Spotlight series
Insufficient insight into a company that you are looking to acquire is a risk. There are plenty of examples of company acquisitions that turned-out to be a poisoned chalice rather than a cup of plenty, because of a lack of knowledge about the business.
Historic, public deals such as, HP’s acquisition of Autonomy; PayPal’s acquisition of Tio Networks, and Verizon’s acquisition of Yahoo’s operating business, all resulted in unexpected and costly surprises once the ink was dry on the contract. Whether the business is public or private, undisclosed accounting “errors”, data handling issues, cyber security, and inaccurate sales data, are just some of the reasons that promising transactions fail spectacularly and are usually the result of poor due diligence processes.
Conducting robust financial due diligence on owner-managed private businesses is more than just a tick-box exercise. Failing to do your homework properly could result in significant costs post-acquisition if legacy issues are discovered; parties walking-away from the deal at the eleventh hour having invested a large amount of time and resources in the deal; or have a significant impact on the price if the deal still goes ahead.
A financial due diligence exercise involves an investigative analysis of a selling company, assessing the key risks faced by the business, determining the key drivers behind profits and cash flows and, of course, identifying any potential transaction deal breakers.
For a due diligence exercise to be of value to a potential buyer of a private business, it needs to look not just at the financial information available in respect of the seller, but also take a holistic approach considering how all the elements of the business fit together. It is also important to understand a buyer’s rationale for the acquisition as well as the founder’s motivation for a sale and what might be a dealbreaker for them. Founders and entrepreneurs will want to exit the business for a variety of reasons, some to realise a retirement nest egg, others to deploy the capital into a new venture. Ultimately, the company represents years of hard work and sacrifice for the seller and the deal contract will need to both respect their work as well as ensure they can achieve their next goal. Understanding their desired outcomes from the start of the process is essential.
What should buyers look for when undertaking due diligence and how can a potential seller prepare for the process?
There are seven key areas to review when analysing a business:
1. Key Performance Indicators (KPIs)
EBITDA, revenue growth, cash conversion and other business specific KPIs are an important focus for buyers, as getting to the heart of what drives the business is an important first step. This can be both from a balance sheet as well as profit/loss perspective. Any work that the seller has already undertaken to analyse trends in KPIs – such as source of income, movements in key clients and renewal/retention rates etc – should be seen as a positive because it gives confidence that management understands and monitors underlying performance. Any work done by a seller to make quality of earnings adjustments to identify a true adjusted EBITDA is also helpful. This is often the removal of one-off items or items which are not expected to continue post-transaction. Red flags on the balance sheet will include aging debtors and creditors. If there are legacy balances, is management aware of what they are and do they have a plausible plan to deal with them?
It is easy to get lost in the detail of the numbers. A good due diligence exercise will avoid this and focus on those risks and metrics which are important to the deal such as, recurring revenue, and cash conversion. The appropriate metrics will change depending on the type of business and industry sector.
2. Systems and procedures
Are there clearly defined systems and procedures in place to process information efficiently and accurately? Are these systems and procedures effective and actually adhered to? More specifically, due diligence will look at: How are financial results reconciled to key systems? How accurately does monthly management information relate to financial statements? and how many year-end audit adjustments are required to comply with recognised accounting standards?
Procedures should be appropriate for the size of the company, with easy to follow reconciliations and explanations of any outlying information.
One recurring finding that commonly crops-up as part of the process is that if there are a large number of adjustments, monthly figures may not be indicative of performance, so the buyer will not be able rely on them for the basis of valuation and the completion accounts, without going through the year end process. When planning the future sale of a business, sellers would be well-advised to improve their monthly processes to ensure that data is more reliable and accurately reflects the underlying performance.
3. Availability of data
Availability of underlying data is crucial to a due diligence exercise. The easier the information is to access and process, the quicker the due diligence team will understand the business. Buyers will often ask for large amounts of data to be presented or cut in numerous ways, which increases the data requirement further. Good reporting capability, in particular the necessary IT and accounting systems, is essential. It is a good idea to sit down with finance teams and software developers to understand the types of reports which their systems can run, for both bespoke and “off the shelf” packages and potentially use data analytics tools such as PowerBI to speed up this process.
4. Legal and regulatory
Legal and other regulatory issues can be red flags to buyers – a significant breach that is potentially not yet concluded at the time of due diligence could lead to problems and/or delays. And, of course, the question needs to be asked as to how such a breach occurred in the first place. By contrast, a senior team showing a positive compliance culture, a well-controlled financial environment, and a recognised compliance consultant or experienced in house team, can be incredibly beneficial.
5. Simplicity and transparency of results
During a due diligence exercise, it is important to get beneath the skin of a business in order to become confident in its results and understand the main moving parts and drivers. The seller management’s ability to present data and results in an easily understandable, consistent and transparent manner is immensely helpful to this process.
6. Culture and approach of management
A positive, upfront and open approach from management can make the due diligence process more effective for everyone concerned. Management’s willingness to work with the due diligence team gives confidence in the answers provided.
7. Quality of advisory team
Finally, the quality of lawyers, accountants, advisers and their experience in the relevant industry gives confidence that the seller has been given good advice. Good advisers can help sellers and buyers in identifying the true adjusted EBITDA, identify and fixing issues before going through and during a sale, and facilitating a smooth transaction. It is important to note that the findings from due diligence will often impact the indemnities and warranties in the SPA, so it is important that the various advisers work closely together.
How can we help
Whether buying or selling a business, having a good appreciation of the due diligence process and its role and importance to the transaction is vital. From identifying adjusted EBITDA, analysing underlying performance, and validating systems and controls, through to uncovering dealbreakers before they become costly, our Transaction Advisory team are here to help.
For more information on due diligence, please contact Joseph Baulf or Doug Eberlin.
