What is business Due Diligence?
How do you perform due diligence in a business?
Due diligence is the process of finding out undisclosed information and confirming that the information provided is accurate. For a business buyer, it is the process of working through all the details provided by the business seller.
During the due diligence phase the business buyer must access to all the businesses books, financials statements and other records. The due diligence phase provides the business buyer with a window to determine if the information provided is accurate. The process can take several days and sometimes up to a month. The Due diligence process is broad and must include financials, marketing and strategy amongst other things. Financial due diligence also includes business-valuation, identifying undisclosed liabilities and a lot more.
Due Diligence Approach
Due diligence is the process of systematically evaluating the target company’s documents and other artifacts. If significant discrepancies are found it can result in being a deal breaker or result in the deal being re-negotiated. Overall, due diligence can be classified in the following categories:
- Management Due Diligence
- Legal Due Diligence
- Financial Due Diligence
- Marketing Due Diligence
- Operational Due Diligence
Information required within each category must be acquired through interviews, financial statements and legal and other documents. The person conducting the due diligence may need to contact the target businesses lawyers, bankers, accountants, clients and suppliers to gather details about the business.
Financial Due Diligence
Financial due diligence requires the business buyer to look into the financial health of the company. It provides the business investor or acquirer information on the debt of the company, capacity to expand and more. Understanding the capital structure of the business is a critical element of financial due diligence because too much debt or poor cash flow can prevent growth and sustainability of a business.
Typically financial due diligence involves review the following documents:
- All published financial statements for the last 4 to 5 years including balance sheets, income statements and cash flow statements. This includes interim financial statements for the current quarter.
- All tax returns and tax payment schedules
- Appraisals on tangible assets including real estate owned by the business
Cash Flow (Financial) Due Diligence
Cash flow is the amount of cash being generated or spent during a specific period of time. It is the change in cash position or in the cash account due to revenue, expenses, operating costs and investments. Cash flow is typically impacted by:
- Accounts Receivable (AR)
- Accounts Payable (AP)ç
- Capital Expenditures (CAPEX)
- Debt Servicing
- Tax Payments and other timing issues
Managing Cash flow is of paramount importance to operating a business on day to day basis. Accounting rules that govern the creation of financial statements are used to measure profit and loss. Therefore Balance Sheets and Income Statements do not provide an accurate and timely view of a company’s cash position. Not managing cash flow can result in a cash crisis. For example, if cash is blocked in accounts receivables (AR) and investments, a business can find itself in a cash crisis even though the balance sheet is healthy. Cash flow can be classified as:
- Cash from Operations
- Investment cash flow
- Financing cash flow
A Cash flow statement is a financial statement that shows companies incoming and outgoing cash for a specific duration. When buying a business, studying the businesses cash flow statements (3 to 5 years) plays an important role and must be completed during the due-diligence process.
Marketing Due Diligence
Marketing Due diligence involves the review of the overall marketing strategy and marketing plan of the business being acquired. Typically a summary of the marketing plan is provided in the investment proposal.
During the Due diligence process the investor or the acquirer must review the underlying market research including the size of the market, market segmentation, competitive pressures, threat of new entrants into the market, threat from substitutes and more. It is important to understand the overall size of the market (industry) the business operates in, the size of the market for the business and more. Reports provided by external agencies provide significant credibility to the marketing plan.
- Review marketing plan and marketing strategy documents
- Marketing material for last few years
- Interviews with the marketing manager or the person involved with marketing
- External and internal research data
Legal Due Diligence
Under legal due diligence the business buyer needs to make sure the business does not have legal problems and is being correctly operated. Legal Due diligence requires the business buyer to review all legal contracts and agreements made by the firm. Several legal artifacts must be reviewed including:
- Review all contracts. A company in business can have several contracts in place including contracts with suppliers, customers, employees and others.
- Agreements with employees
- Corporate charter and bylaws
- Non-Disclosure Agreements (NDA) with employees
- Patents, copyrights and other assets in the company
- Minutes and consent from board of directors and shareholders
- Litigation related documentation and summary of current and pending disputes
- Review tax documentation from a legal stand point
- All artifacts related to the issuance of securities
There are several checklists available online to guide you through the process of conducting legal due diligence.
How do you perform Non-Financial due diligence in a business?
The following are a few non-financial due-diligence considerations a business buyer must account for:
Establish Customer Concentration
An important element of business due-diligence is to determine customer concentration. Customer concentration may be defined as the percentage of revenues coming from a single customer. For example, a business may have five large customers responsible for 60% of its revenue.
Customer concentration is directly correlated with the purchase price and the cash at close component of the deal structure. Let’s say there are two similar companies with equal revenues, margins and net income. The business with lower customer concentration will demand higher price and higher cash at close as compared to a business with lower customer concentration. A business buyer should always model the business losing a few customers when ownership changes. If customer concentration is high, losing large customers when the business changes hands can hurt the business significantly.
When a business changes hands the former business owner still has a relationship with all customers. This relationship becomes a critical element of the due-diligence process if the customer concentration for the business is high. It is possible that after selling a business the former owner may restart the same business in the same area. The business buyer can protect himself from such behavior through non-compete agreements. If the former business owner could be a competitive threat, the business buyer must work with his lawyer to draft a non-compete agreement and get it signed as a part of the deal.