Understanding Due Diligence When Buying a Business

Are you looking to expand your business? Broaden your geographical presence? Diversify your service offerings? The process of acquiring another business can be time consuming and intense, but it’s a necessary step to grow your organization. One of the first things to consider as you work through the merger and acquisition process is the necessity of buy-side due diligence.

What is buy-side due diligence?
In a nutshell, buy-side due diligence allows you to make an informed decision on the potential acquisition and terms you feel comfortable with. The due diligence process ensures all information associated with the deal (financial, operational, tax, IT, HR, etc.) is considered and up-to-date, so you know exactly what you’re buying.

Due diligence in the next phase allows you to focus on finding less obvious opportunities, risks, and threats that could impact the deal value or consideration terms. You may also identify the need for specific language in the purchase agreement or other issues that could cause you to pull the plug all together. It’s also important to make sure you, as the buyer, avoid the trap of confirmation-bias from its initial evaluation of the seller.

It’s important as a buyer to examine everything carefully. For instance, if the seller had an independent audit you probably feel a bit better about the accuracy of the numbers provided, right? But what if those audits are from last calendar year and you are trying to close in August? Does that help you feel confident in the target’s recent performance?

Other questions to consider include:

• Do you fully understand the growing concentration the target has with a particular customer, vendor or product and how that will affect you moving forward?
• Are there one-time events in revenue streams artificially inflating historical earnings or cash flow, or has the cost structure changed in recent months?
• Is there a current order backlog or minimum sales or purchases in existing contracts?
• If we are making a stock or unit acquisition, what tax liabilities are we assuming?
• Can current technologies meet the projections or will significant additional investments be required post acquisition?

These are just a few of the questions you want answered before you make a significant investment for your organization. Red flags or earnings adjustments might cause you to lower your offer, include more considerations in earn-out targets, insert safeguards into the purchase agreement or walk away from the deal.

What does the process look like for due diligence when buying a business?
Once you’ve identified a potential acquisition or Target, the next step is to review their information and request any additional items you may need. Most often, your lender (or another party) will request a third party perform financial due diligence, known as quality of earnings.

The next step is to inquire with various third-party vendors about whether they can perform due diligence. Most often, these are CPA or business advisory firms. Ensure you look for vendors who specialize in due diligence and have a proven process to help you address key aspects of the deal as well as major concerns.

Together with the vendor you have chosen, you will need to decide the scope of work. Each deal is unique and has multiple facets to consider. A typical buy-side due diligence will include the following:

• A quality of earnings report
• Revenue and margin concentrations
• Add-backs and EBITDA adjustments proposed by seller
• Review of significant estimates
• Normalized working capital
• Taxmatters, including state and local tax reporting
• Cyber security considerations
• Technology limitations
• Other diligence including legal, environmental, human resources, insurance, etc.

After the scope of work has been decided, an introduction will be made to the Target’s CFO/sell-side advisor. Together, these advisors will facilitate the due diligence steps for both buyer and seller. At this stage, you will also need to send along the advisor’s data request list and set expectations for the timeline going forward.

From here, the process will flow through the buy-side and sell-side advisors chosen by each respective party. You, as the buyer, can be as involved as you wish in the due diligence process. It’s recommended you be an active participant and take part in calls and visits, so you can ensure you’re getting the information you need to make an informed decision about your potential acquisition.

Normally, the financial and tax due diligence process takes three to five weeks for a report to be presented in draft form. At this time, you will have a follow-up call with your advisor to discuss the findings of the report. These findings could impact the deal terms, historical performance or prospective earnings, so it’s important to make sure you have detailed conversations with your advisor to address concerns and questions.

Step-by-step guide for buy-side due diligence

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What other items could be included in buy-side due diligence?
In addition to the items listed above, a buy-side due diligence agreement could include:

• A financial analysis to better understand daily operational and financial questions.
• A forensic examination and/or background checks. This will allow you to uncover the risks associated with your potential acquisition.
• An analysis of the tax ramifications of the sale.

What do I do next?
Before buying a business, it’s important to make the sure the math adds up. Buy-side due diligence allows you to make an informed decision before you sign on the dotted line. When you work alongside a team of advisors, you will better understand the ins and outs of your potential acquisition as well as the impact it will have on the company you’ve worked so hard to grow.