Whether you are planning to grow your business through a potential merger or acquisition or are considering your options for transitioning out of your business through a sale, you may have heard about required "due diligence." But what does the term due diligence mean and what does the due diligence process consist of?   

"Due diligence" is the term used to describe an extensive and critical analysis of a business that helps both buyers and sellers evaluate the value and risks of a transaction. When you're at the cusp of a significant business decision like an acquisition, merger, or sale, understanding the due diligence process can better prepare you for the time, effort, and information that will be required for any transaction to be finalized. 

The Broad Spectrum of Due Diligence 

The standard due diligence process is comprehensive, allowing potential buyers to assess various facets of the target company. This process includes an extensive financial review (and this is the area where the accountants generally get involved!), but it is so much more than just a financial review. It is an in-depth analysis that covers multiple dimensions of the business.  

As the due diligence process can require extensive time and resources, including the reveal of highly sensitive company information, it is often only undertaken once two parties have expressed very serious intentions toward a transaction (often through the signing of a formal Letter of Intent). 

A few of the key areas over which the overall due diligence process is performed include: 

  • Financial: Financial due diligence involves evaluating the accuracy of the company's financial records, financial statements, and the health of the business. This includes considering past, present, and projected performance. For example, financial due diligence might uncover that a company’s reported profits are not sustainable due to one-time sales, customer concentrations, or non-recurring revenue streams. Below, we provide a bit more insight into what the financial aspect of the due diligence process consists of. Delap's Business Advisors can assist you with completing financial due diligence and help answer any questions you have regarding the process. 
  • Legal: Legal due diligence includes a thorough check of legal aspects, such as existing contracts, intellectual property rights, litigation risks, compliance with the law, and other legal obligations. For example, during legal due diligence it may come to light that a company has pending lawsuits that could significantly impact its business valuation. 
  • Operational: Operational due diligence examines the operational aspects of the business, such as production efficiency, supply chain management, and employee productivity. For example, an analysis might reveal that a company has an outdated inventory management system, leading to potential inventory issues. 
  • Additional Areas:  
    • Market: Market due diligence assesses the target company’s market position, competition, market trends, and growth potential.  
    • Environmental: Environmental due diligence is particularly important for companies in industries like manufacturing, energy, and agriculture. This analysis ensures compliance with environmental regulations and evaluates potential liabilities.  
    • Information Technology (IT): IT due diligence examines the robustness of the company’s IT infrastructure, cybersecurity measures, data management, and software systems.  Delap's Cybersecurity consulting team has experience in evaluating IT systems and networks and would love to help you identify any potential risks in the IT environment of your company, or that of a potential target company, during the due diligence process. 

Each of these different aspects of the due diligence process contributes to a comprehensive understanding of the target company. Analysis of these key areas provides insights into what the company is worth today as well as its risks or potential growth opportunities for the future. This multi-dimensional deep dive into all areas of the business is crucial for informed decision making in any major business transaction. 

A Focus on Financial Due Diligence 

While the general due diligence process covers many areas of the business, financial due diligence holds a central position in any potential transaction. If the numbers don't add up, then most deals won't happen!  

Financial due diligence delves deeply into the financial health and integrity of a company. This scrutiny helps a buyer identify potential risks and validates the financial information presented by the seller. And this is the area of due diligence where a Certified Public Accountant (CPA) can be extremely helpful.   

When performing due diligence over the financials, below are a few areas that are commonly identified areas of concern: 

Related Party Transactions 

Related party transactions are deals or arrangements between the company and entities closely linked to it (i.e., family members, affiliates, or key executives). For example, a company might lease property from a family member at a rate significantly above or below market value. Or the company might have loaned money to a family member or employee and not have a signed formal note agreement or be charging interest.   

It is essential to scrutinize all related party transactions to ensure that they are properly disclosed to a potential buyer. The impact of these related party transactions on the financial statements of the company (and ultimately on the potential buyer) are quantified within a Quality of Earnings (QofE) analysis. Below we provide a bit more insight into what a QofE report is and how it ties into the overall due diligence process.  

Accounts Receivable (AR) 

The quality and collectability of accounts receivable are crucial indicators of a company’s liquidity and operational efficiency. For instance, a high volume of overdue receivables might signal issues with the company's credit policies or customer base. Analyzing AR and a company's customer group helps in understanding the company's cash flow cycle, any potential collectability issues, and the likelihood of converting receivables into cash.  

However, a customer list is often a highly sensitive piece of valuable company information, so it is important to consider the timing and potential impacts of providing this information.   

Inventory Management 

Depending on the type of company and its industry, efficient inventory management is likely a key driver of a company's profitability and operational performance. For example, a construction company with a consistently high level of unsold inventory may be facing issues with project management or market demand.  

