What is Business Due Diligence
Business due diligence will be carried out by investors or purchasers when your high growth small business is seeking new capital from investors, or you are considering selling your business outright (i.e. trade sale). Preparing for business due diligence is another core element of getting your business investment ready.
Business due diligence is typically undertaken after the investor/buyer and seller have agreed in principal to a deal (usually documented in a Term Sheet) but prior to drafting and executing a binding contract.
Investors/buyers will be influenced by the quality of the documentation and other material provided during business due diligence. To ensure you get the best deal, all the information provided during business due diligence must be thorough and accurately reflect the state of your business. This blog post will explain how you can prepare for business due diligence and help you understand the process from the investor/buyer perspective.
Business due diligence is a bit like an audit of your business and its future prospects. It is used an investor/buyer to manage their investment risk as they seek to understand all they can about your business including its:
- customers and markets
- inventory and suppliers
- people and process
- contracts, licences, registrations and agreements
- business and financial performance.
The aim of business due diligence is to provide the provide the investor/buyer with the information they require to make an informed investment decision about your business. Most investors/purchasers will require due diligence to be performed before they enter into final negotiations with your business.
Gathering & Preparing the Documents Needed for Business Due Diligence
Preparing for business due diligence requires gathering a wide variety of commercially sensitive documents that reveal everything about your business. The documents include income statements, cash flow statements, balance sheets, business plans, budget reports, material contracts and financing agreements. If you already have other investors involved in your business, a new investor will expect to receive a statement of changes in equity.
An investor/purchaser will also request documents relating to your intellectual property, including patents and trademarks. They will want to see minutes of Board and Shareholder meetings and correspondence with existing business partners and tax and legal advisors. The type of documents that your business may need to provide are identified in the due diligence stages outlined below. In some instances, the investor/buyer will provide a list of the documents and information they require.
It often helps to use a document management system to keep track of the information gathered. This can reduce the time it takes to collate the documents and makes it easier for a potential investor/buyer to access and review them. Smaller business can simply place copies of relevant documents into indexed files. Larger and more complex business often choose to utilise an online or virtual data room to facilitate remote access to authorised buyer/investor representatives.
The 4 Stages of Business Due Diligence
The investor/buyer process of business due diligence can be divided into four stages.
Screening is early stage business due diligence performed by investors/purchasers. Often it takes the form of a management presentation and high-level information pack given individually to shortlisted investors/purchasers. This will often highlight issues the investor/purchaser may have with your business or deals that are not aligned with their investment strategy or approval criteria.
2. Commercial Due Diligence
The next stage of due diligence is a more detailed exploration of the business. It involves an in-depth analysis of your business model, position in the market, market potential, products/services, management team and business risks.
Some of the questions posed during commercial due diligence are like the ones asked during screening. The key difference is they must be answered in far greater detail. The seller will also have to provide the potential investor/purchaser with certain documents relating to the business during this phase.
The goal of the investor is to understand the nature of your business, its products or services, the skills of managers and the viability of the business model. Questions likely to be asked during commercial due diligence will relate to:
Management team and key employees
Investors/purchasers will seek information about your management team and other key staff, including employment agreements/contracts. They may seek assurances that key members of your team are happy to stay with the business for a set amount of time.
In a trade sale scenario, it may be that not all founders, management, and employees will be retained by the purchaser, so understanding termination/redundancy obligations and liabilities will be an objective.
Investors/purchasers want to see that your business participates in a vibrant industry and has a sound customer base with growth opportunities. You can demonstrate this by documenting your Marketing Plan for the next 3-5 years.
If you are unsure about what to include in your Marketing Plan refer to the Marketing Plan Template and Guide provided by the Department of Industry, Innovation & Science.
Viability of the product/service and competitive advantage
An investor/purchaser will expect your business to demonstrate how its products or services deliver value to the consumer. In addition, your business will have to demonstrate competitive advantage. Some questions to consider when assessing the competitive advantage of your business include:
- What problem does your product/service solve?
- How does your product/service create value for your customers?
- How does your product or service differ from those offered by your competitors?
- What barriers to entry exist that make your product/service harder for competitors to replicate?
Business model risks
Showing how your business plans to maintain or increase profitability is an important part of the due diligence process. You must show investors/purchasers the components of the business that are essential for remaining profitable in the market. Identifying the key drivers of your business’s profitability and how you manage associated risks will likely lead to greater investor/purchaser confidence and possibly a higher valuation of your business.
