What Is Due Diligence?

How do you find out what you don’t know when you are considering buying a business? While a buyer could crack on and take the chance there are no skeletons in the closet, it can be an expensive mistake to acquire a business blind.  While there are warranty protections within the legal purchase documents, it’s a risky business to rely on these alone as your only resolution.

What is Due Diligence?

For every transaction, now matter how small, an element of due diligence should be undertaken. Due diligence is effectively about ‘lifting the bonnet’ and understanding what you’re buying.  Typically this is done after a deal is agreed in principle, and that offer should be “subject to due diligence”, allowing the buyer the opportunity to reflect on the valuation and structure of the deal once due diligence is complete. While it’s generally considered poor form to price chip for relatively immaterial issues identified, it’s a fair assumption that an acquirer will wish to reflect a material risk in the deal structure, and in some cases, the issue is big enough to result in the buyer pulling out. Ironically, it’s in those scenarios that due diligence is at its most valuable.

Why is Due Diligence important?

The importance of financial and tax due diligence is two fold. Firstly, it provides knowledge.  A buyer should gain thorough understanding of the financial accounts of the business and its tax records and liabilities.  This includes evaluating revenue streams (including customer concentration), profit margins, the ability to turn profit into cash, and crucially, a full understanding of assets and liabilities.

That knowledge is crucial to evaluate key items for the price mechanism, and legal purchase agreement, like cash, debt and normalised working capital.  Expertise analysing these balances can make a significant difference to the price actually paid for the business. This area was covered by my colleague Gregor Steedman recently but suffice to say it’s a key area where due diligence can add value.

For strategic acquisitions, knowledge gained during due diligence also helps identify potential synergies between the acquiring company and the target business. Understanding how the two entities can complement each other can justify the acquisition and maximise its value.

Secondly, due diligence should recommend protections, if there are any, to mitigate the risks identified.  Sometimes these are operational/financial improvements, and often they are recommendations on specific indemnities or additional warranties. A good due diligence advisor should be willing to come off the fence and give advice to protect their client. A buyer should make sure they are clear at the outset what they want from their advisor and what support they need.

From a vendor’s perspective, it’s best to assume due diligence is a necessary evil of selling your business, but it doesn’t need to be painful.  Preparation is key, as is making sure you’re financial reporting is up to date. The inability to access data quickly, and date that is accurate, can cast doubts on the robustness of the financial governance and that’s something that can be easily avoided.

We’ll be covering all things due diligence throughout our upcoming series so stay tuned.

If you have any questions about due diligence, or the important steps to the take before purchasing a business please do not hesitate to get in contact with Lyn Calder, or your usual AAB contact.