Do Your Due Diligence and Make Sherlock Holmes Proud

By David Grossman

Thanks to the wealth of information available on the internet, we can (and usually do) research every purchase we make, from vehicles down to can openers. What’s troubling is that some people spend more time and energy researching a car or stereo system purchase than they do researching the purchase of a business. This article is the latest in a series on business acquisitions and will provide tips on conducting a thorough due diligence process. You can find an overview of business-buying best practices in the March/April issue of Cleanfax and advice for drafting a letter of intent in the May/June issue.

The purpose of due diligence is to gather and analyze enough information about the business to make a wise investment. It’s true that you may find a dearth of record keeping from the typical small private company, but much of the information you need is available to the public if you make the effort to track it down. Think of yourself as a detective, gathering evidence and digging deeper into any aspect you find troubling. A thorough due diligence process should allow you to:

• Gain a solid basis of knowledge about the business
• Have the owner help educate you about the industry
• Start preparing for when you are running the business
• Begin to create and/or refine your own internal budget and projections.

Start with the owner

Despite what we may have experienced from our childhood school days, no one has ever committed the crime of doing too much homework. While I advocate digging deeply into all facets of the target business, there are real-world time constraints. Thus, you may want to consider taking a few minutes upfront to develop a plan to maximize your efficiency.

One approach calls for submitting a list of questions and document requests to the owner. This should be the first step immediately after executing the letter of intent since it will frame your future analysis. Also, it will take some time for the owner to address these items. Be professional about it and attempt to develop one list that is comprehensive enough to provide you a solid understanding so that you will not need to make multiple requests for high-level information. Conversely, you may not want to ask for trivial information that will delay her completion of the more critical items.

See the accompanying list of common inquiries from buyer to seller. Two fairly obvious caveats are in order. First, not all of the items on this list apply for every buyer and every business, so customization, additions, and deletions are in order. Second, be prepared for the seller to have incomplete or missing information. After all, this is probably the first time she is going through this process, and she likely manages largely by gut instinct.

To mitigate this risk, you may consider performing an audit where detailed pieces of financial information are examined. This process can include tracking invoices throughout the accounting system and reconciling bank statements with internal records. For the inexperienced, spending money for the assistance of a financial adviser or an accountant may be a solid investment.

To analyze the information from the owner, approach it once again as a detective who initially takes a wide view of the scene, looking at the company’s finances, operations, products/services, suppliers, employees, systems, competitors, and industry. From there, increasingly focus on a smaller number of critical issues that are either most foreign to you or most troubling.

Keep probing deeper on the few key areas until you have learned enough to be comfortable with them or not. If the owner pushes back on your inquiries, then she is either acting unprofessionally (which is likely a sign of how she runs her business) or hiding something (perhaps even more troubling). It is certainly your right to ask for additional information. After all, you are the one in the driver’s seat, and it is your money potentially at stake.

At the end of the process, do not be surprised if you have a better understanding of the company’s true financial picture than the current owner.

[infobox title=’Commonly Requested Information and Questions’]

• Complete financial statements (namely, detailed income statement, cash flow statement, balance sheet, and any accountant notes) for the past three fiscal years and for the current year to date; explanation of the accounting methodology used (i.e. cash versus accrual) and any deviations from GAAP
• Corporate federal tax returns for the past three fiscal years
• Projected income statement for the next three years by quarter
• List of assets (inventory, hardware, and equipment) and their book and fair market values; where applicable include the purchase date and the depreciation method used
• Detail of any real estate including property description, size, book value, depreciation method, most recent appraisal date and value, tenant description, lease terms, and any environmental reports
• Accounts receivable aging report, which is a document listing the total receivables as of a certain date, grouped by the number of days outstanding, commonly <30 days, 31-60 days, 61-90 days and 91+ days in age)
• Schedule of largest vendors and suppliers complete with price paid for each product
• Any business plans or overviews
• Any marketing materials, brochures, and catalogs; explanation of current sales and marketing practices in detail; break out percentage of customers by each advertising placement and referral source and acquisition cost per customer of each
• Breakdown of revenue by both customer and product
• Detail of customer demographics and purchasing behavior including frequency and order size; discussion of lifetime value of the customer
• Any material agreements covering customers, suppliers, vendors, employees, affiliates, leases, and others
• List of all employees, contractors, and consultants—with current pay, date of last raise, average hours per week, overtime, start date, job title, job description, direct report, most recent year W2 or 1099 form, and any special relationships—and indicate any who are unlikely to remain with the company
• Description of all employee benefit plans and eligibility requirements
• Product catalog with pricing information
• Description of all material ongoing contingencies, commitments, and liabilities
• Explanation of any customer or revenue sources that may be damaged or lost upon new ownership
• Detail of any past or current litigation, investigations, or inquiries by a third party, employee, affiliate, vendor, customer, or government agency of which the company was a part as either plaintiff or defendant
• List of all software packages used including version numbers
• Overview of the technology architecture
• Description of any intellectual property such as copyrights, patents, and trademarks
• Description of customer-fulfillment system from order to collections
• Educational sources or primers on the industry
• List of memberships in trade organizations and other affiliations; list of any board or active membership roles; list of major trade organizations and publications
• List of competitors including online and offline local, regional, and national players with an estimated size and explanation of how each one differs from your company
• Viewpoint of the current state of the industry, emerging trends, and the company’s position
• Explanation of the most attractive growth opportunities for the business

[/infobox]

Benefits of a consultant

While you want to keep your due diligence expenses low, you may want to turn to a consultant, particularly if the industry is new to you, you have never previously attempted to buy a business, or you feel your finance skills are weak. With some investigation, help can be found to address virtually any need. For instance, an industry veteran may assist by providing background information on the industry and competitors. An experienced business buyer can help you determine the appropriate price for the company, conduct the financial due diligence, or devise the income and cash flow statements.

