President's Faces on Money

Due Diligence on Due Diligence

07 Mar 2017

A merger or acquisition should be on the radar as one potential growth strategies for business owners. An acquisition will often provide an established business the opportunity to quickly and profitably expand into new markets or service lines, acquire new customer bases, increase their competitive advantage, or gain access to new technology and talent. After a potential target has been identified, one of the crucial steps in the process becomes due diligence. To properly perform due diligence, you need to focus on different levels; legal, operational, risk, culture, and financial. This article will only focus on financial due diligence.

Financial due diligence refers to the process wherein the investor performs an investigation or “quasi-audit” of the target to confirm the accuracy of the information presented in the initial negotiations and to gain further insight into the target entity’s operations. The process is designed to help the investor make a more informed decision about the acquisition, determine if the factors driving the purchase price are accurate and fairly reported, and mitigate the risks inherent in acquiring a company. While similar in concept, the due diligence process is an agreed upon procedure and not statutorily an audit. Therefore, there is no assurance from a certified public accountant.

Due diligence should go above and beyond a cursory review of the target’s financial statements; it should be a complete examination of the financial performance and the operations of the target. While the process may seem invasive, and at times can make the target feel “uncomfortable,” especially if they have never been audited before, this should all be part of the negotiations.

Understanding not just the gross amount of revenue a target has generated, but the sources and quality of this revenue is crucial in a due diligence process. Does a majority of their revenue come from one customer? What are the terms with their customers in general? Are the contracts with their customers able to be transferred easily, or will they require re-negotiation? For targets in heavily regulated industries it is also important to check on the compliance with applicable regulation as well. The due diligence process for revenue should also include an appropriate level of independent testing to make sure that the revenue that has been quoted during the initial negotiation process is accurate. Target companies may have incentive to expedite revenue recognition if it will get them a higher pay-out from the acquirer. A thorough analysis of the customer mix, contracts, receivables, and controls related to revenue are all should be completed. We have seen instances where, due to inappropriate spending in a cost based reimbursement system, the purchase price was significantly overstated and was only caught through the due diligence process.

During due diligence, there should also be a detailed investigation into the expenses of the target. It is during this time an investor can get a detailed understanding of their incurred expenses and begin to understand where there may be efficiencies to be found after the acquisition. Are there redundant positions that exist? What long term contracts and commitments exist (such as leases)? Are there any owner or officer discretionary expenses that can be eliminated? Is the company potentially understating expenses in order to make themselves look more attractive? Have all obligations (e.g. lawsuits, staff paid time off, etc.) been accrued? Do any staff contracts include severance packages that could hinder your ability to terminate highly compensated staff?

Another key objective of financial due diligence should be an examination of any potential tax risks of the target company. The current tax regulatory environment is very complex and can be an area of high exposure after an acquisition. The diligence process should include a review of prior filed tax returns for aggressive or incorrect positions which may have a material effect on the enterprise value. Beyond reviewing the tax returns, an investigation should be done that the target is current with all required tax filings and payments (such as payroll taxes) and that they are compliant with state and local tax regulations. Sales tax laws have become increasing intricate and aggressive in recent years and an analysis should be performed as to the target’s compliance with sales tax in all appropriate states.

The final major function of financial due diligence is to gain a deeper and further understanding of the assets and liabilities of a target. Often privately held companies will list assets and liabilities on their books to either the shareholders or other controlled entities. Are these real assets and liabilities which will be acquired? Understanding how and why these transactions were performed and their legitimacy is vital. A fiscally strong balance sheet can suddenly turn weak when the majority of their assets may not be realizable upon acquisition. A physical observation of major fixed assets should be performed to ensure their existence and to better gage their fair market value. Book value is a historical cost and depreciation only an estimate of wear and tear; the actual economic situation may be different. Equity should be analyzed to understand who owns the company and if there are any equity issues such as employee options or potential former owners who may look to cash in after the acquisition. You also need to be cognizant that all obligations have been recorded … Are any royalties due? Are there pending or threatened litigation? Are warranty reserves properly calculated? Were there gift cards sold that haven’t been cashed in yet? It is important you work with someone knowledgeable of your industry when doing due diligence.

Financial due diligence exists in order to better bridge the information gap between an investor and a potential target. The process should be comprehensive in order for the investor to minimize the inherent transaction risk of acquiring an enterprise and also allow the target to get fair value for their business. The level of due diligence will differ depending on the nature of the acquisition; stock (purchasing the shares of the stock so the entity continues) or assets (just purchasing the assets from within the company). After financial due diligence is complete, an investor should have a stronger understanding of the actual financial performance of the target and feel more comfortable that the acquisition will result in the growth of their current business and that the full value of the target will be realized.

This article was also featured in our newsletter Bottom Line Vol. 15.