How to conduct due diligence for a business acquisition

The ideal way to conduct due diligence is to first assemble a team of legal, accounting and other professionals, to then sign a Letter of Intent (LOI) with the seller, and finally, to follow a step-by-step process to analyze and evaluate the business. 

What is due diligence?

Due diligence means conducting a deep dive into the inner workings of a business. It allows you to identify its opportunities and risks, to determine whether it is desirable to purchase and, if so, calculate a potential purchase price.

How do I carry out due diligence?

Due diligence is not easy — it’s a detail-oriented process that, if done correctly, can take weeks or even months to complete. It is wise to define what your process will be at the outset so that no stone goes unturned. There will be a temptation to save time and money by hurrying the process, but being methodical in your due diligence is crucial to ensure that you make the best decision and avoid negative surprises after the deal is signed and there’s no going back.

Define a process

Your due diligence process should address a series of key topics. Here are some of the essential questions to ask:

• How financially sound is the business? This includes a line-by-line analysis of revenue and expenses over time to understand how profitable the business is and which way its sales are trending.
• How healthy is the environment? This refers to factors outside the four walls of the business, such as trends in the economy, regulation, technology, and the market in which the business operates.
• Who and what will you have access to? This could include the physical premises, financial and legal records and, possibly suppliers, customers, and employees.
• What are the key risks? This includes risks within the business and risks associated with the market and environment where it operates. And when you identify those risks, how can they be minimized or managed?
• Who are the suppliers and customers? This area is closely tied to the risk profile of the business. Having a diverse set of suppliers and customers is generally less risky than depending on just a few key players.

Assemble a team

Ideally, the members of your due diligence team will have been with you when you started the search for a business to acquire. Working with a seasoned business broker, accountant, or lawyer can help you spot red flags early in the search process, and potentially save you the time and effort of pursuing dead ends. Having said that, once you find a business that you like and are ready to move into serious due diligence, certain experts will be essential:

• Lawyer. Generally, prior to starting due diligence you will provide the seller with a Letter of Intent (LOI). This letter states your interest in acquiring the business, roughly outlines the terms of the deal you have in mind, spells out your desired due diligence process and timeline, and often includes a confidentiality agreement to put the seller’s mind at ease. It is usually wise to have a legal professional draft the LOI for you. A lawyer can also help you make sense of the legal matters of the business you are acquiring, and draft the final offer if and when you are ready to make it.
• Accountant. One of the most important aspects of due diligence is a careful analysis the of the financial statements of the business you plan to acquire. Unless you are trained in this area, it is advisable to have the assistance of a qualified accountant. The more complex the finances of the business, the more risk there is of missing an important detail that might not be obvious to the untrained eye.
• Business broker. A business broker may not be as essential as a lawyer or an accountant, but an experienced one can bring a valuable perspective to the table. They have seen many businesses bought and sold over the years and this can give them a good sense for which types of businesses work and which ones don’t. They can compare the characteristics of a given business against similar businesses, and have a good instinct for its valuation and future prospects.
• Industry specialists. Depending on the type of business you want to buy, there may be professionals who can provide specialized insight. For example, an IT professional who can assess technology, a consultant who can study contaminants and hazardous materials, or an engineer who can analyze physical property or machinery for you. 

Capitalization analysis of the company 

The capitalization of a business refers to how much the business is worth. A higher capitalization means a higher valuation of the business. In general, more valuable businesses tend to be more stable, with more diverse customer bases and stronger reputations. On the other hand, a very small business might be dependent on just one key supplier or only a handful of customers — making it more volatile.

Capitalization can also refer to how a company is financed. For example, if you were interested in acquiring a business that owned valuable equipment, that equipment would be considered an asset. If a loan was used to acquire the equipment, it would be considered a liability. The value of the equipment minus the outstanding loan represents the equity in the equipment, and that amount would be added to the total value of the business.

Reviewing revenue, profit, and margin trends

Revenue is the amount of money that comes in every month, quarter, and year. Profit is the amount that is left over after paying all expenses, including the owner’s salary. Dividing the profit by the revenue produces a percentage known as the profit margin.

All three of these numbers are important. If revenue grows but profit does not grow with it, that could be a sign that something is wrong. You are potentially working harder for less money. If revenue and profit grow, but profit margin shrinks, again, the business is becoming less efficient at making money.

