What is Due Diligence?
By Don Beezley
Trust but verify.
That is the essence of the “due diligence” process. An offer has been made for your company, most likely based on a review of financial statements, possibly tax returns, discussions with you, and the financial presentation you approved that your broker/advisor developed to portray adjusted EBITDA numbers and other information about the company.
That’s the trust part. The buyer has valued the Company based on largely surface level information provided up to that point—they’ve trusted the information provided to come up with their offer.
Once you‘ve accepted the offer, whether via signing a Letter of Intent (LOI) or a Purchase Agreement, the buyer goes into verification mode. That’s when the buyer has the opportunity to verify with source materials the initial information they relied upon to make an offer. This will likely include most schedules that support the financial statements—payroll registers, bank statements, GL’s, contracts, invoices, depreciation schedules, employee lists, equipment appraisals and inspections, and so on.
Areas covered in due diligence typically include:
- Financial
- General business processes
- Legal
- Operations
- Personnel
- Safety & Risk Management
- Tax
- Technology
The due diligence process can feel a little overwhelming and even a bit repetitive, but a buyer who is about to write a multi-million-dollar check has a right to validate the information upon which they are valuing and buying the Company.
A simple example is verification of sales. Your financial statements for the last three years show $10,000,000 per year in sales. A basic request is to see monthly bank statements to see if deposits made match those amounts and can be reconciled to cash and the balance sheet.
A buyer may also want corporate records such as minutes and stock certificates, and insight to past or current legal issues.
Due diligence is essentially a mini audit of your company’s financial and operating history.
One of the most important things a buyer is trying to validate is “EBITDA”—Earnings Before Interest Taxes Depreciation and Amortization. This is essentially the cash flow of the business available to service the buyer’s debt, reinvest in the business for growth, earn a return on the investment, and pay the buyer a norm al salary. A buyer wants to verify the stability of EBITDA and the likelihood it will continue after sale, increase, or decline. A term you may hear as part of the process is “Quality of Earnings” or “Q of E.” It’s the part of the process designed to validate the earnings of the business.
“No deal is ever done until it’s done.” A buyer may find things in due diligence that are different from what they first assumed, or other issues may come up that have to be dealt with. If, for example, EBITDA numbers don’t add up, that’s usually the biggest issue that evokes a stimulating conversation and a revisit of the offer since EBITDA is primarily what the buyer’s valuation was built on.
Due diligence lists can seem long and overwhelming at first, but a review of the list with the buyer to determine what is actually applicable to the company will typically pare it down somewhat. The rest is simply what is needed for verification to get your deal done.
Buyers may do their own due diligence, though most will at least involve their CPA and/or attorney. Larger or more sophisticated buyers may use an outside Quality of Earnings firm to validate the financial results that have been presented. It’s also possible banks or other lenders and finance sources will have their own separate due diligence lists and processes in addition to the main Quality of Earnings effort by the buyer.
Your attorney and CPA are important parts of your deal team too. Be sure to involve them in due diligence to help you respond to inquiries and deal with questions and issues that come up. Timely response to requests is a key part of getting the deal done.
Due diligence can seem exhausting, inconvenient, and repetitive. Just remember: You can’t expect a big check if the buyer can’t verify your information.
Try to see due diligence as a happy part of the process that helps you achieve your goal of a successful sale!
Sample of two sections of a due diligence list:
No. | Category | Data Request |
Key Questions to Answer: Who is the customer, how do they get them, how do they keep them?
What is the sustainable competitive advantage and what’s neccessary to maintain and extend that advantage? |
||
1.01 | Commercial | Sales by Service, Segment and/or Customer Analysis for 2018-YTD |
1.02 | Commercial | Revenue Mix: Sales by Product or Service Category by year — Monthly report of revenue by service/product type for (2018-2022) |
1.03 | Commercial | List of major suppliers with 1) name, 2) description of products purchased, 3) length of relationship, 4) annual spend for 2018-2021, 5) description of rebate/discount programs, 6) payment terms |
1.04 | Commercial | Examples of customer and supplier invoice documentation |
1.05 | Commercial | Documentation or description of sales/estimating procedures and pricing guidelines |
1.06 | Commercial | Current pipeline/jobs funnel (e.g. RFQ/out for bid, backlog, in process, completed) |
1.07 | Commercial | List and description of all external certifications and awards |
1.08 | Commercial | Copies of current production report, backlog report and any other report used by management |
Financial |
Key Questions to answer: QOE, Profitability, profit trends, cost trends, working capital requirements, capex requirements (including maintenance capex) |
|
2.01 | Financial | Monthly trial balance level financial staements, balance sheets and income statements for 2018-21. Strong preference for Microsoft Excel, if possible |
2.02 | Financial | If possible, please provide a detailed GL (i.e. transaction level detail) for 2018-2021, including the description/memo fields and any other detailed information available |
2.03 | Financial | Copies of any external accountant/prepared documents (e.g. review of financial statements ) for the last three fiscal years, if applicable. |
2.04 | Financial | Monthly /quarterly internal reporting packages or management dashboard used in monitoring & evaluating the business including financial, employee, customer or any other relevant key performance indicators |
2.05 | Financial | Detailed list of one-time revenues or costs/EBITDA adjustments with descriptions, 2018-2021 (monthly if possible) |
2.06 | Financial | Monthly bank statements from June 2019-July 2021, including list of any non-revenue related deposits (e.g. loans, deposits from the sale of a fixed asset) that flow into the bank statements |
2.07 | Financial | Copies of communications/letters from external accountant (e.g. board presentations, planning/completion slides, management letter/improvement observations, signed management rep letters and attachments, internal control observation letters, etc.) |
2.08 | Financial | Annual revenue, 2006-2017 |
2.09 | Financial | A/R aging schedule with name of customer and amount , EOY 2018-21 |
2.10 | Financial | A/R aging schedule with name of vendor and amount , EOY 2018-21 |
2.11 | Financial | Inventory report with products, quantity, retail value, average sale value, and average cost |
2.12 | Financial | List and description of major capex purchases, 2018-21 (ideally labeled as “maintenance” vs “growth”) |
2.13 | Financial | Fixed asset listing with equipment name, age, year purchased, estimated working life, gross value, accumulated depreciation, and depreciation method (please provide both book and tax values/methods if different) |
2.14 | Financial | Recent appraisal of hard assets and/or real estate, if applicable |
2.15 | Financial | Composition of significant accrual balances including payroll, benefits, incentive benefit plans, retirement benefits, pensions, self insurance, commission, service warranties, etc. |
Don Beezley is President of Proforma Partners, LLC and a Business Certified Appraiser (BCA) with over three decades of M&A, banking, and business operations experience.