Due Diligence: What is It?

Sometimes when thinking about business concepts, it’s helpful to think about consumer concepts.  Due diligence – a term you’ll start to hear a lot when buying or selling a company- is a great example.

Why do car buyers use CARFAX?

CARFAX describes its business as a service that supplies vehicle history reports on used cars and light trucks. As the firm’s website states: “Every CARFAX Report contains information that can impact a customer’s decision about a used vehicle.” The car buyer gets reliable information about the vehicle’s maintenance history, car accidents, and odometer readings. This data helps the car seller get a fair price for their car, and the buyer pays the price based on the vehicle’s actual value.

These same principles can be applied to a potential business sale. The buyer wants to ensure that the price paid for a business is based on accurate information. On the other hand, the seller wants to receive a fair value for the business sale. Both sides get what they want through a process called due diligence.

Due diligence is defined as an investigation of a company to determine all of the material facts regarding a sale. It involves digging into the details of a company’s financial statements, customer agreements, and other issues. The phrase “material” refers to information that would influence a buyer’s opinion, and this phrase is used in accounting. The information must be significant enough to change someone’s mind.

An auditor, for example, provides an opinion as to whether or not the financial statements are materially correct. The audit opinion does not state that every account balance is accurate down to the penny. Instead, the auditor provides an opinion using materiality.

Timing of Due Diligence

The due diligence process occurs after a buyer provides a letter of intent (LOI) to the seller. Completing due diligence is a condition that must be met before the sale can be closed.

Preparing for Due Diligence

A seller can make the due diligence process much easier by preparing for the process far in advance. The seller needs to ensure that all accounts, particularly the cash account balances, are reconciled promptly. The financial statements should be generated each month and backed up using an easy method to access. Customer agreements, vendor contracts, and employee agreements should be carefully documented. All of this advanced work will speed up the due diligence process.

An example

Assume, for example, that Extreme Sporting Goods manufactures baseball and football equipment. Consider these critical factors in the due diligence process to sell Extreme Sporting Goods.

Financial statements

All businesses should use the accrual method of accounting, which requires revenue to be matched with the expenses incurred to generate that revenue. On the other hand, the cash basis posts revenue only when cash is received and records expenses when they are paid. Using the cash basis distorts the financial results and should not be used. A buyer wants to see accrual basis accounting.

The seller should create an annual budget and analyze variances from that budget each month or quarter. A variance is defined as the difference between budgeted and actual results, and reviewing variances helps a manager make changes to improve business results.

Finally, every business should plan for capital expenditures, significant purchases that need to be made in the coming months and years. If, for example, Extreme Sporting Goods must replace a $200,000 piece of equipment in two years, the firm needs a plan to either accumulate cash or take out a loan for the purchase.

These financial practices allow an owner to make informed business decisions, and a well-managed company is more valuable to a buyer.

Customer and vendor agreements

Many firms enter into formal agreements with vendors that sell the business many products. Extreme Sporting Goods, for example, has a contract with a company that supplies leather for the firm’s baseball gloves. Since Extreme must have a reliable supplier, the manufacturer enters into a written agreement for the amount of leather supplied and the cost. Some companies also have agreements with large customers, indicating the sale price charged. A firm may also have employment agreements with key employees.

A potential buyer needs to see these important agreements in the due diligence process. If the agreement is non-transferable, the vendor or customer must approve that the agreement will stay in place with the new owner after the sale. The buyer needs to review employment agreements and determine if a particular employee should receive additional incentives to remain with the firm.

Contingencies

The most challenging topic to address in a business sale is uncertainty. Every company has contingencies or situations in which the outcome is unknown. A company may have several types of contingencies:

• Legal: A legal dispute is posted to the accounting records only if the contingency is probable and the dollar amount can be reasonably estimated. If both of these conditions are not met, the contingent liability may be included in a footnote to the financial statements or not mentioned at all. The discussions between the buyer and seller need to move beyond the accounting definition of contingent liability. Specifically, a buyer needs to understand the types of litigation risks the business faces each year.
• Succession plan, key employees: When a buyer purchases a firm, that purchaser is relying on the ability of senior management to continue doing what they are doing. Senior management has the customer relationships and expertise to generate sales and profits. If senior management leaves the firm for some reason, the business results can suffer. A buyer needs to know if senior managers have been given financial incentives to stay and whether the firm has a succession plan to replace managers who leave.

Two points of view

Due diligence is the one opportunity for a buyer to get a clear and detailed picture of how the business works and its long-term profits. On the other hand, a seller needs to realize that buyers are looking for potential problems that impact the business. Sellers need to invest the time and effort to address potential problems before the due diligence process starts.

An effective due diligence process will help a sale close sooner, and both sides can negotiate a reasonable sale price.