Spotlight series
In the last couple of months a number of companies in promising relationships have taken a step back from tying the knot. The Pernod Ricard merger with Brown Forman aborted because of a failure to agree financial terms and potential mega-deals including Rio Tinto and Glencore falling through due to fundamental differences in valuation and strategy. Nobody doubts that bringing global deals to a successful conclusion is extraordinarily complex and difficult. Smaller deals should be a lot easier, right?
Wrong! The due diligence procedure is the same and smaller businesses face a distinct set of due diligence challenges. A little knowledge is a dangerous thing… when it comes to buying a business, our article published earlier this year, provided owner-managed businesses with a “what to do” guide, highlighting areas for attention when embarking on a deal. By contrast, this article focuses on “what NOT to do” and looks at the due diligence pitfalls and how to avoid them.
One of the biggest issues is that many sellers simply aren’t prepared for the level of detail due diligence requires. They underestimate how much information buyers will ask for, or how long it will take to pull it all together. Without the right preparation and adviser support, what should be a manageable process can quickly become overwhelming, drawing owners away from running the business at a critical time.
The Five Key Pitfalls
1. Data challenges
Data underpins the entire due diligence process, yet it is often the area where businesses struggle most:
- Reconciling data sources
Many owner‑managed businesses rely on a mixture of accounting software, CRM tools, and bespoke systems. These don’t always “speak to each other,” which can lead to inconsistencies in the numbers. That can slow things down, confuse buyers, or raise unnecessary red flags.
- Data quality and granularity
Businesses rarely track financial information at the level of detail a buyer expects and that’s completely understandable. But when explanations can’t be backed up with data, it risks delays or even value adjustments.
Performing internal reconciliations on both a monthly and annual basis in advance of a transaction is recommended. Where legacy data issues or irreconcilable differences exist, early engagement with advisers can help resolve or provide clarity over these matters, and provide buyers with assurances that the items have been appropriately reviewed.
2. Revenue risks and sustainability concerns
Buyers need confidence that revenue is both stable and sustainable. Several factors can undermine that confidence:
- Is growth truly sustainable?
It’s important to understand what’s driving revenue growth. If it’s mainly down to external factors, like the broader market or one‑off events, rather than genuine business performance, buyers may question how long it will last.
- Reliance on key customers or contracts
Many smaller businesses lean heavily on one large client or contract. Buyers will always ask: What happens if that customer leaves? How secure is the contract? Is the revenue recurring?
- Contingent or variable income
Revenue that depends on certain conditions, like performance‑based fees or success metrics, is naturally less secure. Buyers may discount this income or remove it from the valuation altogether.
Ahead of a sale process, preparing detailed analysis of both the existing customer base and the forward pipeline is advisable. Where possible, discussions with prospective customers should be documented in writing, and any informal arrangements formalised into contractual agreements. These will all help to reduce the risk for any potential acquirers.
3. Forecasts and budgets: a common weakness
Forecasts play a key role in buyer confidence, yet they are an area where smaller businesses often fall short.
- Outdated forecasts and missed budgets
Because a deal process can stretch over several months, forecasts can become out of date quickly.
- Models that are too simple or too complex
Overly complex models tend to hide errors. Overly simple models miss key revenue and cost drivers. And both can make buyers uneasy.
When putting together a forecast and budget, clearly setout the assumptions, use transparent formulas and include reasonable sense‑checks. While these may seem obvious, they are frequently overlooked and can significantly affect the credibility of a model.
4. Balance sheet issues affecting deal value
Balance sheet items often have a direct impact on value and are a common source of unexpected adjustments.
- Missing provisions
Items like holiday pay, deferred revenue, bonus accruals, and dilapidations are frequently missed by smaller businesses. These are important because they impact net working capital, net debt and, ultimately, the price paid.
- Simplified accounting approaches
A simple accounting set-up works fine day‑to‑day but often results in “debt‑like” adjustments during diligence. Identifying these early helps avoid surprises and protects value.
- Working capital requirements
Working capital can feel abstract or irrelevant to daily operations, so sellers often misunderstand it. Buyers, however, analyse it closely to set a working capital target. If this isn’t accurate, it can lead to extended negotiations or reduced value.
Reviewing the balance sheet and breaking down the balances into operational and debt-like items is a good idea. If there are any legacy balances ensure that work is performed to understand them and appropriately look to clear them ahead of the sell process.
5. Tax considerations
Tax issues can materially affect both process and price, particularly in share transactions and where personal expenses are involved. These, along with other common tax‑related pitfalls, will be explored in more detail in a separate article.
These pitfalls increase risk and have the potential to slowdown the deal process. The key takeaway is simple: preparation is everything. Engaging experienced advisers early, understanding the level of detail required and allocating sufficient time and resources can significantly reduce stress, protect value and build trust with potential buyers.
How PKF can help
PKF works closely with clients on both the buy side and sell side to address these challenges and implement practical workarounds wherever possible. Financial due diligence can feel daunting for owner‑managed businesses, but with the right preparation and support, it doesn’t need to be. At PKF, we help both buyers and sellers identify issues early, manage expectations, protect value and keep transactions moving.
