Due Diligence is a vital part of any M&A transaction. The aim of due diligence is to factually verify claims made by the vendors during the process of selling a business. At heart it is about ensuring that the acquirer is buying the business that they think they are buying.
Due Diligence is not an Audit
Many accountants that have not been fully trained in due diligence will offer to complete due diligence but really they will be completing a form of audit. An audit is about verifying the historical accounts provided are correct based on applicable accounting standards. Audits have a lot of value but they are no substitute for properly conducted due diligence.
The difference is due diligence seeks to look forward. The historical sales and cost base might be being reported entirely accurately but changes have occured in the business or market that mean these historical figures are no longer a sensible way of looking at the business. A due diligence practitioner will identify the changes a business has made and adjust the earnings to take this into consideration.
Forecasts are a big part of due diligence. Clearly predicting the future is never easy but a good due diligence accountant will seek to find whatever evidence is available to support the forecast. At its simplest level this might be to review contracts and verify that a certain proportion of the forecast is provided by the existing contract base. This will usually then leave a portion of un-contracted future revenue. To gain comfort over this the due diligence accountant can start looking at historical trends and growth rates to underpin the forecast and KPIs such as sales conversion rates, referral rates and the historical success of new product launches.
Due diligence should also uncover liabilities. During an acquisition what should be considered a liability (or debt) is different to what accounting standards refer to as a liability. For example some liabilities are kept off balance sheet such as the cost of restoring an office to its original condition prior to exit. If the acquirer plans to leave the office shortly after completion then this is a very real liability the acquirer will have to meet that does not need to be included on a balance sheet per UK GAAP.
It’s important that an acquirer understands the level of working capital that is required to fund ongoing business. The sellers of a business will often try and get away with little tricks like not paying off suppliers or depleting the level of stock prior to completion. This has the effect of raising the level of cash in the business prior to completion (which will normally be taken out by the seller) but forcing the acquirer to find new cash shortly after acquisition in order to keep the business going. Due diligence will help verify what a ‘normal’ level of working capital should be and compare that to the current level of working capital.
Sale and Purchase Agreements (SPA)
Due diligence will uncover risks and uncertainties. Sometimes the uncertainties can never be totally resolved. In these cases certain warranties and indemnities can be included in the SPA (the contract detailing the sale of the company) to protect the acquirer. For example if the future of a significant customer is looking in doubt it may be possible to gain protection in the form of a sort of refund if this customer does fail. A due diligence report should proactively suggest possible risks that need to be covered off in the SPA and then work with the acquirers legal team to get the wording right.
How Caprica Online Accountants can help
At Caprica Online Accountants we are experienced due diligence practitioners. If you’re making an acquisition we can provide financial and tax due diligence for as little as £999 + VAT. Find out more about our great value due diligence.