Due diligence is one of the most time-consuming stages of acquiring a company and it is arguably one of the most important stages as well. This article provides a detailed guide on what due diligence is, the documents required, and how to do industry analysis and valuation due diligence.
Acquisition due diligence is the process of investigating a company and industry before making a major investment decision. During the due diligence stage, the business buyer will investigate all info relating to the company, its management, and the industry he is evaluating. The goal of due diligence is to ensure that the decision to invest in a company is a wise one. The process can take a long time and is often very difficult. The due diligence phase starts once the LOI (letter of intent) is signed.
After the LOI is signed, the buyer needs to set up a data room. This is where the buyer will store all the pertinent information collected from the seller. Common data rooms for those acquiring a business are Dropbox, DealRoom, ansarada. Simultaneously the buyer will also send over a due diligence checklist, requesting all the documents and information necessary to become familiar with the inner workings of the company.
The second step is to collect documents and information about the target company from the checklist. The documents and information that you should collect in the diligence process include:
Some of the financial documents you should collect are the income statement, balance sheet, and cash flow statement for the last three years. You should also obtain any year-to-date financials. Other financial information to collect will be the accounts receivable and accounts payable info, a list of all bank accounts and bank statements, and business and capital budget plans as well as the last three years' tax returns. Make sure to have an QOE (Quality of Earnings) expert review the financials.
The sales info the buyer should collect on the target company includes customer lists and information relating to its customer base. Understanding what the inputs drivers to a repeatable sales motion is critical.
Gather a list of any real estate owned or leased by the company and copies of all the lease agreements or mortgages, if any. There are many ways to get creative with structuring a deal when real estate is involved. You don't have to take the real estate in the deal but the expense is always a legitimate one. Don't let the owner or a broker convince you it is an add-back!
If purchasing any land or real estate associated with the deal, it would be a good idea to have a Phase 1 environmental done.
You will need to get from the seller a list of the inventory on hand, and any other details regarding inventory. Check to see what is old and aged. You can choose not to buy this or carve it out of the deal.
You will want to collect all the loan agreements and any contracts the seller has with regard to the financial dealings of the company.
The amount of time that the owner has owned the business is important to know, and if there were previous owners before them. If the company is over ten years old it is a good sign that the business has developed a reputation and a customer base that you can tap into.
You should also get a feel for how much time the owner spends working in the business. If the owner is working every day in the business and needs to be actively engaged in the day-to-day, then you will need to figure out if you want to take that role and be just as actively engaged or if you can hire someone on to take his role.
If this is your first time buying a business, it would be convenient to know that the owner is willing to stay on for a set amount of time to help ease the transition and offer support during this critical period. It is also a good sign that the owner is willing to still offer support because it shows that he cares about the legacy of his business, and wants to help ensure you will steward the business well.
Seller financing is advantageous to the seller and the buyer for many reasons. It benefits both parties because it allows the seller to continue to have a stream of income over an extended period of time, and allows the seller to save in capital gains tax savings over time. Seller financing also shows that the seller still believes in the long-term success of the company. The benefit to the buyer is that it allows him to minimize the amount of capital he needs to put down, and he will also be able to have more flexibility in negotiating the interest rate on the promissory note.
This is important to know because most business owners will over justify the price of their business. This is understandable because of the amount of hard work, blood, sweat, and tears that went into building it. But the simple matter is, you can not put a premium on that. You need to see through the weeds and get to a suitable valuation that you can purchase the company.
If the owner is not paying himself, then the business is most likely not profitable.
Taxes, lawsuit history, insurance, asset information, intellectual property, business plans, and projections.
The industry analysis and valuation stage is usually done during the preliminary due diligence phase, but further detailed analysis can be done during the due diligence phase after the LOI is signed. Not only is it important to collect all information pertaining to the ins and outs of a company; but it is important to have an understanding of the industry you will be purchasing the target company. Remember, the best company in a bad industry will still fail.
For example, let's say you are doing due diligence on a target company that is in the defense industry that produces weapons and ammunition. The first step in your industry due diligence would be to get an overview of the industry and the key metrics. North star metrics are always industry-specific.
Total addressable market size. This gives you an idea of how big the industry as a whole is.
CAGR stands for the Compound Annual Growth Rate. It is the measure of an investment’s annual growth rate over time, with the effect of compounding taken into account. It is often used to measure and compare the past performance of investments or to project their expected future returns. You will want to have an understanding of the CAGR for the following industry metrics: revenue, profit, profit margin, industry gross product, number of enterprises, employment, and domestic and international demand.
Capital intensity refers to the weight of a firm's assets—including plants, property, and equipment—in relation to other factors of production. Having an understanding of how capital intense an industry is, will help the business buyer get an idea of the return on capital investments and labor for the industry. It is also important to understand the industry margins and how the target company's margins relate to competitors. Business buyers can find info on competitors by looking up similar companies that are publicly traded, by going to SEC and looking at similar companies' 10Ks. Also, reading industry whitepapers will help acquisition entrepreneurs understand the target companies' industry better. (McKinsey is a good source for industry reports).
Having an understanding of the key drivers and market fluctuations of the industry will help the business buyer get a better grasp on what factors play into the success of the companies operating within this industry. Do socioeconomic and geopolitical instability increase industry profits or make them decline? How much industry revenue is generated from federal funding?
It is good to understand what influences drive customers toward a company's goods and services besides price. For example, brand strength, quality, or outstanding customer service may drive customer preference.
How often is the industry being disrupted by new innovations? If the industry is constantly being disrupted, it means you will be spending a lot on R&D and product development.
It is important to understand the market strengths and weaknesses of an industry you are entering. This will give the business buyer knowledge on whether the market timing is right to invest in this industry and if there are high barriers to entry.
When doing industry research it is key to understand what precedent transactions have taken place to help you analyze historically what comparable companies within the industry are being acquired. This will help give a range of valuations for similar companies that have been acquired. A common metric used in private equity comparable analysis is the EV/EBITDA multiples by sector.
It is important to also note in any comparable analysis the cyclicality of the sector that is being invested in. For example, if you are buying a target company during a recession. You should take into account what transactions were completed during a sector downturn as well as in a stable industry environment.
Arguably, due diligence is one of the hardest phases of the acquisition process. The investment you have made in building trust with the seller will be tested here. Take your time. It is better to lose a deal than to buy a bad business. Remember, that this is also where deal fees start to explode: and you need keen judgment to determine when to bring in third-party service providers, the most costly being QOE and legal. This is the time for the buyer to become intimately acquainted with the business to see if this is a company that the buyer wants to eventually acquire.
iGOTHAM will soon be launching a community for Acquisition Entrepreneurs and CEOs, where they can network with each other, and pursue business acquisitions. If you would like to receive a free comprehensive due diligence checklist form, sign up for the waitlist at https://www.igotham.com/wait-list and send an email to firstname.lastname@example.org asking to receive iGOTHAM's due diligence checklist.
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