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What is Due Diligence in a Business Acquisition?

Jonah Pollone

If you’re curious about the definition of due diligence and why it’s relevant in the acquisition of a business, you’re in the right place.

A common question that often comes up when I’m talking to new buyers and sellers of businesses is, “what does due diligence mean?”

In this post, I define due diligence when buying or selling a business and cover more, including: 

  1. Due diligence meaning
  2. How long does it take?
  3. How do you perform it?
  4. What happens when it expires?
  5. Is due diligence only financial?

This article is not intended to provide legal and/or tax advice. Every business transaction is unique, and buyers and sellers should always consult with the appropriate professionals (attorneys and accountants) when considering a business acquisition/sale.

Due diligence definition

Due diligence is simply the investigation of a potential investment. Typically, it starts after an offer is agreed to by both buyer and seller.

Its purpose is to confirm the accuracy of the information presented (usually by the seller).

Usually, what I see as the most important goal of the buyer is to confirm the cash flow being represented by the seller. The buyer wants to make sure the company has positive cash flows so they can pay their debt or equity obligations and make a good return on their investment.

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Due diligence can be performed by the buyer, the buyer’s attorney and accountant, and the lender involved. It’s important to keep in mind who is requesting information because that determines how to move a transaction forward.

Due diligence can also be performed by the seller to make sure the buyer has sufficient assets to complete a transaction. Doing this early in the process helps the seller mitigate confidentiality risk.

How long does it take?

Typically, the due diligence period lasts for 45-180 days, depending on the sophistication of the buyer and complexity of the deal.

With more complicated deals, it could last six to nine months. Brutal!

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A buyer and seller agreeing to an offer is a great sign of progress in a deal, but it usually means they’re only halfway to the day of closing.

For an individual buyer of a MidStreet-size ($1M-$25M in revenue) company, due diligence usually lasts 30-45 days.

NOTES

Individual buyers are typically high net worth individuals (HNWs) with a significant amount of cash (and/or total assets) to use in part with an SBA 7(A) loan.

For a private equity group or strategic buyer of a similarly sized business, it usually lasts longer; from 60 to 180 days.

How do you perform due diligence?

Due Diligence Process-1

 

Due diligence can be as simple as a “book check” of a business or as complicated as a full group of attorneys and consultants analyzing a company.

Typically, private equity or strategic buyers of businesses will perform a “Quality of Earnings” analysis.

NOTES

A Quality of Earnings analysis (also known as a “QoE”) is an analysis of the company performed by accounting and legal professionals on the financial, legal, and operational aspects of a business. It can be painful for buyer and seller.

Don’t send a premade due diligence checklist from the internet to the seller.

As a buyer, doing so is a huge mistake – trust me.

There’s nothing wrong with using a list off of the internet as a starting point, but every business is unique.

We always recommend buyers sit down and think through what things you should research more for that particular business. You don’t want to overwhelm the seller with requests or lose their trust.

For example, when creating a due diligence list for a manufacturing company, learning about their real estate property tax history likely wouldn’t be nearly as important as learning more about how often they purchase new equipment.

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Prioritize due diligence requests in order of importance.

For MidStreet companies (businesses doing $1M-$25M in revenue), common due diligence items include:

  • Financial statements (3 years of P&Ls, 3 years of tax returns, and a recent balance sheet)
  • Incorporation documents from the target business
  • Furniture, Fixture, and Equipment list
  • UCC filings
  • Vehicle and/or trailer titles
  • Customer concentration information
  • Accounts Payable and Accounts Receivable Aging reports
  • Real estate leases
  • Condition of the assets
  • Customer contracts

After due diligence is completed, the buyer and seller will likely work together in training & consultation for at least a couple of months.

The buyer’s goal should be to ask them as few questions as possible that satisfy their comfortability with the acquisition.

Even though an item is on a list, that doesn’t mean you should ask the seller for it.

If the buyer cannot get comfortable with a transaction and don’t feel trusting of the seller, consider abandoning the deal.

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For individual buyers, remember, your professional advisors are not buying a business, you are. If you get to the point where you’re comfortable proceeding with the deal and start to feel like your attorneys are slowing down a transaction unnecessarily, you might have to assert your role in the transaction.

Remember, there may come a point where if you push too hard on the seller, you could blow up a deal. You could lose a great business by pushing too hard on something that isn’t actually too much of an issue.

What happens when due diligence expires?

The letter of intent (also known as the offer) typically includes a due diligence clause, which sets the terms for the parties involved, the buyer’s rights during the investigation, how long due diligence lasts, and what happens after it ends.

This is what’s known as the due diligence contingency. The investor can still withdraw from the contract if they are not happy with what they find from the investigation.

Once due diligence is over, the buyer has three options:

  • Continue forward and close the deal
  • Back out of the transaction
  • Re-Trade,” or renegotiate the purchase price

Can you negotiate during due diligence?

Re-Trading is the act of renegotiating the price of the business after initially agreeing to purchase at a higher price.

In my opinion, re-trading is only fair play if you find something that actually affects the value you originally offered on the business.

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A Re-Trade usually occurs after the investor gets the business under contract under an “exclusivity agreement” during due diligence. Dishonest investors use it to reduce the owner’s negotiating leverage.

Is due diligence only financial?

Most people think due diligence just means reviewing the financial aspects of the company.

While assessing the financial health of the company is one of the most important items to review, due diligence is a very broad term.

You can perform many types of it, including due diligence for real estate, legal due diligence, and more. It’s important to go beyond the numbers.

See the graphic I made below for types of due diligence:

Types of Due Diligence-4

Financial Due Diligence

Financial due diligence is an analysis of the target company’s financial records.

Understanding the financials of the business helps the investor better understand valuation and determine potential risks.

What financial documents should the investor collect?

  • Revenue, profit, and growth trends
  • Short and long-term debts of the company
  • Income Statements (AKA Profit and Loss Statements, or P&Ls), balance sheets

Legal Due Diligence

Legal due diligence is important to perform to verify the legal structure of the company.

Here are some things to consider for legal due diligence:

  • Warranties
  • Inventories
  • Customer reviews of the seller
  • The customer base
  • Contracts (if applicable)

NOTES

Corporate Finance Institute has a great guide on the different types of due diligence that exist.

Conclusion

In mergers and acquisitions transactions, due diligence can be lengthy, complicated, and require significant effort on behalf of all parties.

The entire goal of the due diligence process is to get the buyer to a position in which they trust (and confirm) what is being represented by the seller.

If the buyer asks the right questions with a good team of advisors around them, the buyer and seller should both feel positively about the acquisition process.

Thank you for reading this article. Feel free to reach out to me with questions and comments: jonah@midstreet.com.

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