You will, of course, have to pay for a consultant, but view it as the initial part of your investment. A consultant can not only help inform your decision to buy the business, but also save you time in the due diligence process by handling some of the work and pointing out the most relevant issues to investigate. Some people can comfortably handle the process themselves, but for many, the price paid for outside assistance is a good investment—and it is only a fraction of the cost of the total business acquisition.

Projections and adjustments

If financial projections for the target business were not developed prior to signing the letter of intent, then you will most certainly want to create them at this point. It can be a simple exercise. Using the owner’s historical growth rate as a baseline, future revenue can be projected.

Adjustments should be made based on a number of factors, including your ability to manage the business, investment capital available, trends in the market, competitor movements, and inevitable road bumps and distractions during the transition. This projection will most likely be more conservative than the seller’s projection.

A similar exercise can estimate expenses, starting with the current expenditure level. On a relative basis, expenses should increase less than revenue so profit margins should widen (or if currently unprofitable the business should become relatively less so). If detailed expense records have been maintained, you can perform reality checks and make appropriate adjustments. Key steps include:

• Modifying the owner’s compensation to a level with which you are comfortable: This decision is important since it will need to be high enough to enable you or someone you hire to devote full-time effort to running the business, yet not so high as to limit the cash flow available for growing the business.
• Contacting vendors and suppliers: This is a good way to find out if current product costs are reasonable going forward.
• Changing the rent expense to what your costs will be: This is particularly relevant if you plan to relocate the business or the seller owns the real estate.
• Refining costs: Marketing and acquisition costs should be adjusted based on your plans for the business.
• Examining payroll expenses: It’s important to find out if employees are making market wages, which can lead to an upward or downward adjustment, and if overtime is being paid.

Note that your estimates of future expenses will likely be more accurate than your sales expectations. They are also more controllable should reductions be needed. That said, it is wise to plan a sizable cash reserve for the inevitable unforeseen expense such as replacing an employee with a higher priced one, buying office or other equipment not anticipated, or upgrading antiquated software. (Of course, some of these expenses may be deferred, and countermeasures such as deferring owner salary can be taken.)

More importantly, revenue slippage may occur due to the loss of some accounts upon new ownership, the seller losing momentum while focused on the sale process, or collections of receivables taking longer than planned.  Any of these occurrences can lead to significant shortfalls in cash, which is the measure most important to you. The business does not need to be overfunded when the deal closes, but extra capital should be available.

Finally, do not forget to account for deal expenses. These expenditures consist of any hired consultants, accountants, and lawyers plus other due diligence costs including travel, credit reports, and third-party background searches performed on the company and the buyer. A hard-and-fast number is difficult to provide, but assume legal fees alone will cost at least $10,000.

Predicting cash flow

Your projections of revenue and expenses, developed for the next 1-3 years, can be used to generate a cash flow model. The cash flow statement is arguably the most important financial forecasting tool for most small businesses. The adage “cash is king” rings true since profit does not pay the bills, but cash does. And after all, what good is growing sales if increased inventory leads you to run out of money to pay your employees, your vendors, or yourself? This is a very common occurrence that can be mitigated through proper cash management planning.

To construct a cash flow model, start with the net income and add back any non-cash expenses such as depreciation and any outside debt or equity investments into the company. Next, subtract capital expenditures and any debt financing (the principal portion only since interest has already been accounted for in net income). Finally, the timing of the lags between sales and collections (a negative hit) as well as invoices and bill payments (a positive one) should both be incorporated. As with the income statement, err on the side of caution when forecasting available cash.

Should the projected cash position become negative, then the business must be run differently. While out of the scope of this primer, suggestions include:

• Scaling back marketing initiatives—even though this will result in slower growth
• Leasing equipment or financing capital purchases as opposed to buying them outright with cash
• Stretching payables with your vendors
• Offering discounts to customers in exchange for quicker payments.

Your internally generated income and cash flow statements should be continually revised as you learn more about the target business. View them as works in process as opposed to one-time static exercises.

Final thoughts

Upon refinements, if you reach a point where the acquisition investment is no longer attractive because the economics are poor, the risks are too great, or any other reason, there are three choices: Make no change, renegotiate with the seller even if you risk losing the deal, or walk away. If you are truly honest with yourself, you probe deeply on the key issues during the due diligence process, and you do your best to remain objective, then you will make a better decision. The worst outcome is making an acquisition while ignoring your strong negative feelings. You may win the battle by closing on the transaction, but you will have increased the odds of losing the war.

Look for the final installment in this series, which will offer an overall quick-tip guide for the business-buying process, in early 2022.

David Grossman is president of Renue Systems Inc., a global franchisor and operator of specialized deep-cleaning services businesses to the hospitality industry. He can be reached at [email protected] with more information available at www.renuesystems.com.