Due Diligence is the process where a party contemplating the acquisition of a privately held company verifies the information provided that made the business attractive for purchase. A proper due diligence traditionally includes evaluation of financial records, customers, suppliers, employees, equipment, & facilities of a business. In the sale of a professionally represented business, due diligence should be a verification process where known information is confirmed. Due diligence is a process that benefits both the buyer & seller that optimally is conducted in an environment of full disclosure & cooperation. It allows a business buyer to enter an acquisition with “open eyes” and a proper assessment of the opportunities & risks associated with the purchase of a business. Due diligence allows a seller to mitigate their post transaction liability, as information known prior to acquisition provides a poor vehicle for future buyer litigation if business performance underperforms expectations after the transaction is completed.
IBA, the premier business brokerage firm in the Pacific Northwest, has facilitated over 4000 due diligence processes in its forty years of serving the entrepreneurial community. Traditionally, we facilitate due diligence in an environment of full disclosure and cooperation where known information is successfully verified on the road to successful completion of a transaction. We have also witnessed information being discovered which jeopardized or enhanced the appeal of a potential business acquisition. The following are some common & uncommon discoveries made by potential business buyers in due diligences facilitated by IBA:
1. Undocumented Revenue – A common discovery in due diligence is undocumented revenue that exceeds the revenue reported on the company’s tax returns. This discovery traditionally enhances the value of companies represented by IBA, as it is our policy not to incorporate “off the book” revenue into the models we employ when determining a market price prior to commencing a representation project. Although, likely not a “deal killing” discovery, the discovery of undocumented revenue necessitates the inclusion of appropriate representation, warranty, and indemnification clauses in the legal documentation associated with the transaction, so the business buyer is protected against trailing liability from the relevant taxing authorities post transaction. It is our general recommendation, that business owners eliminate undocumented revenue during the tax year prior to sale to help facilitate achieving the maximum sale price possible for their business and mitigate post transaction liability exposure.
2. Discretionary Expenses – It is a common tax minimization strategy for business owners to incorporate discretionary expenses that provide personal benefits into the operating expenses of a business. This is an advantage of ownership that is very attractive to entrepreneurs. It is also a strategy that can result in a buyer having additional cash flow for compensation and/or debt service post acquisition. Identification of discretionary expenses in the operating expenses of a business traditionally enhances the attractiveness of an acquisition to a buyer.
3. Customer Concentration – A proper due diligence will evaluate revenue generation by customer. A concentration of revenue with one or a few customers should be disclosed and the risk assessed. If having more than 10% of revenue tied to a customer causes concern, the acquisition may not be appropriate for a specific buyer. That said, IBA has facilitated numerous transactions where a significant percentage of revenue is concentrated with one or a few customers (Boeing, government entities, Microsoft, etc.), where the buyer retained the customer long term and generated an excellent return on their investment despite the risk that existed from potential client attrition at time of acquisition.
4. Key Employees – The value of employee assets at time of acquisition should not be underestimated. A proper due diligence will evaluate the team in place and assess the probability of retaining key employees post acquisition. Employee strengths & issues should be disclosed during due diligence. A pending employee retirement may not be a “deal killer”, but can create post transaction liability for a seller, if known and not disclosed. Conversely, there is no slavery in America, so employee retention post sale will primarily be determined by the management style & corporate culture created by the business buyer post acquisition.
5. False Financial Records – All representation projects at IBA are started with the assumption that the financial records provided to us by the seller are an honest representation of the performance of the company. Unfortunately, fraudulent financial records have been discovered in a few of the transactions we have attempted to facilitate. It is said that there is a fine line separating the minds of a genius and criminal. My experience has led me to believe this is a true statement, as the creativity I have experienced with fraudulent financial records is remarkable. The following are two “eye raising” examples of entrepreneurs providing false financial records in an attempt to facilitate the sale of their business at a premium price that were uncovered during due diligence by buyers & their professional advisers in transactions IBA was attempting to facilitate:
An entrepreneur who owned multiple companies contacted IBA about selling one of his manufacturing companies. A review of multiple years of tax returns found the company to have stable revenue and good profitability. In addition, the company had a reputation in the marketplace for providing quality products at a fair price and good customer service. IBA took on the project, identified multiple potential buyers, and successfully facilitated agreement on a letter of intent at a fair price. Due diligence commenced and was proceeding positively when it was determined that the company was inflating its profitability by expensing operating costs of the company through the other companies owned by the seller that were not being sold. In this situation, the composite personal tax return filed by the entrepreneur was accurate; however the relevant corporate tax returns were fraudulent. The buyer walked away from the transaction and IBA ended its representation of the business. It is IBA’s policy to terminate our representation agreement with the business owner when due diligence fails due to criminal or fraudulent practices.
The owner of a professional practice contacted IBA about selling his business. A review of multiple years of tax returns found the business to have increasing revenue and good profitability. In addition, the veterinary hospital had a good reputation and loyal customer base. IBA took on the project, identified multiple potential buyers, and successfully facilitated agreement on a letter of intent at a fair price. Due diligence commenced and was proceeding positively. The buyer decided to audit bank statements for the prior year to reconcile deposits against reported revenue. A large single deposit was discovered and an inquiry made as to the business conducted that resulted in the deposit. After some equivocation, the seller disclosed that the deposit was the result of an inheritance check received. The seller in this situation understanding how business valuation models worked had deposited the amount in his business account and paid taxes on the resulting profit recognizing that the in business valuation that profit is multiplied by a figure appropriate for the anticipated investment return on the acquisition and that his benefit in terms of increased sale price would exceed the cost of paying taxes on the inherited amount.
Due Diligence is an important step in the purchase or sale of a business. It is prudent to employ appropriate professional advisers to assist with the process. In a professionally facilitated transaction, an environment of full disclosure & cooperation will exist that will make due diligence an administrative process of verification and not discovery. It is IBA’s recommendation that if a buyer uncovers information that makes them uncomfortable that they dig into the subject matter until they reach a level of comfort, renegotiate the terms of the transaction to reflect the new information, or terminate negotiations.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, and mergers & acquisitions community 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 in terms of successfully negotiating transactions that are “win-win” in an environment of full disclosure between the parties.