The ‘Diligence’ in Due Diligence

Over this last year, we have had many due diligence engagements (both purchase and sale side) and this month alone have completed six due diligence engagements, so as this is on my mind, it becomes the default technical topic this month.
Each due diligence engagement is unique and there is no one approach, however the below explores some of the considerations which should be applied in a general sense when conducting or partaking in a due diligence.
I want to sell my business – what should I be doing to prepare?
The cleanest and easiest transactions to complete are where the required information is readily available. We suggest if you are contemplating selling your business, taking the following steps now will assist you

1. Capture relevant information: Think about the information you would want if you were to purchase a business such as yours. Where are the perceived risks? The most common areas we look at are top 5 to 20 customers over previous years, supplier concentration and risk, ensuring that gross margins are captured accurately and assessing variability/consistency with this. Some businesses we recently looked at thought they had a job costing system, however the reported job margins per the accounting system were not reflected in the gross margins per the financial systems. We found that labour was not allocated to jobs, especially subcontractor labour. Our interest was in the job profitability, and which types of jobs were generating adequate margins. If your business is product based, you should capture information on the product mix and margins per product as accurately as possible. Capturing such information will assist the business perform better in any case, as well as attempt to mitigate perceived risks by a buyer in any proposed transaction
2. Clean up the financials: Particularly in closely held SMEs or other family businesses, it is common to find many related party balances on the balance sheet, or even sometimes personal expenses intermingled with business expenses. We suggest you speak to your accountant to plan for keeping transactions unrelated to the business out of the financial statements. It is easier to keep personal expenditure separate rather than try and explain on a business sale or valuation that some of the deductions were overstated.
3. What will you sell? In most cases for third party (non-related party) sales of businesses, the transaction is structured as a business sale rather than a share sale. However there are situations where a share sale is required. Due diligence for share sales are more onerous as the purchaser inherits all the current (and potentially past) liabilities of the business including off balance sheet or contingent liabilities. When a share sale is being contemplated, it is more important the balance sheet is clean of related party transactions, and all returns are filed and payments made on time. There is often a focus on tax, therefore all tax opinions or tax treatment of material items should be documented, and historical information retained. Details of any past tax audits, any legal claims/disputes/settlements should be retained. Aging of debtors and creditors is also important, and best efforts should be applied to complying with credit terms, and timely collection of debtors. Other types of sales might consist of asset sales only where only certain assets of the business are sold.
4. Keep employment agreements and other important contracts safe and secure.

Vendor Side Due Diligence

I am ready to sell my business, who should conduct the due diligence?
It is not necessary to engage your accountant to manage your due diligence if you are the vendor. If you know your business well, there is no reason you cannot manage this yourself. You can always call your accountant on anything you need assistance on.  However due to time constraints, often it is the business accountant who manages the due diligence process, or at least provides the information required.
How do I protect the privacy of my information?
Usually a due diligence is conducted after the signing of a conditional Sale & Purchase Agreement or a Heads of Agreement with a confidentiality clause. Accountants are bound by their professional bodies to maintain confidence.
Must I provide all information requested?
Short answer – you should. When we request information for a vendor due diligence engagement, and the request is unusual, we often provide a reason. In all cases, we ensure we know the relevance of all information we request. So, if you are unsure, ask. If the request is valid, however you do not have the information, it is best to say so, and provide any information you can on the request. If the request is for a valid reason and information is not provided, it becomes a risk for the purchaser in consideration of whether to proceed. It can also be a post transaction risk for you if the missing information results in a breach of warranty agreed to in the Sale & Purchase Agreement.

Purchase Side Due Diligence

I am buying a business, who should conduct the due diligence?
It is not necessary to engage your accountant to complete a due diligence, but it is more common on purchases of business to engage your accountant. An accountant can review financial statements for accounting treatment, and knows what information to ask for at least to verify financial information. If you have a good accountant, they should also be able to identify the risk areas in an operational sense and tailor information requests for this.
Is there a ‘checklist’ for a due diligence?
Short answer is yes, most accountants have a due diligence information checklist they work to. However, your accountant should know what is required and what is not based on the context of the transaction. It is important to have a sale and purchase agreement or a heads of agreement outlining the proposed transaction. This will give your accountant guidance on what to request, and on what areas to spend the most time. We have had clients purchasing businesses with an identified purpose for acquisition. In these cases we determine alongside the client what information is important– so the due diligence is more limited or focused.
Are there ways to structure a transaction to mitigate identified due diligence risks?
Yes, again this is based on the particular situation. Some structuring we have suggested include retaining bonds or a portion of the purchase price for an amount of time sufficient to cover the risk item, earn-out clauses where portion of the purchase price or a premium is paid based on achievement of criteria (e.g. successful transition of relationships, maintenance or growth of earnings), and warranties incorporated into the Sale & Purchase Agreement. We strongly suggest a legal professional drafts the sale and purchase agreement, and covers relevant legal due diligence. We have always found it is best when the accounting and legal professionals talk to each other to ensure that all risk items are covered off.
So whether purchasing a business, or selling a business, due diligence is an essential process that needs to be tailored to the proposed transaction. Whether you are managing the process yourself or not, we strongly suggest consulting with your accounting professional. From a business purchase point of view, conducting a financial due diligence is essential – it is better to be safe than sorry. From a seller’s point of view, preparation is half the battle.