Due diligence is the evaluation process used to inform decisions about business opportunities, such as a merger, acquisition, privatization, investment, or other financial transaction. During due diligence, the interested party will request documents, explanations, and information about the prospective company so they may structure and evaluate the deal and make a determination about whether to move forward. The purpose of due diligence is to help identify key risks and opportunities in a potential business transaction.
Who Goes Through Due Diligence?
Companies expecting a financial transaction should expect a period of due diligence with the interested party. Due diligence is a common step during any major business transaction, including mergers, acquisitions, privatizations, or capital raises.
However, due diligence is not sequestered only to B2B transactions. Companies may perform reverse due diligence on a prospective buyer or investor, individuals may perform reasonable due diligence using public information before making a stock decision, and companies may even perform due diligence on a potential employee by performing background checks. For the purpose of this article, we will focus on due diligence during business finance transactions.
What to Expect During Due Diligence
Any time a business is going through a significant change such as a merger, an acquisition, or capital raise, they can expect to go through a due diligence process before structuring and closing the deal. During these transactions, a company will usually undergo “hard” due diligence, which concerns numbers, and “soft” due diligence, which concerns people and culture.
The due diligence process will look a little different for every investigating company, but there are some key areas that you can expect, including:
- A complete financial inspection analyzing historical and forecasted financial reports, structures, assets, costs, and liabilities
- Analysis of the target consumer market
- Review of potential or ongoing litigation
- Evaluation of third-party relationships, including those with customers, vendors, subcontractors, and consultants
- Review of employee agreements, compensation and incentive programs
- Solicitation of explanations of corporate structure, culture, employee relationships, leadership, & more
Letter of Intent
The due diligence process most often begins after a letter of intent is signed by both parties. The letter is non-binding, stating both parties’ interests to sell, buy, or merge. It often includes a proposed price, but it is only a starting point.
While some due diligence begins before an official letter of intent is signed, most of the nitty-gritty details are shared and learned after signing.
The due diligence process can take months or even up to a year to complete. The timing depends on the transaction’s size and scope. It’s best to be prepared for a long process–in most cases, due diligence can’t be reasonably rushed without essential details being overlooked.
Due diligence can also be a very stressful time. The purpose of due diligence is to reveal all the relevant insights about the company that the interested party may need in order to make a decision–including the less savory details. It can be uncomfortable for some founders to expose their company’s warts when they want to put their best foot forward.
Financial Analysis
The first stop for all parties involved in due diligence is a deep dive into the finances of the company. If the numbers don’t add up, there is usually no need to continue in the process.
Most often, the financial reports and metrics requested in an acquisition or merger are:
- Cash flow report
- Income Statement
- Balance Sheet
- Budget & Actual-to-Budget Reporting
- Financial Projections
- Long- and Short-Term Forecasts
- Tax Returns
- Inventory
Legal Contracts
Every business has legal contracts. Things like leases, bank loans, contracts with suppliers, etc. These will be examined closely to determine whether there are any outstanding or potential legal risks within the company. Often leases still may have years left on them; suppliers may require minimum purchases monthly, etc. All of these things can alter a business transaction.
Reading the fine print is essential. It is not uncommon to find “strings attached” that make contracts transferable to new owners.
Customer Retention and Loyalty
On average, a company’s purchaser wants to be sure at least 60% of the customers will remain customers even if there is a new owner. This data can be challenging to obtain without spilling the beans that the company is up for sale. Anonymous interviews of customers, sometimes disguised as customer satisfaction interviews, are often used to help determine customer loyalty.
Employee Structure, Performance, & Morale
An investigating company will want to know more about how the workforce of the company is structured and will do “soft” due diligence on employee performance and morale. They’re looking not only to see how the employees currently perform, but also whether to expect turnover or resistance during transition, where optimizations and adjustments might be made to boost performance, and how easy or difficult the employee base is to manage (high/low turnover, etc.).
Reputation and Culture
Unlike financial and legal contracts, learning and understanding a business’s reputation and culture can prove more difficult. It is not laid out in black and white on a piece of paper or in any report.
While an acquisition or merger may look good financially, if the company has earned a bad reputation or has an embedded culture unlike what the seller has in mind, it may indeed be a bad investment.
The investigating company will be looking at company culture to determine whether they believe the culture is appropriate in relation to the company performance, and to ensure the company is compatible with their business portfolio.
Final Thoughts
Due diligence is an important component of any large financial business transaction, and it can be intimidating. One of the best ways to prepare for due diligence is to ensure the financial reporting of your business is complete and up-to-date and that you have a member of your financial team who can answer the “hard” questions that will arise during due diligence. The best person for this job is usually a highly experienced controller or CFO–or even a temporary outsourced CFO.
About the Author
Wes Anderson, CFO
Wes Anderson is an experienced CFO with significant international finance experience. In his previous roles as Director of Financial & Tax Reporting, Senior Financial Controller, and Chief Financial Officer in the international travel industry, Wes coordinated two corporate restructurings involving entities in four countries. He also built and executed financial models consolidating multiple foreign subsidiaries into a parent holding company.
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