By examining inventory turnover rates and the aging of inventory, potential buyers can assess how well the company manages its assets and whether there are risks of obsolescence or write-downs. 

Revenue Recognition 

The way a company recognizes revenue can significantly impact its financial statements. A software company recognizing revenue upfront for multi-year contracts might inflate short-term earnings. Understanding the policies and practices around revenue recognition is vital to assess the sustainability and accuracy of the company’s earnings, which is extremely important to any potential buyer. 

During financial due diligence, the goal is not just to verify numbers but to understand the story they tell about the company's past, present, and future financial health.  

This information and the findings of the financial due diligence process can be provided to the interested parties through an informal format or through a due diligence report. Most formal due diligence reports will include a QofE analysis, which we explain in further detail below. 

Quality of Earnings Analysis Report 

A Quality of Earnings (QoE) report is an in-depth analysis of a company's financial records, focusing beyond the basic financial statements.  

Many potential buyers begin their assessment of a business's value by considering the target company's Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). The QofE takes all the financial analysis performed during the due diligence process and quantifies the impact of each item on the financial statements, specifically by making adjustments to EBITDA (or another metric as requested by the interested parties). These adjustments take EBITDA from the numbers provided (either historical or projected) and updates them to show the EBITDA a buyer might have actually earned if they had owned the business. After all the adjustments, a QofE report provides a more consistent and comparative presentation of the target company's financial health, which aids in developing an accurate business valuation.  

Common adjustments on a QofE report include the following: 

  • Non-Recurring Income/Expenses: QoE reports scrutinize the income statement for non-recurring revenues or expenses. For instance, the sale of an asset or a one-time legal settlement might have temporarily inflated the company’s earnings, which is not indicative of future performance. Alternatively, if the company is incurring additional consulting or legal costs in preparation for an upcoming transaction, these are expenses that would not be expected again in the future. More recently, the impact of Paycheck Protection Program loan forgiveness or the receipt of the Employee Retention Credit represent non-recurring income items that can significantly skew historical financial statements. 
  • Owner Expenses: QofE reports update EBITDA to recognize the impact of owner expenses. This includes adjusting non-market-based salaries paid to the owners, key employees, or family members in a family-owned business. This might also include considering the total distributions historically taken from the company or estimating the value of personal expenses of the owner that are covered by the company, such as a club membership or an automobile lease. As these types of expenses would likely not be paid by potential buyers, the impact of these expenses is removed from EBITDA. 
  • Discretionary Expenses: QofE reports may include adjustments for certain expenses that can vary significantly at the discretion of management, such as advertising and marketing expenses, certain types of travel and entertainment expenses, or discretionary bonuses. 
  • GAAP Adjustments/Corrections of Errors: QofE reports may include adjustments required to reflect changes in accounting policies or principles that impact the comparability of financial statements over time. For example, the implementation of the new lease standard would need to be recognized consistently across periods for the financials to be comparable across years. In addition, some adjustments may be required for any errors or mistakes found during the financial due diligence process. 
  • Future Changes: Adjustments may be made to a QofE report to reflect the impact of known or anticipated events that have not yet occurred but are expected to affect future earnings, such as changes in tax rates, the completion of a planned restructuring, or the end of a lease agreement that will not be renewed. 
  • Unquantifiable Issues: Certain issues may be identified during the financial due diligence process; however, too much time and effort would be required to quantify the total impact on the financial statements. These items may be called out, but not quantified, on the QofE report. 

The primary goal of a QoE report is to present a clear, detailed picture of the company's economic performance and potential future earnings. This financial scrutiny not only informs buyers about potential liabilities and future projections but also serves as a crucial tool for negotiation and decision-making. 

The Importance of Due Diligence 

The comprehensive due diligence process is a vital step in any business transaction, ensuring that every aspect of the potential deal is scrutinized for accuracy and viability. This evaluation is not just about ensuring financial transparency; it's a safeguard for both buyers and sellers in understanding the true value and potential risks of the transaction. Navigating this intricate landscape can often be overwhelming for business owners and can be a drain on personal and business time and resources. 

In these situations, the guidance of professional advisors becomes indispensable. Advisors familiar with the due diligence process can help translate intricate financial data and legal jargon into actionable insights, improving negotiation opportunities. Their role is crucial in steering business owners toward decisions that are not only financially sound but also aligned with their long-term goals. 

At Delap, our Business Advisory Team is equipped to guide you through the multifaceted due diligence process. Our experts are committed to offering personalized, comprehensive support to ensure that your acquisition or sale journey is as seamless and successful as possible. Whether you are on the brink of a merger, considering an acquisition, preparing your business for sale, or just want to be prepared for whatever type of transaction may come in the future, we invite you to reach out.  

Allow us to be your trusted partner in achieving a fair, transparent, and beneficial transaction for your business. 

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