Due Diligence in Mergers & Acquisitions
The primary goal of due diligence is to collect as much information as possible about an opportunity and ensure that it is a legitimate opportunity. If the target company, for example, turns out to be a fraud, then the diligence process was not successful.
Its ultimate purpose is to help decision making on whether or not to proceed with the deal. The financial due diligence process and team assigned will vary depending on how much risk there is (and therefore how much money will be at stake) and what stage of development the deal is in.
The process is usually managed by the financial due diligence team, which is part of the legal or acquisition team.
The following is an overview of the financial due diligence phase in M&A.
Some investors may not carry out any form of due diligence before acquisition, especially for smaller-dollar acquisitions. This can be risky, as they are often acquiring a company without fully understanding how it makes money or what its true value is. Although this approach makes it faster to make a decision, there are two possible problems:
- If no due diligence is carried out before acquisition then the new owners assume that they are buying a profitable company for cheap … which is seldom the case.
- If they do carry out due diligence and discover that the company is not profitable, they may be forced to write down goodwill, change capital structure or restructure the business. This could result in large income tax liabilities for them or worse, bankruptcy.
To avoid these problems most investors will usually do some form of due diligence before finalizing an acquisition.
Financial Due Diligence Process
The financial due diligence process is designed to collect as much information as possible about the target company, its customers and suppliers, accounts receivable balance, pricing trends and so on. The process is designed to find problems that could affect the business or deal. It is not to find problems that are already known or that can be factored into the price.
Investors (and banks) will usually appoint an audit team (which may include lawyers, accountants, IT professionals and analysts) to carry out financial due diligence for them. These professional fees are included in the overall transaction cost.
The objective of financial due diligence is to understand how the company makes its money (its revenue streams), where all its assets are (to ensure there is no hidden debt), whether its cash flow is strong enough to repay debt, whether it has any tax issues and so on.
In order to do that the auditors will look into the following areas:
- Accounts receivable and payable – It is important to understand how much money is owed to customers and how much to suppliers/vendors. In most countries, companies must prepare a monthly statement for their customers detailing amounts due from them. This information should be accurate and include supporting documents such as evidence of payments received. Failure to do this can result in a breakdown in trade relations with a customer, causing financial difficulties for the company.
- What can be easily shown must really be what you have – the team will also look into the asset side of the business. They check that all buildings, vehicles, machinery and equipment are owned by the company. If they are being leased then there should be a legally binding contract to do so. If none of these assets are owned by the company, any cash tied up in them is at risk because they could be repossessed by lenders or lessors at any time without warning or consultation with management.
- Security provisions – all fixed assets should have title insurance policies in place to protect against fraud and theft … but too often, these policies are not renewed on time, if at all. It is a good idea to check that property is insured and that the insurance policy has been renewed.
- What is the value of receivables? – all accounts receivable should be reviewed for accuracy. Loans from related parties should be verified since they may not have been repaid in full, or at all. Any loans from customers should also be evaluated on a case-by-case basis to determine whether they exceed the normal terms offered to other customers or whether there are any additional collateral requirements on them (for example, car loans that require cars as collateral).
- All payments made to employees and all expenses and payments for capital expenditures must be verified and reconciled. This also includes payments to other companies as well as costs associated with leases and trust deeds.
- Critical ratios – the auditors will assess the business’ financial health based on its key ratios, such as EBITDA (earnings before interest, taxes, depreciation and amortization) and cash flow.
When the first financial analysis is completed, you should receive a draft valuation analysis and should discuss it with your lawyers, accountants or trusted advisors to ensure that they are comfortable with it. You may need to make some adjustments or provide additional information before signing any documents for due diligence approval.
If any issues are found during the financial due diligence process they are usually addressed in detail during closing documentation discussions.
Closing the Deal
Once all the financial due diligence is complete, when it appears that there are no more problems with the target company, final negotiations may begin. At this stage, valuations are running around two to three times EBITDA (earnings before interest, taxes, depreciation and amortization).
The most important thing you must remember when negotiating this stage of the deal is that no deal is final until all documents are signed. This means that all terms of any agreements in place in the financial due diligence phase will be in place during closing unless you can negotiate an agreed version with your lawyers or advisors.
If you do not have a lawyer, you should find one who has experience in acquisitions and be sure to discuss the issues with them at every stage of the deal because no two situations are ever quite alike.