An investor/purchaser will want to understand:
- The most profitable product/service lines
- The level of working capital required to meet forecast sales
- New plant and equipment necessary to meet forecast sales
- The reasons behind and your plans for under-performing product/service lines
- Industry outlook, risk of disruptive technology and strategies for managing industry and market risk.
Investors/purchasers will want to analyse your customer mix and profile. This includes your customer concentration, which is how total revenue is distributed amongst your customer base including geographic/demographic information.
Key suppliers and associated terms and conditions
Investors/purchasers will be interested in learning more about your key suppliers, including any associated terms and conditions, to assess the stability of trading relationships and risks on non-supply.
Finally, the investor/purchaser will look at your overall business to determine if it is a good strategic match with their investment criteria. They will consider how your business fits in with their other investments, their view of your industry/market niche, and their ability to implement changes they see as important to the future profitability of the business.
3. Financial Due Diligence
Financial due diligence is typically performed in conjunction with commercial due diligence. It involves an in-depth review of your business’s historical financial and taxation information to identify trends and risks. It will usually include the following aspects:
Historical financial information and accounting policies
Your business will have to share financial information dating back at least three years. This will include your business’s balance sheets, budget vs actual detailed income statements, and statements of cash flows. The accounting policies used in the preparation of all historical financial information will also need to be disclosed.
Identify unusual or non-recurring transactions
One of the most important aspects of financial due diligence is identifying any unusual or one-off transactions. This could be the profit/loss on the disposal or closure of a non-core segment or loss on the fire sale of a discontinued line of inventory. Your aim is to present the historical financial results of your business in its current or ongoing form. The investor/purchaser may also adjust your historical financial information to better reflect their view of the best way to manage your business. The objective of such adjustments and add-backs is to determine the likely future maintainable earnings of your business.
Analysis of historical results versus approved budget
As alluded to previously, investors/purchasers will seek to validate your forecasts by looking historically at actual versus budget incomes and expenses. A history of meeting or beating budgets may add credibility to your forecasts/projections.
Review correspondence with tax accountant/advisors and auditors
Potential investors/purchasers want assurances that your taxation obligations are in order. They do this by reviewing emails, letters, and other correspondence with your tax accountant/advisors and auditors (where applicable).
Review tax forms/returns and correspondence with tax authorities
Any correspondence between your business and the Australian Taxation Office or overseas tax authorities (where applicable) will be requested, including all submissions made on your behalf by your tax accountant/advisor.
Review year to date actuals against approved budget
Investors/purchasers will want to review the most recent financial performance of your business. You can provide year to date results and a full year forecast versus approved budget.
Review financial projections
The potential profitability of your business over the next 3 to 5 years is important information for investors/purchasers. They will ask for financial projections, with details of their underlying assumptions, to evaluate the future earnings potential of your business.
Review accounting systems and internal control environment
Not only will investors/purchasers look at the financial results of your business, they will also consider the suitability of your accounting systems and procedures that generated the financial reports. Fit for purpose accounting systems with a sound internal control environment will add to the reliance they can place on the historical financial information provided.
Working capital analysis
Working capital is a measure of operational efficiency and the short-term liquidity of your business. It is the difference between current assets (like cash inventory and accounts receivable) and current liabilities (like accounts payable and income taxes/GST payable). When added to fixed assets (like property, plant and equipment), it reveals the operating capital of your business. Investors/purchasers will analyse carrying values of working capital by reviewing aged debtors reports and inventory turnover reports and ensuring completeness of all supplier, tax and employee liabilities.
Property, plant and equipment
Verification of title and possession of property, plant and equipment is another key objective of financial due diligence. Ensure your asset listing or fixed asset register is up to date and reconciles to the fixed asset accounts in your balance sheet. Expect to be asked to prove ownership and possession of significant items of property, plant and equipment.
Identify related party transactions
Related party transactions are business deals, payments and other arrangements between two parties with a pre-existing special relationship. For example, loans and payments made on behalf of directors or shareholders are related party transactions. Trading between businesses that have directors or shareholders in common are also related party transactions. Investors/purchasers will look for such transactions and determine if they are on usual trading terms and conditions or “arm’s length”. If not, profit adjustments or add-backs may made to the historical and forecast/projected trading results of your business which may adversely impact the purchase price.
