Any organisation negotiating a business sale or purchase must challenge the assumptions being made about the deal. The purpose of due diligence is to provide comfort by reviewing and validating all of the financial, commercial, operational and strategic assumptions. It confirms that buyer and seller agree to what is being traded as well as giving the knowledge and confidence to ensure that both get what they want from the deal.
Due diligence has a major part in establishing the true value of a business.The right information contributes to the contents of the sale agreement. Due diligence enables the negotiation of the best terms. Ultimately, it is not just about ensuring all the “I’s” are doted and “t’s” crossed, it ensures that both sides achieve best value.
Types of due diligence
The fundamentals of any due diligence exercise must cover legal, financial and commercial considerations.
Areas of legal due diligence include:
- I.P. – ensuring that any intellectual property is actually owned by the seller and that they have the right to sell.
- Legal structure – confirming the legal owners of the shares (if a company sale) or the legal owners of the assets (if an asset sale).
- Contracts – looking at both customer and supplier contracts to ensure that there is security of tenure. It is quite common for this type of contract to include a clause to terminate the agreement upon any change in ownership.
- Financing – considering any bank facilities (overdrafts, term loans etc.), invoice discounting or factoring, finance leases and other finance, ensuring that they will remain in place or if there are any penalties for early repayment.
- Business premises – if they are owned, do they form part of the sale, if leased are there any clauses in the lease re change of ownership.
- Employment – consideration of employment contracts, looking for any unusual terms as well as the more common things such as notice periods, remuneration, benefits etc. Consideration should also be given to any previous employees with a view to potential legal claims and any on-going disciplinary actions.
- Litigation – has there been any litigation either by or against the business. Is there any currently in progress or potential for any in the future.
Financial due diligence concentrates on verifying any financial information already provided and also gives an idea of the future performance of the business. Areas of financial due diligence include:
- Turnover – looking at historic, current and future turnover to give an indication of the value of the acquisition. This will include reviewing the client base, level of turnover for each and security of on-going income.
- Assets – those assets to be included in the sale, who owns them, what is their current market value and how does this compare with the book value currently shown on the balance sheet. Is the acquirer getting fair value?
- Liabilities – those liabilities to be included within the sale. The acquirer will have responsibility for these once the sale has been completed.
- Cash flow – the acquirer needs to forecast what the effect of the acquisition is likely to be. Not only from the point of view of the cost of acquisition, but also in terms of any restructuring costs as well as the continued trading position once the acquisition is fully integrated.
- Debt – does the acquirer need to raise finance to fund the purchase. If so how does this effect future cash flow. Is the acquirer taking on any existing debt with the acquisition.
Commercial due diligence considers the markets in which a business operates. This usually involves talking to clients and looking at any competitors. A thorough review and challenge of all of the assumptions that lie behind the business plan should be undertaken. All of this is intended to test its robustness, viability and likely success of the acquisition.
The Hard Truth
Carrying out a due diligence exercise is time consuming, inconvenient and tedious. It goes way beyond any checks that would normally be made in the course of everyday business. For it to be considered a success, by the end of the exercise the acquirer should know just as much about the business being acquired as they do about there own business.
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