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10 Areas of Focus When Preparing for Due Diligence

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Adams Price

  • September 20, 2022
  • Perspectives

Buyers and investors are increasingly granular in their approach to due diligence. What was once a process of turning over stones to ensure the business is what it is purported to be, has now become a process of continuously turning over grains of sand right up to the point of transaction close. It is time-consuming and often taxes the organization’s senior leadership, which is ultimately tasked with keeping the business performing at the high levels that make it attractive. At the same time, the nature of the transaction itself requires the principals to respond to information requests prudently, thoroughly, and quickly. Time can kill deals, and response delays can harm the outcome. Preparation in advance can make the process smoother, more responsive, and less taxing on the senior executives. Ultimately, this can pay large dividends in terms of a successful and less-stressful transaction process.

  1. Quality of Earnings Review (QofE)

    It is likely that a buyer will perform a QofE on the target business as part of its due diligence and will rely on the results for finalizing enterprise value. The QofE drills into components that contribute to EBITDA, seeking any revenues or expenses that cannot be counted on in future periods, as well as variances to GAAP accounting (such as revenue recognition, inventory management, etc.) that could result in a material difference in EBITDA performance. The findings could result in an enterprise value adjustment after the LOI, which often jeopardizes the entire transaction. A business that has a QofE performed prior to going to market will be able to understand what a buyer will find and how the buyer will likely perceive the potential impact on value. The process also prepares executives for what will be requested in a QofE.

  2. Legal

    Businesses should maintain a complete inventory of company contracts with vendors, employees, customers/clients, contractors, etc. It is critical to keep track of any contractual commitments that might be triggered by a major liquidity event (such as change of control restrictions, rights of first refusal on a sale, employee bonuses/equity events, and the like).

  3. Key Metrics

    Businesses must demonstrate a thorough understanding of where the business is today, backed up by operational and financial data. In addition, the business needs to demonstrate a thorough understanding of where the company is going, as measured by a consistent process of optimizing the backlog of existing contracts, the pipeline for new business, and the financial projections of future growth. Investors will expect to dive deep into this data to understand the business’ prospects as well as the management team’s understanding of future prospects for the company.

  4. Taxes

    Businesses must meticulously maintain a database of all tax filings, including federal, state, and local revenue department correspondence. Investors expect to see a full accounting of the company’s tax history. In addition, the investors will focus on state and local taxes (SALT) and any nexus issues that may exist as a result of doing business in various states. The challenge of SALT issues during a transaction is that they are hard to quantify, which means the risk burden falls on the seller and can be onerous. It is better to have a clear picture of all the tax history for the business to avoid such complications in a transaction.

  5. Employment and Benefits

    Investors dig deep into the organizational structure and legal/financial commitments to employees and contractors. It is important to have a full census of the employees and contractors, as well as ensure agreements are in place with each. The employee handbook should be up-to-date and understood by employees. Businesses should have a thorough understanding of any collective bargaining obligations (unions) and an inventory of the employee benefits, with particular attention to retirement and pension plan obligations. If a multi-employer pension plan is in place, it will be important to know the state of other employers in the plan and what a buyout obligation might be if such a decision is taken as part of a liquidity event.

  6. Working Capital

    Investors typically expect to retain a minimum working capital in the business to continue operations post-transaction, which can be a subject of intense negotiation. A business can be prepared for these inquiries by performing an 18-month working capital analysis to understand fluctuations over time and what caused the fluctuations (the QofE often provides this initial analysis). If the business has material inventories, they need to be able to demonstrate the results of periodic cycle and physical counts. Investors may want to discuss in detail slow-moving inventory versus obsolete inventory and the defining difference. In addition, investors will want to walk through accounts receivable, collection processes, and bad debt write-offs, where applicable.

  7. Facilities

    Businesses should have a complete inventory of facility leases. If the facilities are owned by the company or the shareholders, it is important that the facilities’ rents are in line with market rates. If the rates are out of line, it could result in an EBITDA adjustment, which in turn impacts enterprise value. Depending on the type of operations at the facility, investors may call for environmental assessments; it can be beneficial to commission a phase 1 assessment before going to market to understand what might be found.

  8. Capital Expense and Plant & Equipment

    Investors will want to discuss past and future anticipated capital expenses in detail. That said, businesses should have a current inventory of capital equipment and plant investments, along with maintenance cycles and replacement plans. Future capital expenses directly impact future cash flows from the business, which in turn impact the current perceived value of the business. Understanding past and future capital expenditures make the buyer more comfortable regarding potentially unforeseen future cash outlays.

  9. Litigation

    Litigation happens, and investors typically understand that. However, they will expect full disclosure of all litigation and all the relevant information and filings for recent litigation (3 to 5 years), whether resolved or in process.

  10. Allocating Internal Support

    A consideration for due diligence that often gets less attention until a transaction starts is who from the business is part of the process. The fewer people from the business involved, the more burden on those who are. The more people are involved, the more people know about it, which can disrupt their day-to-day responsibilities and performance. It is a balance between a pragmatic approach to sharing the load and discretion that should be contemplated and decided well in advance of starting on the journey to a liquidity event.

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