Due Diligence Is an Essential Element of a Successful Acquisition

Due diligence is an essential element of a successful Acquisition

When purchasing a business the due diligence stage allows the buyer to assess the value of the business and to verify the information pertaining to the business in order to determine whether to proceed with the purchase. The due diligence period also permits the buyer to determine if there are any barriers or risks associated with the transaction. Accordingly, the transaction is usually conditioned upon the due diligence stage being completed.

While there are many operational, legal, and financial components of due diligence, some less talked about ones are the seller’s due diligence of the buyer, and the buyer’s due diligence of the seller, including the reason for sale. Most M&A checklists cover financials – I cover those plus the human side that I learned from 35 years as CFO buying retail stores, including a fraud case that cost $104k.

Reasons for Sale: If It’s So Profitable, Why Sell?

Some M&A advisors claim the reason for sale is immaterial – my colleague recently saw a sale listing citing ‘their mother’s ailing health as a reason for sale.’ He quipped that the reason for sale didn’t need to be examined as much as that the business needed to be analyzed. Was the multiple justified? Was it a good fit for the buyer?

But just like anything else for sale, if the business is so good or profitable, why doesn’t the seller just keep it? Are they retiring? Could they gift it to a relative, if there is someone in their family who would be a good operator?

In my retail store fraud case, the reason for sale was “moving” – but the real reason was the store was losing money and mall rent was too high. Understanding true reason for sale would have saved me $49k plus inventory.

Good reasons for sale I see that are legitimate:

• Retirement with no family successor (best case – seller wants legacy)
• Partnership dispute (opportunity – but need forensic exam, see my forensic accounting exams page)
• Health issues (verify – is business still being run well during illness?)
• Serial entrepreneur who built to sell (check prior sales – did buyers succeed?)
• Need capital for larger business (seller keeping minority – good sign)

Bad reasons that are red flags:

• “Focusing on other business” – why not keep this cash cow?
• “Moving” – business should be sellable regardless of owner location if systems are good
• “Burned out” – often means business is declining and seller is exhausted from trying to fix it
• Won’t give reason – walk away

It may be good for a buyer to understand who the seller is. What is their background? Have they operated or sold other businesses successfully? What has happened with the other sales – were the new owners able to get a good deal? Is the seller a serial entrepreneur or can they not execute? Did the numbers add up? Did the financial projections/trends continue or was there some element of exaggeration or fraud? Some businesses are dependent on the seller’s special skill or knowledge. In the hands of a new buyer, they may not be as successful. Then the buyer has wasted his money.

Buyer’s Due Diligence of Seller: The Financial Checklist (CFO Level)

Beyond reason for sale, here is the financial due diligence I do for $1M-$100M acquisitions as fractional CFO:

1. Quality of Earnings (QOE) – Not Just P&L
Don’t accept seller’s P&L. I rebuild EBITDA:

• Add-backs: Is owner’s $200k Tesla lease, family payroll, personal travel really “one-time”?
• Revenue: POS vs bank vs sales tax vs P&L – do they tie? (This caught the $300k revenue fraud that was actually $72k)
• Customer concentration: Is 40% of revenue from one customer who may leave?
• Deferred revenue, AR collectability, inventory obsolescence

2. Working Capital Peg
Most purchase agreements have working capital target. Seller will try to drain AR and inventory before close. I set average 12-month working capital peg and test it 3 days before close.

3. Debt and Debt-like Items
Seller says “debt-free” but has $200k of customer deposits, $150k of accrued PTO, $300k of deferred rent, and PPP loan forgiveness that hasn’t been approved. All of that is debt-like and should reduce price.

4. CapEx and Maintenance
Is equipment fully depreciated but needs $500k replacement next year? Seller hasn’t invested, so EBITDA is overstated.

5. Lease and Contracts
Does lease allow assignment? Does it have percentage rent based on sales reports? (Landlord sales reports are your fraud check). Are customer contracts assignable or do they terminate on change of control?

6. Tax – Federal, State, Sales
Is business filing sales tax? I pull BOE filings to verify revenue. Is S-corp election valid? Are there 409A issues if they issued stock options cheaply?

7. Background Checks
Pull seller’s background, prior business failures, criminal records. In my fraud case, both seller and broker had criminal records – we found after, should have found before.

Seller’s Due Diligence of Buyer: When Seller Financing or Stock Is Involved

Typically these type of searches are performed by the buyer, but in certain circumstances, the seller will also conduct searches and other diligence on the buyer. For instance, if there will be seller financing or the seller will be receiving shares as part of the purchase price the seller may wish to conduct their own due diligence. Whatever consideration isn’t received at closing is worth less – like the old saying a bird in the hand is worth two in the bush.

If you are a seller taking a $500k seller note over 3 years, you ARE a lender. You need to underwrite buyer:

• Credit check, background check
• Proof of funds for down payment
• Business plan – how will buyer run business better than you?
• Collateral for note – is note secured by business assets?
• Personal guarantee from buyer

If seller is taking stock in buyer’s company as consideration, seller needs to do full due diligence on buyer’s company – valuation, cap table, burn rate, 409A. I’ve seen sellers take worthless stock in buyer’s startup that later failed.

How Due Diligence Changes the Purchase Agreement

This stage also provides the buyer with information to assist with the negotiation of the main agreement. The results of the due diligence may cause the buyer to request that specific representations and warranties be set out in the definitive agreement, that certain additional indemnities be given by the seller, or even that the purchase price be adjusted.

What I ask for after due diligence:

Reps & Warranties:

• “Financial statements are true and complete in accordance with GAAP”
• “No material adverse change since “[date]
• “Sales tax returns match P&L”
• “No undisclosed liabilities”

Indemnities:

• Seller indemnifies buyer for sales tax audit for pre-close periods
• Broker indemnity does NOT cover fraud – per California Civil Code 1668, you cannot contract away fraud

Price Adjustment:

• Working capital adjustment at 90 days post-close
• Earnout if seller’s projections are aggressive – “You say $500k profit, I’ll pay you based on actual profit next year”
• Holdback: 10-15% of price held in escrow for 12 months for reps breach

If you are purchasing a property or a business, it is critical to ensure that the due diligence associated with the purchase is conducted in a complete and thorough manner. The due diligence stage, if conducted properly, should provide the buyer with a complete understanding of what he or she is buying and an analysis of any risks associated with what is being purchased, so that the transaction may be completed without any unpleasant surprises.

As a CFO who has done due diligence on both sides, I offer a flat-fee due diligence review for acquisitions $500k-$50M: QOE, working capital peg, and purchase agreement reps review. Contact at hpaccounting.com – based in Fremont, serving Bay Area.