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Due Diligence – Private Investigation of a M&A Deal

I recently watch “Soaked in Bleach”, the story of private investigator Tom Grant’s efforts and analysis associated with the facts surrounding the death of Kurt Cobain.  Interesting movie that identifies some noncongruent elements between the “official” narrative regarding the death and information that would appear to be relevant to the situation.   In a transaction involving the sale of a privately held company, an investigation of the business commonly occurs by the buyer and their professional advisors prior to the acquisition being completed through a process called due diligence.  The most common professional advisers employed to assist with due diligence are CPA’s, CFO’s, and attorneys.  The due diligence process has many similarities to investigation of a crime scene in that it requires the investigating party to collect documentation, information, and knowledge to properly assess the situation and make a decision.  In a potential business acquisition, the decision being made is whether to complete the transaction and purchase the company.

Due diligence is a process that benefits both sides of the transaction.  For the buyer, it is a process to verify the information used to make the decision to purchase the business.  If the information is not verified, the buyer will either exit from negotiations or attempt to renegotiate the terms of the transaction.   For the seller, the goal is to create an environment of full disclosure for the buyer, so the buyer completes the transaction with “open eyes” with a clear understanding of the potential and risk associated with the acquisition.  If an environment of full disclosure & knowledge is created, then post transaction liability for the seller will be mitigated because the future success or difficulty of the company after the change of ownership will be tied to management ability and not a lack of knowledge.

There is enough risk in entrepreneurship without adding the variable of making decisions without a good foundation of knowledge.   An experienced mergers & acquisitions professional will outline a strategy & process for facilitating due diligence between the parties.   Many potential transactions are lost in due diligence.  Facilitating due diligence without an experienced business broker managing the process can have similar results as asking a builder to construct a house without an architectural blueprint.

As a 24-year mergers & acquisitions professional, I have successfully facilitated 100’s of due diligence processes on the road to completed transactions.   I have also like a private investigator seen information discovered during the investigative process that surprised me.  The following are two examples of fraud being conducted by a seller in the sale of a business that were discovered during due diligence by buyers resulting in a withdrawal from the transaction.  In both situations, there was no way the business broker facilitating the transaction or the buyer purchasing the business would have discovered the situation without a comprehensive due diligence process.  It is also true in both situations the seller understood the mechanics of business valuation and attempted to manipulate the sale process to their advantage.  It is my hope in sharing these stories that the information can be used by future business buyers to avoid completing a transaction at an inflated value resulting in enhanced entrepreneurial risk.

The Case of the Shell Game Playing Entrepreneur

The seller in this transaction owned two companies and operated each under a unique set of tax identification numbers with the IRS and State of Washington.  One company was a mature company with a good customer base making reoccurring purchases and a track record of increasing revenues & profitability.   The second company was a young business that was struggling to reach profitability.  The seller in this transaction wanted to sell his mature business to inject capital into the new enterprise to enhance the tangible & employee infrastructure, rate of growth, and potential for success of the new company.  Superficially, this was a reasonable narrative regarding the motivation for sale.  The mature company was valued based on its historical financial performance and presented to potential buyers in the marketplace.  Market reaction was positive and agreement was reached with a buyer for the sale of the business.  Due diligence commenced and the buyer, their CPA firm, and lender all found the tax returns & historical financial documents justified the value of the business agreed to in the letter of intent.  Funding secured the transaction was targeted for closing.  As a final stage of due diligence, the buyer reviewed the accounting software employed by the business for paying bills with the primary goal of identifying expenses that could be reduced after acquisition through better management and potential vendor migration.   However, the investigation uncovered unexpected information.  The mature company was not paying all the bills associated with its operations.  A percentage of its bills were being paid by the business that was not being sold.  The net result of this action was negligible for the seller when the financial performance of the two companies flowed together in the seller’s 1040 tax return.  However, for the buyer the action had significant implications as it resulted in a significantly overstated purchase price for the mature company because every dollar of additional profit was multiplied five times when the goodwill of the business was valued.  The shell game revealed, the buyer exited from the transactions with encouragement & facilitation by IBA.  Shortly afterward, IBA ended representation of the client.  On a positive note, IBA presented another company to the buyer and the party completed the transaction successfully achieving their acquisition goals.

The Case of the Doctor Who Wanted More for His Practice

The seller in this transaction was a doctor who wanted to retire and sell his practice.  It was a good practice in a good location with an excellent staff.  The seller was happy to sign a robust non-competition agreement, as retirement would start with the sale of his practice.   The practice was valued based on its historical financial performance and presented to potential buyers in the marketplace.  Market reaction was positive and agreement was reached with a doctor for the sale of the practice.  Due diligence commenced and the buyer, their CPA firm, and lender all found the tax returns & historical financial documents justified the value of the business agreed to in the letter of intent.  Funding secured the transaction was targeted for closing.  As a final component of due diligence, a reconciliation of monthly revenues was conducted between QuickBooks and the bank statements.  It was identified during this process that the company had an abnormally strong revenue day.  Curiosity demanded investigation.  The buyer for obvious reasons wanted to know what had occurred and whether it could be repeated.   Unfortunately, what was discovered could not be repeated.  The seller had deposited an inheritance check in the business account and counted it as business revenue.  This action had increased the value of the practice significantly when a multiple was applied to the additional net profit in the subject year when calculating the value of the practice.  The inappropriate action revealed, the buyer exited from the transaction with encouragement & facilitation by IBA.  Shortly afterward, IBA ended representation of the client.  Like in the previous example IBA eventually facilitated the sale of another practice to the buyer.

George Bernard Shaw famously said, “The most tragic thing in the world is a man of genius who is not a man of honor”.   History is full of geniuses who made the world a better place and people who used their intelligence to find shortcuts to fame and fortune.  Over time sunlight will generally reveal the truth about any situation.  IBA is pleased to employ “best practices” in the sale of privately held companies.  It is our goal in every transaction we facilitate to create an environment of full disclosure & transparency between the parties during the due diligence process.  The knowledge & experience of how to facilitate a due diligence process correctly is one of the reasons why IBA has successfully sold more businesses to entrepreneurs in the Pacific Northwest than any other business brokerage firm since 1975.

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 based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.