Due diligence is vital when buying a business

Technology companies are in a dynamic sector. You may want to expand your business through acquisition, or you may want to sell your company.  In either situation you need to go about the process in systematic way which means becoming familiar with due diligence.

When you are excited about buying a business (or selling one) you can easily miss important steps that will help establish if you are making a  good decision. Due diligence is a process to help achieve a deal. It uses checklists and also relies on combining these with good business sense: without due diligence you could make a deal you regret. It’s my view, after many years of experience, that not enough people undertake proper due diligence.

Here are eight suggested steps to guide you (some of which will occur in parallel):

1. Getting started

You need to understand what it is you are considering buying.  Companies have different ownership arrangements. They may be co-owned, or have ownership of common assets.  In family businesses, you need to understand the relationships. Relatives may be employed and there maybe costs associated which need to be removed to get to the "true recurring business" profitability. This can be difficult to establish. There is no substitute for a meeting with people who understand the business. You should also meet the people who keep and prepare the management and published accounts.

2. How strong is existing management?

Whatever type of company you are purchasing you must understand the management.  Is their record of achievement good, what is their future strategy, and how well are they thought of in the industry?  I recommend speaking to people who know the owners/ managers. The track record of the most senior players will be particularly valuable.

Focusing in on the issues and understanding what has gone well or less well is also important.  It is often the case that business failure results from cash flow issues. You want to make sure the management has an adequate sales, marketing and prospecting business process.

3. Draw up heads of agreement early

Early on you want to get "heads of agreement", so you have a reference point. Any deal will be subject to a Sale and Purchase Agreement ("SPA"). This should provide a mechanism to cope with anything which needs adjusting for in the price. It’s possible that information will be found which turns out to be slightly different from what is recorded in the accounting records.

Business owners don’t usually intend to create complications, but as a buyer you need to check everything thoroughly.

4. Getting financing in place

Due diligence will help you to confirm the financing required to complete a transaction.  It is essential to arrange discussions with banks or equity providers to ensure the capital/debt or other finance can be arranged.  As a potential buyer you want to have offers in place subject to due diligence. If you want to move forward when the time comes the financing must be there.

5. Established business or startup?

The type of business you are looking at is also important.

If it’s a start up, you won’t be able to see a business track record. There are examples of financiers convincing themselves that loss making tech companies were worth billions of dollars.  They ended up with egg on their face.  So be realistic. Work out how quickly the team can make money, i.e. have they got customers ready to buy their product or service?  Startups are a risky purchase, as you are reliant on other people to get a new product and service into market. Should you wait until they’ve proved sales can be made?

If you’re looking at a more established business then the next steps become even more relevant to your due diligence.

6. Actual results vs budgets and forecasts

For an existing business you must pay attention to the results to date and the trajectory they show.  Understanding the cost base is also vital to establish how any cash invested might be used to drive the business forward.  Inter-linking the current results to forecasts and budgets is a useful exercise. This can help you understand the reasons for any deviations.

If a company has a budget and a forecast you can assess where a management team is headed and whether they are meeting their goals.  The forecast needs to take account of the plans for the business after the deal. This again will help you assess the financing requirements. (If no budget or forecast exists you’ll have to look at past performance and make a judgment on how well they are doing).

The comparison between the forecast, the reality and the budgets is crucial. A management team that is always near to budget is preferable to one which misses the target time and time again. You will discover if the current team are realists or fantasists.

7. Earnings Before Interest Tax Depreciation and Amortization

EBITDA will give you the true recurring profitability underlying all the other figures. It offers a "clean" figure to use for comparisons. The profitability of the business is important to understand to help you determine what you should pay.  Understanding this and drivers of the business, and therefore the progression of the profit into the future is vital.

8. The deal depends on driving the process and communication

Nothing happens in a transaction without someone driving the deal: the process itself and the communication between everyone involved. Talking to people in the right way is a must!  I once saw a big deal collapse because a manager was incredibly rude to the would-be buyer’s team.  You’d also be surprised how often people say "I was seriously interested in buying. Why didn’t they get in touch?" You must keep both the process and the conversation going.

And finally

Whatever you do don’t skimp on due diligence. It will help highlight important issues. Using the steps will help you to make an informed decision on whether to go ahead and what you should be paying.

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Published under license from ITProPortal.com, a Future plc Publication. All rights reserved.

Clive Hyman FCA is founder of Hyman Capital Services offering expertise in due diligence and managing change in business including raising equity and debt capital, mergers and acquisitions, interim management, board management and governance, deal structuring, and company turnaround.