Essential Due Diligence Steps for Buyers and Sellers

October 19, 2018 | Article

By Frank Donati

All deals are unique in the world of transactions. However, unique does not have to equate to surprises on either side. A seller wants a defensible position for the value they’re anticipating from a sale. Meanwhile, a buyer doesn’t want surprises while sitting at the closing table or, worse yet, after the deal has closed.

So how do you avoid costly surprises that may be waiting in the shadows of a deal? There are a number of essential steps both parties need to take during the due diligence phase.

We are selling, but when or how do we start?
Whether you know it or not, you have been preparing for a sale for years. Now is the time to start developing the materials to explain your results and tell your story. Understanding your value prior to going to market gives the seller bargaining power. It can also help keep the deal on track and on time by identifying pitfalls well in advance.

The process begins with taking a step back and putting yourself in the buyer’s shoes to look at the company’s three- to five- year history. A preparatory due diligence, sometimes called Sell-Side Quality of Earnings (QofE), covers the financial aspect of this process. It includes questions like:

  • Have we had any significant one-time events, infused significant growth, or added process improvement capital that affected our financial performance?
  • Have we prudently managed our working capital and cash flow?
  • Do we have discretionary expenses affecting EBITDA?
  • How do our compensation packages or commonly owned property rents compare to the market?
  • Have we reasonably forecasted our growth?
  • What are the capabilities of the management team which will be in place post close?
  • Have we outgrown our current technologies?

An unbiased evaluation of the company’s operations through a financial lens using questions such as these is essential to understanding the value of the organization. Depending on how these questions are answered, waiting to sell for another year could return significant value. This additional time allows management to focus on improving key performance indicators and value drivers.

An Informed Decision for the Buyer
Prior to entering into a letter of intent, you have probably already gone through your projections regarding future cash flows, synergies and process improvements that will turn this target into the next big thing for your organization. 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.

Involve Your Transaction Team
Does your staff have the experience and capacity to avoid the stumbling blocks mentioned above? It is important to understand that engaging transaction advisors and due diligence providers can be as simple or extensive as the seller or buyer wishes. Involving your advisors early in the due diligence process allows them to better understand your needs and help you formulate an appropriate due diligence strategy for your sale or acquisition. Whether it’s a high-level analysis of the entity in preparation for a potential sale, a gross margin analysis of a seller’s new product offering, or detailed historical four- year and projected EBITDA and working capital analysis, your advisor can make sure you don’t overlook surprises.

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