Due Diligence – Necessary, Valuable, and Beneficial to Both Sides

Jul 9, 2024

IBA has an approximately fifty-year reputation in the business brokerage industry for facilitating transactions in environments of full disclosure with transparency employing best practices.  This reputation is why attorneys, accountants, wealth advisors, and bankers find comfort when their clients select IBA for sell side representation or identify an IBA represented company for acquisition.

A comprehensive due diligence process benefits both sides in a transaction.  In a properly facilitated transaction where an environment of full disclosure is created prior to execution of a Letter of Intent to allow parties to make business issue negotiating decisions (e.g., company value and terms of payment) from a foundation of a knowledge, due diligence is commonly more of a verification than discovery process.   The process allows a buyer to enter into a transaction with open eyes and a seller to create a safe harbor from post transaction litigation.  The safe harbor is created for the seller because if a buyer is aware of all relevant facts related to a company (e.g., 17% of revenues are generated from one customer) prior to acquisition then post transaction they cannot be held liable if that situation should change.  In a perfect world, the only reason a buyer should struggle post acquisition is if they do not have the executive management ability to successfully run the company.  Both parties in a deal should acknowledge that the one thing that cannot be sold in a business sale transaction is the executive management ability of exiting ownership.  It is this risk that creates the significant return on investment opportunity found in M&A.  New ownership will be superior or worse than old ownership in running the company, they will never be exactly the same.   Broker Note:  It is never recommended that a seller make representations or warranties in the purchase & sale agreement related to elements they cannot control (e.g., that a long-term employee will remain with the company into the future). It is fine to encourage and incentivize a key employee to stay post sale, however it should be readily acknowledged that there is no slavery in America and an employee who had the intention of staying with a business post sale could have health issues or buy a winning Powerball ticket that changes those plans. 

IBA business sale intermediaries are often asked by buyers what they should request during due diligence.  Unfortunately, that is a question that IBA will never answer as the risk is substantial for the firm that we may leave something off the list that is important in a specific transaction.  Our common recommendation when asked that question is that a buyer should compile a comprehensive due diligence list to be fulfilled by the seller by combining lists obtained from their accountant, attorney, and bank, if acquisition financing is being sought. Sample lists are also readily available with an inquiry into any search engine.  If bank financing is a component of a purchase strategy, the due diligence done by a bank prior to funding an acquisition will provide a second due diligence on the company to that of the buyer. There is no “dumb” money in the world of business acquisition financing.  If a bank finds something negative during underwriting, they will bring it into sunlight and require resolution or funds will be withheld.  This is a good thing in IBA’s opinion, because at our firm we do not want a buyer taking the helm of a company ship with undisclosed threats out of sight beneath the surface.

As a thirty-year M&A professional, I have worked with my sell side clients to fulfill due diligence request lists of a spectrum of lengths and depths.  The size of a list has no baring on whether a deal is a good or bad acquisition.  I have seen buyers purchase quality companies with a very superficial due diligence process who have been very successful post acquisition and came back to IBA in the future to acquire additional companies.  I have also seen buyers get “paralysis of analysis” during due diligence and walk away from transactions by overthinking deals only to have another buyer acquire the business and grow it from seven figures in revenue to eight multiplying EBITDA several times.

Based on this experience, the following are some of the items that I believe have the most benefit to buyers during due diligence.

Tax Returns

No item is more valuable during due diligence than tax returns.  All relevant tax returns filed with federal, state, or municipal governments should be reviewed.  The advantage of tax returns over internal financials are that the seller is accountable to an outside authority for their accuracy.

Internal Financials

Internally generated profit & loss statements and balance sheets are a valuable tool for tracking the accuracy of the evolution of financial reporting from what is done at a company level to what is reported to the government.  In addition, internal documentation provides information relevant to time frames between required tax reporting periods.

Monthly Revenues

One of my favorite tools when evaluating a company is to look at revenues on a monthly basis over a multiple year period.  This analysis allows for the identification of high and low revenue periods, seasonality, trends, and the creation of twelve-month periods other than a calendar year to assess company performance.  For example, a July 2023 – June 2024 assessment of revenues or a trailing twelve month income statement in comparison to the 2023 federal tax return for a calendar year filing period company can sometimes identify a value proposition in terms of an acquisition or a company that is overpriced with antiquated data.

Bank Statements

In the Academy Award winning movie, “All the President’s Men”, Deep Throat provides (https://youtu.be/OzcP65m5L9c?si=rXMIAzjXEkrQLmaP) Bob Woodword, played by Robert Redford, with the guidance to “Follow the Money” on the pathway to uncovering the Watergate scandal. In due diligence, it is prudent to reconcile cash deposits against financial reporting of revenue.  The numbers should match.  If they do not, to quote another movie, Apollo 19, “Houston we have a problem” (https://youtu.be/Bti9_deF5gs?si=AkgzE8BrkvQMRl94).  Consideration should be given in this analysis for whether the company utilizes a cash or accrual basis accounting methodology.

Customer Concentration

When appropriate, a review of the top 20 customers by revenue for the past couple of years can identify a strong diversification of revenue streams mitigating risk or a relationship that warrants additional scrutiny prior to acquisition.

Contracts

All significant contracts should be reviewed prior to completing a business acquisition.  Contracts common to IBA facilitated transactions include leases, customer agreements, employee contracts, and franchise agreements.

Employee Files

It is prudent to clearly understand employee positions, responsibilities, compensation, and benefits prior to completing an acquisition.  Employee retention is fundamental to a smooth transition of ownership.

Furniture, Fixtures, Equipment, and Vehicles

All tangible assets of a business should be inspected and verified prior to business purchase to identify the condition and future potential capital expenditure needs to successfully run the business.

Intellectual Property

Patents, trademarks, and other proprietary assets that create a competitive advantage for the business should be identified, documented for inclusion in the transaction, and reviewed.

The above nine items are some of the elements that should be reviewed during a comprehensive, quality due diligence process.  As indicated previously, both sides to a deal benefit from completing a transaction in full sunlight.  The best decisions are made from a foundation of knowledge.   IBA has successfully facilitated more transactions, 4300+, than any other business brokerage firm serving Washington, Oregon, Idaho, and Alaska. We believe this long resume of achievement has occurred because it is our goal to facilitate “win-win” transactions in an environment of full disclosure employing best practices in every professional representation project.

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, real estate, legal, and accounting communities on subjects relevant to the purchase & sale of privately held companies and family-owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.