Due Diligence By The Buyer – Dig Deep

This article is from the perspective of a buyer acquiring a small/medium size business. In recent years there has been much emphasis on a seller’s due diligence on a buyer, to satisfy the seller that the buyer is really a buyer and can afford to pay the price. The seller’s due diligence on the buyer will be covered in a separate chapter.

Due diligence is the process whereby the buyer satisfies himself that he is in fact buying what the seller states he is selling. It is an investigation (not an audit) of a potential acquisition to confirm to the buyer’s satisfaction whether to carry on with the transaction or withdraw.

The extend of the investigation depends on the size of the transaction, and regrettably for the small to medium deals the investigation can be more complex than bigger deals because of poor corporate governance, ( King 3 Report indicates that small businesses must also conform to corporate governance requirements-directors conditions are being carefully looked at) lack of legal compliance, poor accounting/administration systems and often taking short cuts with the tax man, hence the need for the buyer to dig deep.

Following the principle of keeping it simple and practical, the areas which generally need specific attention, understanding and if necessary clarity, usually centre around-

• Are the financial statements accurate and up to date-Go back 3 years.
• Is stock in a saleable condition.
• What is the condition and real value of the assets. This is an area which needs careful consideration, sometimes the values are way out of market rates and unrealistic.
• To ascertain potential benefits and liabilities, is it a declining market.
• Is the business solvent?
• What are the business risks, is there new technology which can make the business redundant
• Is there a positive cash flow, guaranteed monthly income is the prize.
• The ongoing commitment of employees, are they motivated.
• A clear understanding of the industry to be entered and importantly who are the competitors.
• What is the future of the business and its competition>
• Will contracts remain in place after the change of ownership.
• How strong are the sales and marketing departments.
• The image and reputation of the business.
• Accountability and transparency of owners, directors and management.
• How effective is the businesses planning,
• Is the business legally and financially compliant?
• Are there legal cases pending which could affect the image of the business.
• Verification of the claims made by the owners/management.
• Ascertaining opportunities which are available.
• No surprises.
• WHY IS THE BUSINESS FOR SALE-If the answer is not clear walk away
• How can the buyer increase the revenue and profits of the business and merge them with its own.
• Are there other offers on the table, don’t get caught in an auction, get a commitment from the seller that during the due diligence investigation, he will not negotiate with other parties.
• What are the price and payment terms and how are they justified, tax is an area which needs specific attention.
• Assessing all the findings from all the participants, lawyers, accountants etc to ensure that there is a clear picture of the business from all angles. This is often an area where because of lack of communication the buyer does not get a comprehensive picture of the business and as a consequence makes a wrong decision

It is important to take the stance that “the seller will tell the truth, the whole truth and anything but the truth”. He will not disclose “any skeletons in the cupboard” The buyer must find them himself.

It is stated that the investigation can frustrating, time consuming and expensive, but the buyer puts himself at peril if he does not do his homework. The use of outside advisers is often necessary, but can be expensive. Therefore, ensure that they have extensive experience. Use “Men not boys” –i.e. those who have the experience and knowledge for the business at hand. Don’t be penny wise and pound foolish. However, ensure that your agreement with the professional adviser is in writing, setting out what he is to do, for how much and when will delivery be made.

To elaborate on the above the following points are relevant - The legal investigation is to satisfy the buyer that the legal affairs of the business are in order, especially ownership of assets. That the business complies with statutory requirements and that the main contracts affecting the business are in order.

The major components of the financial investigation centre around, comparing budgets with actuals, are forecasts realistic, checking business trends, and importantly the quality of the accounting systems. Check that there have been no auditor’s qualifications; they can be a deal breaker (“Circumstances which are so serious as to affect a significant difference from the transaction so as to make the buyer uncomfortable with concluding it”)

From a human resources position, matters such as salary levels, restraints of trade, pension rights and terms in the employee’s contract (especially notice periods) must be considered.

At the end of the day, if anything is found which is negative, this factor can be used to negotiate a reduction in the purchase price. Don’t be rushed, only fools rush in. It is no use being wise after the event. Checking first avoids problems later.

Bob Power Corporate Consultants
www.powerconsulting.co.za