Buy-Side Due Diligence: Find Hidden Risks to Unlock True Value

What you do before getting to the deal table will determine the ultimate success of a transaction and help you avoid costly surprises, such as delays in post-deal integration or even M&A litigation. Acquiring a business is a complex process whose success lies in performing the proper due diligence as part of a sophisticated strategy and detailed plan.

The most important reason for conducting due diligence before an acquisition is to identify and mitigate potential risks, just as you would with an inspection or final walk-through before purchasing a home. Due diligence creates transparency, limiting risks and ultimately making the deal more valuable. Diligence efforts can also help identify and plan for integration and performance improvement initiatives prior to acquisition – so you’re ready to go on day one!

These four crucial pillars of the due diligence process will help determine what a deal is worth and may provide you with negotiating leverage:

1. Tax due diligence
2. Accounting/Financial due diligence
3. Operational due diligence
4. IT due diligence

1. Tax due diligence

Study the tax structure of the business to determine the most advantageous structuring of the transaction, whether you will be making an asset or stock purchase, and what type of entity should make the acquisition (e.g., C-corporation or S-corporation). When purchasing stock, you should also identify whether there are any outstanding tax liabilities, as these will become your responsibility as the new owner of the business and may put you in an undesirable position. An optimal tax structure can also limit potential legal liabilities after close and maximize tax benefits.

Furthermore, thorough tax diligence could also assist with determining differences in earnings reported to the Internal Revenue Service, as compared with earnings reported on the internal financial statements. For example, if the founder of the company you plan to acquire was running their personal expenses through the company for tax purposes, but excludes them when it comes to valuation, a detailed assessment will help you, as the buyer, determine whether to accept these adjustments. Based on tax diligence efforts, you may determine it is more advantageous to acquire assets in order to eliminate any potential tax, legal or non-operational liabilities.

It’s also important to factor in purchase price allocation, which values the intangible assets acquired from the transaction and provides for a portion of the purchase price to be deemed as goodwill.

When purchasing the assets of a company, most buyers can realize a significant tax benefit in the first 15 years following the transaction. Therefore, it is imperative to accurately value/appraise each of the assets being acquired. Proper valuation/appraisal, together with the appropriate purchase price allocation, are imperative for accurate tax reporting and can help buyers maximize tax benefits.

2. Accounting/Financial due diligence

As a buyer, it is in your best interest to identify any undisclosed risks of the company as early as possible. You will need to assess the historical working capital of the company you plan to acquire, including future requirements and its potential impact on purchase price. Is the seller able to provide audited financial statements? Has the company lost an important client who was a large source of revenue? Are there any expenses hidden within the balance sheet that should be in the income statement? Inappropriately capitalizing costs and treating business expenses as owner distributions can have a significant impact on a company’s financial picture. These concerning questions, amongst others, are why it is crucial to team with our professionals for purposes of reviewing the target company’s quality of earnings.

You should also evaluate the consistency of year-over-year, monthly, quarterly, and annual trends – this can give you more confidence about the company’s abilities to consistently generate disclosed earnings. In some cases where risks are identified, diligence efforts may conclude that it is beneficial to establish a hold-back of up-front cash consideration and instead create an earn-out structure until you reach desired earning levels.

It’s also important for buyers to be comfortable with the seller’s calculation of EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) adjustments, which are likely to factor in non-recurring expenses, future operational enhancements, and synergistic adjustments (such as management redundancies), among others. The seller should provide supporting documentation to verify any adjustments, including calculations for any estimates made.

3. Operational due diligence

In addition to financial information, your due diligence process should include a detailed look at the company’s operational health. Any new performance initiatives that have affected the business in the past can be pro-forma adjustments for valuation purposes. These adjustments need to be carefully documented so that your due diligence team can follow the logic and evidence clearly and give it the credit due – this usually results in significant savings for some buyers on unanticipated transaction costs.

You should look for standard operating procedures as a guide to how the business is run. A clever tool to better understand the company’s standing is to compare operating key performance indicators (KPIs) to industry benchmarks or other businesses recently valued or sold. Additionally, understanding the KPIs the current management team reviews on a daily/weekly/monthly basis could help identify the value drivers of the business.

Are the reporting and operating systems automated? Is there consistent data integration? All of these can add up and influence the projected performance of the business and your future earnout structure, plus any other future payout that is based on realized post-acquisition performance.

4. IT due diligence

As the buyer, you should understand the information technology landscape of the company you plan to acquire, including the current software being utilized and any data management systems. If the seller has software limitations that are hindering your due diligence efforts, it could be an early sign that the IT systems may need upgrading.

Is the IT infrastructure aligned with the business operations? The current software should provide management with the financial and operational KPIs needed to accurately assess the business’ performance.

You may also dig deeper into audit work papers to further test the nature or classification of related software costs. Having a full understanding of the current systems can help you determine whether a significant investment must be made to integrate or upgrade operations after a deal. This could potentially impact the purchase price.

Holistic approach to buy-side preparation

In addition to the four main aspects of due diligence, our team works hand in hand with your legal representation to identify the key terms and clauses that can ultimately affect the economics of the deal and/or prevent against future litigation.

If your company is ready to increase market share, expand into new markets, obtain more advanced technology or hire a team of experienced personnel, a business acquisition may be a viable option. Before finalizing a deal or even during the process of drafting your Letter of Intent (LOI), make sure you have the proper team in place to cover all aspects of the due diligence process.

Contact me or another member of Kaufman Rossin’s Business Consulting practice to learn more about our transaction advisory services and how we could help you limit your risks and maximize your negotiating leverage in a business acquisition.