Due diligence, or sometimes referred to simply a ‘DD’, is often integral to a transaction or funding round, but what does it actually entail? And how can you make sure the process is a smooth one that covers all the key issues for everyone involved?
If you are looking to secure funding from, for example, your bank or a private equity house, DD will generally be instructed by the lender as part of the assessment process to establish whether your business can service the new lending, minimising their risk and providing them with a greater degree of comfort in your business relationship.
When it comes to an acquisition scenario, there are a number of reasons that DD may be required. Fundamentally, if you are the purchaser, you will want to investigate every aspect of your proposed investment, to allow you to determine whether you are going to proceed with the transaction. Due diligence can also help in renegotiating the terms of a deal, such as an amendment to the headline price or something more subtle, such as the identification of a revised post-transaction working capital requirement.
What does due diligence cover?
DD is not limited to running the rule over financial information; there are many areas where a prospective purchaser or funder might want to take a closer look, such as, depending on the business in question, legal, commercial, environmental and technical DD.
Financial due diligence (“FDD”) covers a broad range of analysis and will often centre on gaining an understanding of a business’ underlying EBITDA (earnings before interest, tax, depreciation and amortisation). This is a key indicator of how cash generative a business is, which is vital in assessing the likely returns for an investor, or indeed the debt serviceability for a funder.
FDD is also likely to incorporate a review of recent balance sheets, as well as both historic and projected financial performance; this is often in the context of the relevant sector, and/or the business’ interaction with key stakeholders, particularly if they are subject to contractual arrangements with customers and suppliers.
Often overlooked, a review of taxation affairs can provide a valuable insight to issues which may not have been given due consideration. In addition to ensuring ongoing compliance with HM Revenue and Customs’ requirements, a more detailed review may include PAYE, National Insurance and VAT, as well as more complex issue specific to the business in question; for example IR35 considerations or the impact of overseas trading. Alternatively, in the case of an acquisition, a potential purchaser may look to minimise exposure by the inclusion of a robust tax indemnity in the Sale and Purchase Agreement.
Ultimately, the purpose of financial due diligence is to maximise the likelihood of surprises, post-acquisition.
A targeted approach
It is important that the key concerns of the addressee are understood at an early stage to allow a bespoke report to be compiled covering all the key information. The ‘one-size-fits-all’ process-driven approach taken by some DD providers is best avoided.
Consider involving key personnel, for example, a member of the funder’s credit committee, early on in the process and even in scoping the assignment. It is better to be clear at the outset on all the areas to be addressed than to discover once the report has been completed there are still areas of concerns. Not only will this approach lead to a more focused scope which concentrates on the key financials, it will ultimately produce a concise report to support the funding application or transaction.
Any FDD process and its outcome depends entirely on the extent, and indeed the quality, of the information that is made available to the provider. If there are concerns in this area, make sure that all parties are aware of these limitations, and the implications, early on in the process. In the context of the cost of rectifying an unpleasant surprise post-acquisition, financial due diligence is an investment well worthwhile.View all insights