Taking a snapshot of these three numbers is usually not sufficient, because any business can have a particularly good or bad month, or even quarter. When conducting due diligence, you want to track these numbers over the longest period of time possible to capture a clearer picture and spot a trend. 

Review of competitors

Researching your competition is an important step in predicting the future success of a business. The more direct competition you have, the more pressure there will be to compete on price (which reduces revenue) or provide more value to the customer (which increases expenses). Both of these actions can hurt profit margins.

During due diligence, it is wise to compare the profit margins of the business to its competitors, if possible. It is also good to understand any competitive advantages that make the company a leader among its peers, and whether the overall industry is growing or not. A growing industry can accommodate more competitors, but there will be casualties due to competition in a stagnant or shrinking industry.

Valuations

Company valuations are always a mix of art and science. Although you can analyze the financial performance of a company and get a quantitative measure of its profitability, there are always going to be qualitative elements at play that are harder to measure. 

Like the stock market and the real estate market, the market for private businesses is influenced by trends, future expectations, and how they compare to other businesses. For example, shoe repair companies with decades of proven revenue may not trade at the same valuations as artificial intelligence companies that have little or no revenue, but limitless potential.

As the buyer of a business, you need to look at revenue, expenses, profits, assets, liabilities, and the business’s overall potential to arrive at a valuation that you believe is reasonable and will meet your objectives.

P/E ratio inspection

The ratio of a share price to earnings per share (P/E) is one of the most widely-used stock market metrics. For example, over the past century, stocks in the S&P 500 have traded at prices roughly between 5 and 40 times their earnings per share. Stocks with the most attention or highest growth prospects tend to attract the highest earnings multiples.

Although a private business does not have shares that trade on a stock exchange, you can still use a similar approach while conducting due diligence. In fact, the valuation of a business is often described as the net income or earnings times a certain multiple. It can help to look at other business transactions in your industry to benchmark the multiples that are typical, and then to adjust based on the unique attributes and growth prospects of the business you are evaluating.

Long and short-term risks

Every business faces long and short-term risks. For example:

• In the short term, some external economic factor could cause an input cost to rise and squeeze your profit margins. Or a key employee could resign. Or a licensing or regulatory issue could delay your expansion plans.
• In the long term, demographic trends could negatively impact your customer base. Or updates in technology could render some current offering of your business obsolete. Or rising competition could put pressure on your profit margins.

While many risks are unavoidable, being aware of them is the first step toward preparing contingency plans. In addition, if you know that a business will require capital investment in order to head off future risks, that can be helpful in negotiating the price of acquiring it.

Assessing purchase terms

Your findings from the due diligence period may influence the purchase terms. For example, you could make an offer to purchase that is contingent on the seller making certain representations and warranties. These might include ensuring any tax liabilities are paid, that all equipment and assets are in good working order, or that all existing contracts and agreements will be assigned to you.

What are the types of due diligence

Here are three of the main types of due diligence:

• Commercial due diligence. This involves how the company makes money. It looks at the business model, market share, economy, industry, competitors, customers, and its risks and opportunities.
• Financial due diligence. This involves analyzing the company’s financial records. It looks at financial statements, trial balances, financial forecasts, tax returns, bank statements, budgets, operating expenses, and other financial data.
• Legal due diligence. This involves reviewing the legal issues that affect the business. It looks at past or present litigation, contracts, agreements, leases, licenses, permits, patents or other intellectual property, corporate documents, and more.  

Hard vs soft due diligence

Effective due diligence looks at both quantitative (or hard) factors as well as qualitative (or soft) ones. Here’s a summary:

• Hard due diligence is based on numbers and data. It involves studying income statements, balance sheets, and other financial documents. Accountants will often express their findings in the form of ratios, such as the ratio of debt to equity, or the ratio of a company’s valuation to earnings. Hard due diligence is essential, but it often can’t capture the context surrounding the numbers. This is why soft due diligence must also be part of the process.
• Soft due diligence is based on people and behaviour. It involves studying the management team, the staff, partners and suppliers, and the customer base. This allows you to understand issues like the company’s vision, employee satisfaction, the strength of key relationships, and the loyalty of its customers. When business acquisitions fail, it is often because these human factors were ignored.