigation will be carried out primarily, for the purposes of due diligence, to ensure that everything is in order. Tax advisers will seek to minimise their client’s tax burden whilst the investigating accountant will also seek to protect the tax position of the client. Compliance with rates & taxes and regulations should also be investigated.
Due diligence work will inevitably focus on areas where problems might exist. The report is not a marketing document or a sales memorandum – it is for the target to sell itself in the best light. The investigating accountant will seek to report in a fair and balanced way. Reports can take a variety of forms:
Full long form writtern report
Summary form written report