4 steps to doing due diligence when buying a business
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Due diligence is a vital step when buying a business. A thorough review of the target’s financial records, legal issues and market positioning is important to make sure you don’t stumble into a costly post-transaction surprise.
Due diligence can also help you confirm your perception of the target’s value to your business, arrive at an appropriate offer price and structure a favourable transaction. Yet, despite the stakes, many buyers fail to do careful due diligence and end up regretting it later.
“It’s like hiring an inspector when you buy a house,” says Patrick Hagarty, a business acquisition expert and BDC’s Team Lead, Solutions Development, High-Impact Firms. “You can wind up with a nasty surprise if you don’t get a professional home inspection. In the same way, many businesses end up with unexpected financial shortfalls or an unexpectedly costly acquisition because they didn’t do appropriate due diligence.”
Hagarty says due diligence typically involves these four steps.
1. Set out a due diligence process
Once you decide on an acquisition target, it’s vital to do due diligence before completing the purchase. The acquisition process typically starts with the buyer and seller agreeing to a letter of intent that outlines a framework for arriving at a final purchase agreement. The buyer should be sure to include provisions for due diligence as part of the letter of intent.
The provisions generally include a timeline for completing the due diligence (one to two months is common) and a process for the seller to provide access to records, premises and, in some cases, key employees for the review.
Records are often made available through a secure online portal. These generally include:
- the company’s strategic plan, articles of incorporation, bylaws, ownership information, organizational chart and marketing and sales strategies
- financial statements and tax returns for the past three years
- budgets and financial projections
- breakdowns of sales, expenses, gross margins, accounts receivable and payable, product lines, inventory, liabilities, customers, markets, competitors, assets, intellectual property, equipment leases and insurance coverage
- a description of legal, regulatory, tax and customer issues affecting the company
- details on personnel, outside professionals and third parties working for the company
Due diligence often also requires on-site visits to inspect buildings and equipment and interview key personnel.
2. Assemble your due diligence team
It’s vital to select qualified people for the due diligence.
An accountant specializing in business acquisitions should analyze the company’s financial records.
A lawyer should review legal issues affecting the company. The legal review may require specialized counsel to advise on certain issues, such as labour agreements, real estate assets and intellectual property.
Buyers may also want to bring in other experts—market assessment experts; IT specialists to check technology assets; or environmental consultants to study contaminants and hazardous materials.
“I highly recommend using third parties for due diligence,” Hagarty says. “You get what you pay for. When you look at the fees, they’re negligible versus the size of the deal and the potential downside of the acquisition not working out as expected.”
3. Conduct the due diligence
a. Study the books
An accounting due diligence review is critical for a successful acquisition. A specialized accountant should review the target company’s financial statements, budget, projections, tax returns and other records to analyze the numbers and the assumptions behind them. The goal is to make sure the figures add up and that the company is worth what you’re proposing to pay.
“Every number has a context to it,” Hagarty says. “What are the assumptions behind the forecast? Will the numbers materialize next year? You need to validate that the EBITDA and your projected synergies will stand up after the acquisition.”
You need to validate that the EBITDA and your projected synergies will stand up after the acquisition.
The accounting review can also uncover important issues such as:
- tax liabilities
- an undiversified customer or supplier base
- poor product profit margins
- significant needed repairs
- old equipment
- sluggish inventory turnover
- slow-paying customers
- operational inefficiencies
- high employee turnover
b. Carry out legal due diligence
It’s also important to carry out a review of all legal issues affecting the business. These can include:
- pending or threatened litigation
- employment contracts
- customer and client agreements
- laws and regulations affecting the company
- licenses and permits
- real estate and intellectual property issues
The legal review allows you to quantify any legal risks and understand potential remedies. It also helps structure a purchase agreement that’s appropriate for the company’s legal risks, governing documents, contracts and applicable laws.
c. Look at the market
An often-overlooked step in due diligence is a validation of the target’s market environment, known as commercial due diligence. This process looks at the company’s market share and positioning, industry trends, assumptions behind projections and future risks and opportunities.
“Commercial due diligence is often not on the radar, but it’s important if you have any doubt about the company’s future market positioning or if the market is outside your knowledge base,” Hagarty says. “The company may have good profitability right now, but what if its model isn’t sustainable?”
4. Reassess the purchase terms
Depending on what your due diligence uncovers, you can revisit your offer price and other terms in negotiations on the purchase agreement. It’s common for the offer price to be revised downward because of the due diligence review and even for the purchase offer to be retracted.
“You may need to update your valuation numbers based on an adjusted EBITDA or a different multiplier because of the due diligence,” Hagarty says.