Identify material unrecorded and/or contingent liabilities
A contingent liability is a potential liability that may occur depending on the outcome of an uncertain future event. For example, your business may be currently battling a lawsuit which will result in a liability should you lose. Material unrecorded liabilities are payment obligations that have arisen because of past events but are yet to be paid nor recorded as a liability in the balance sheet of the business.
To determine if any unrecorded or contingent liabilities exist, investors/purchasers will request you disclose any that you are aware of, review correspondence with legal/tax advisors, investigate any significant recent payments and review the minutes of Board meetings.
Assess employee liabilities
Employee related liabilities can be significant in businesses with high levels of staff. Investors/purchasers will review payroll records to verify employee liabilities such as unpaid or short paid salaries and wages, annual and long service leave entitlements, unpaid superannuation, and unpaid employee tax withholdings.
Review insurance policies and claims history
The interactions between your business and its brokers or insurers, including workers compensation insurance, will be of interest to investors/purchasers. They will review all correspondence with your broker or insurers, especially your claims history, to ensure that your business remains in good standing with insurers and that cover hasn’t been refused.
Review debt facility agreements
You will be required to provide copies of all loan and financing agreements for review during the financial due diligence. This includes all credit cards, bank overdrafts, bank loans, factoring facilities, and other lines of short and long-term credit including hire purchase and leases.
4. Legal Due Diligence
Legal due diligence is typically undertaken by the investor’s/purchaser’s lawyer with the aim of collecting, understanding and assessing all the legal risks associated with the investment in or outright purchase of your business.
Legal due diligence interacts with commercial and financial due diligence and completes the process of identifying and assessing the risks of the proposed transaction, allowing the purchaser/investor to make an informed decision about whether to proceed.
Objectives of legal due diligence include:
Identify all business risks
All risks facing the business are identified through review of all material contracts of the business and correspondence with your legal advisors. Notable business risks include pending and potential lawsuits, patent disputes, warranty obligations, claims under trading agreements, workers compensation claims and disputes with lenders and suppliers.
Identify deal breakers
Legal due diligence may identify issues which could dramatically affect the agreement through renegotiation of the purchase price or even cause the investor/purchaser to withdraw from the proposed transaction.
Finalise preferred transaction structure
A purchaser in a trade sale scenario may choose to structure the deal as an asset purchase rather than a share purchase to mitigate the risks associated with potential unrecorded vendor liabilities.
Prepare for drafting or amending the Sale & Purchase of Business Agreement
Risks identified can often be managed through inserting additional vendor representations and warranties in the business Sale & Purchase agreement.
The process of legal due diligence includes the following:
- Review of outcomes of Commercial and Financial due diligence
- In-depth research the regulatory environment effecting your business
- Review material contracts
- Discussions with your legal advisors regarding any pending, threatened or settled litigation and legal claims
- Assessing the validity of patents, trademarks and other forms of IP protection
- Assessing validity of licences and approvals
- Consideration of compliance with competition regulations
- Compliance with employment regulations and contracts
- Review compliance with Corporations Act and other general corporate matters
- Review minutes of Directors and Shareholders meetings
- Identification of potential environmental issues and compliance with environmental laws
- Identification of any workplace health and safety issues
- Review compliance with Privacy laws
- Validate the ownership of business and domain names
- Identify issues that impact the value of your business and/or future operations
- Identify minimum necessary vendor representations and warranties
- Identify minimum vendor conditions precedent for settlement.
When to Start Preparing for Business Due Diligence
The extent of investor/purchaser due diligence will depend on many factors including the size and complexity of your business, investor/purchaser budget and appetite for risk, valuation/purchase price, industry/market and the risk profile of your business. Generally, the greater the value of the proposed transaction the greater the level of investor/buyer business due diligence.
A well-managed and administered business (one with a good filing system) will find preparation relatively easy, although time consuming when juggling simultaneously with the ongoing demands of your business.
Being prepared for business due diligence will make the process more efficient and may even reduce the risk of adverse purchase price adjustments from prospective investors/purchasers. Most importantly it will reduce the burden on the business founder/manager once business due diligence begins.
It is recommended that you start preparing for business due diligence when you first consider strategies for seeking investors or purchasers of your business. Due to the complexity of selling some or all of your business it’s best to engage experienced professionals to guide you through the process to ensure your overall strategy and conduct maximises the value of your business.