BY NOT INVESTING SUFFICIENT TIME AND RESOURCES IN DUE DILIGENCE, MANY PROSPECTIVE BUSINESS BUYERS MAKE THE MOST EXPENSIVE MISTAKE OF THEIR LIVES!
What is due diligence?
Due diligence is the responsibility you have, as an ordinarily prudent and reasonable investor, to investigate and identify issues – in the context of a business acquisition, this responsibility is to yourself, to your business partners, to your company’s shareholders or to anyone that may be affected by the decision to a acquire a business.
Due diligence is probably the most critical stage in the buying process. Many prospective buyers incorrectly identify this period as strictly a financial review, but it is far more than that – it is a complete investigation and review of a business from a variety of specialist perspectives (financial, tax, legal, labour, etc.).
What is the due diligence process?
The due diligence investigation process should begin the moment a business becomes of interest to you. By taking a prudent, inquisitive outlook from the start, you’ll be in a better position to be able to ask the proper questions of the seller throughout the business acquisition process. Once you progress to the stage of an accepted offer, you should then commence the detailed due diligence investigations.
To conduct financial, legal, tax and labour due diligence the potential investor will generally use in-house resources, or hire a consulting firm that specializes in due diligence and corporate investigations, to investigate the background and situation of the target business. This investigation normally involves full access to the company’s books, records and files, and detailed conversations with its management and advisors.
The investigative results are presented in a ‘due diligence report’ that the investor uses to understand risks involved in the investment, to identify potential upsides and downsides, and to understand the business’s solvency and assets.
What will a due diligence report really give me?
Due diligence is the way to discover potentially crucial information about a business before you buy. Once you close the deal it will be too late!
You may feel confident in being able to conduct proper due diligence yourself, you may have even bought businesses before. You should bear in mind, however, that every seller knows things that he does not want you to discover – how confident do you really feel in conducting a full due diligence investigation on the business you are considering buying?
A due diligence report will provide you with crucial information with which to assist your decision. This will typically include a ‘Quality of Earnings’ analysis, whereby the results of the business as reported by management are adjusted for certain items to produce a fairer reflection of the true profitability of the business. Such adjustments may be of an accounting nature (e.g. revenue being incorrectly recognized) or of a business nature (e.g. to adjust for one-off items). This ‘Quality of Earnings’ analysis is generally the buyer’s best tool in negotiating a better price.
Whether or not you decide to use professional assistance, there are some important factors you should bear in mind with respect to due diligence at the start of negotiations with the seller:
1. Thanks Give the seller a complete information request list, allowing plenty of time for its preparation
Time will be limited, especially once you have made a preliminary offer to the seller. Make sure you allow plenty of time for the preparation of financial, tax, legal and other information. Make it easier for the seller, and ultimately better for you, by putting an information request list together in language, i.e. both in Spanish and in words he will understand. Do this well in advance! No matter what you’re told, do not begin the process until they have everything ready for you.
2. Do not be pressurised into making a decision based on unsatisfactory information
Many sellers, and almost all business brokers representing the seller, will press for a sale, and will cheerily tell you that you can have full access to financial and other information. In reality, however, the quality of information that is provided is often well below what you asked for and expected to be given. Do not allow yourself to be bullied into accepting poor information if you believe that better information can be readily produced. Financial information is often not geared towards giving an outsider a good understanding of the business and, crucially, of its profitability. Give yourself ample time to review all information and to complete this part of the process.
3. Accept that things will not always go as you expect
The due diligence process rarely runs smoothly. Expect a bumpy ride, especially if you are dealing with an owner-managed business (these are extremely common in Spain). There will be misunderstandings. More often than not, these misunderstandings are not in bad faith, but simply that you will have a different way of doing things than the seller. Get clarification and build your case. Very few problems cannot be overcome, but if you do find a major problem, make sure you understand it fully before making a decision or confronting the seller.