The Due Diligence Process. Challenges & Solutions !

Background

The due diligence process is the key element of any business exit, as invariably the whole process will stand or fall based on the outcome(s) of the exercise.

Also irrespective of the size of any transaction or the sector involved, where a third party is investing into your business or indeed acquiring your business, you can be guaranteed that there will be a due diligence process involved !

Due Diligence – What is it ?

Due diligence can therefore be defined as:

1. an investigation into the affairs of a company prior to it’s acquisition, disposal, re financing …… or other similar transaction

2. a bridge that must be crossed in nearly all transactions and without it, the risk of problems or failure along the journey (for the buyer) are increased

‘’The aim of due diligence is to enhance a user’s understanding of key information underpinning a corporate transaction enhancing the parties’ ability to make informed investment decisions”

Timelines

 Due diligence commences only once there have been positive initial discussions, which lead to a broad agreement between the parties on the key issues i.e. Heads of Agreement

1. Third Party Approach
2. Initial Discussions
3. Heads of Agreement
4. Due Diligence
5. Renegotiation/Warranties/Indemnities
6. Purchase and Sale Agreement

Characteristics of the Due Diligence Process

There are a number of unique characteristics applicable to due diligence, which are not typically experienced by business owners during other business transactions or projects.

1. Generally time driven : once the Heads of Agreement have been agreed upon, the buyer usually has a short period of exclusivity to fully investigate your business, meaning that what follows can be an intense and stressful period responding to queries and providing the relevant data/information

2. Significant involvement of finance team and senior management : the due diligence process will add significant additional workload onto both finance staff and the senior management of the business, hence the risk of ‘taking your eye off the day the day activities’

3. Purpose of the process is risk management : as the party looking to exit (the seller) it is important for you to understand the purpose of the process i.e. it is predominantly for the buyer to investigate all of the potential risks in your business PLUS be able to validate the opportunities

4. Largely out of YOUR control : as per the above, the process is largely outside of your control, however there are elements of the process that you can manage proactively, such as ensuring that the opportunities for the buyer are constantly highlighted, while being supported by the financial and other data being provided along the way

5. Inadequate due diligence = RISK : there is risk for both parties where the due diligence process is not managed inadequately i.e. for the buyer that a key risk or a potential opportunity is not clearly investigated ahead of the completion of the deal, while for the seller poor management of the process results in a lack of credibility, errors or delays i.e. affecting deal completion or price.
   

The Process Itself

Although every transaction can be different in size and nature, the process itself typically consists of the following elements

1. Financial due diligence

2. Commercial due diligence

3. Operational due diligence

4. Legal due diligence

Financial Due diligence

The financial due diligence typically covers a 5 year window e.g. 3 historical years and 2 years in the future. The main aim being to review and ‘sense check’ all aspects of tax compliance, accuracy of the basic bookkeeping, the key financial metrics and margins, as well as the overall quality of the management reporting for decision making in the business.

Therefore the financial due diligence process will cover:

• Historical financials
• HMRC compliance track record
• Gross profit, Operating profit, EBITDA %’s
• Client and project profitability
• Cost of sales and overheads
• Cashflow management
• Budget/forecast structure

Commercial Due Diligence

The commercial due diligence process aims to ‘get under the skin’ of the business, ensuring that the ‘direction of travel’ over the period can be clearly understood, what the business strategy is and/or how it may have changed and how this has contributed to the growth and development of the business.

It will also consider in detail commercial aspects such as new business processes and pipeline(s), the type and nature of existing client base, the strength (and length) of client relationships along with a consideration of the sector and competitors etc.

Therefore the commercial due diligence process will cover:

• Business strategy
• New business processes, lost clients/projects
• Business strengths and potential weaknesses
• Customer relationships, contract lengths, lifetime values
• Competitors
• Budgets/forecast assumptions

Operational Due Diligence

The main purpose of the operational due diligence is mainly to establish the likely involvement of the new business owners in order to deliver on the budget/forecast post acquisition. Therefore, the main focus is on reviewing the existing structure and management team i.e. what are their backgrounds and experience, does the team has the requisite breadth of necessary skills etc.

It will also focus on how the rest of the business is structured and/or whether certain key departments are overstaffed or understaffed, how do current internal processes operate and whether core business systems are ‘fit for purpose’.

Therefore the operational due diligence process will cover:

• Structure of management team
• Business organisation structure
• Internal business processes
• Internal systems and controls
• Other issues e.g. Disaster recovery, data protection etc.

Legal Due Diligence

Finally the legal due diligence process aims to establish whether all of the elements of the business ‘hang together’ from a legal point of view e.g. are all Clients under contract and subject to the appropriate terms and conditions, are there any financially onerous terms in agreements with suppliers or in certain circumstances with landlords etc.

Similarly legal issues relating to employees (are they operating under appropriate contracts relevant to their seniority etc.), ownership of assets (whether physical or IP related), clarity and accuracy of shareholder and mortgage/debt registrations and details of commercial, employee or other disputes will be reviewed, analysed and considered.

Therefore the legal due diligence process will cover:

• Contracts and terms with Customers
• Contracts and terms with Suppliers
• Office lease agreement with landlord
• Employment contracts and service agreements
• Company secretarial
• Asset ownership, IP ownership, licences
• Legal, commercial and employment disputes

Outcomes and Issues Post Due Diligence

At the completion of the due diligence process, any issues and ongoing queries, financial risks and potential liabilities, or indeed any concerns around future direction or expected business opportunities should have been clearly identified, which will result in one of the following outcomes occurring :

1. the transaction proceeds to completion with a ‘Sales and Purchase agreement’

2. there is no deal, and one or other of the parties ‘walks away’

3. there are issues raised which result in further discussions, price re negotiation(s) and/or additional legal ‘niceties’ (which may lead to completion or No Deal)

Take Action NOW ahead of an Expected Business Exit

Therefore given the importance of a successful exit from your business i.e. it’s likely to be the largest financial transaction in your career, and also knowing the complexity and intensity of the due diligence process, what is Sakura’s advice to our clients and/or those considering an exit in the medium term ?

1. PREPARE for the due diligence process significantly in advance

2. RESOLVE ‘fixable’ issues ahead of an exit

3. BUILD credibility by ensuring basic financials and compliance are in place

4. CREATE a strong management team

5. ENSURE that any negative impact on trading is minimised

What happens next?

We can help you plan in advance for the expected due diligence processes where you are considering exiting your business in the medium term. Alternatively we can help if you are currently in the midst of due diligence.

If you have any questions please contact Damian Connolly: damian@sakurabusiness.co.uk

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