How to conduct due-diligence as a buyer and what to expect as a seller

Due diligence is one of the most crucial part of any acquisition deal. It is the part that lets you look behind the curtain and under the hood to make sure that everything is above board and that the buyer won’t get any nasty surprises once the check has cleared. 

There is a long list of things a buyer needs to take into account before signing a sales agreement, and it requires taking a deep dive into every aspect of the business, including its finances, its business plan, its product lines, sales channels and more. 

This is especially true if the deal is structured as a stock sale, as opposed to the asset sale, meaning the buyer is taking on the legal company itself rather than assets it owns. 

What does a buyer need to look for during due diligence?

Financial and Corporate

The big obvious one. Perhaps the most important thing the buyer needs to know is what financial shape the company is in. Things can look pretty on the outside but a bad set of books can reveal a rotten core. The buyer needs to investigate a number of questions, including: 

• Who are the company’s current shareholders and how much does each own? What kind of rights do each currently have?
• Are there any right of first refusal agreements in place with relation to a potential sale?
• What does the competitive landscape look like? Who are the company’s biggest rivals and how big is its addressable market?
• If the company’s financial statements audited, how far do the audited statements go back? 
• Looking back at annual, quarterly, or even monthly financial statements over the past three years, what is revealed about the company?
• How are the company’s margins? In which direction are they trending?
• The buyer will need to determine if the underlying assumptions on which financial projections have been made make sense and are believable. 
• How much normalized working capital is needed to been the business operating, and how working capital is defined in the first place. 
• How much does the company need to spend to keep growing? What are the current capital commitments and debt obligations it has on its books. 
• In terms of debt, when does it need to be paid back? 
• Is the company in good standing with tax authorities?
• What kinds of insurance does the company have in place?
• Does the company have appropriate compliance policies in place?

Technology/Products/Contracts

The buyer needs to know what state the company’s proprietary information is in, how viable its products are and what contracts the company has in place. Some of the things to consider include: 

• What kind of protections does the company have in place for its intellectual property?
• What products and technology does the company have that the buyer doesn’t already have?
• What licenses does the company have, if any, for the software it uses?
• If the company’s business depends on proprietary information, processes, or other trade secrets, what kind of protection does it have in place for them? 
• To what extent is the company infringed on someone else’s intellectual property and vice versa? 
• Are there currently any legal disputes ongoing about the company’s intellectual property?
• What customer and supplier contracts are in place? 
• Review all employment and exclusivity agreements. 
• Review all license agreements, real estate leases, power of attorney contracts, indemnification and other agreements. 
• Who are the company’s most important subcontractors, if any?

Sales and Customers

There is no revenue without customers, so the buyer must find out as much as it can about sales channels and the business’ ability to bring in money. This means familiarizing itself with the company’s customer base and sales pipeline. The buyer will have to look at: 

• What is the company’s rate of retention vs. churn? Are customers staying with the company or moving on quickly? How is the company attracting them back if they churn?
• Key KPIs like conversion rate, traffic, customer activity, and how it compares to competitors.
• Does the company have a good understanding of their customers’ journey? How good is its analytics capacity?
• Who are the company’s top customers and clients, and how much revenue does each of them bring in?
• Are there any issues with customer concentration (i.e. is too much of the company’s income coming from too few customers)?
• How is the payment for sales people structures? What is the ratio of salary to performance-based pay? To what extent would the acquisition have an effect on those incentives?
• Are existing customers happy with the company? Are they likely to stay after a takeover is completed?
• Is revenue or working capital subject to seasonal changes (e.g. a spike because of holiday sales)?
• What kind of customer backlog does the company have?
• What are the company’s current policies regarding returns, exchanges or refunds? Has the company been seeing unusual levels of these?
• What marketing agreements does the company have in place, particularly with external agencies/representatives?

Matching/Strategic fit/ Employees

Buyers may not see this as their top priority, but many who have gone into a transaction without doing proper due diligence on whether the target company is a good strategic and cultural fit for them have seen a disastrous result. Buyers need to consider and have a good understanding of:

• Does the target company actually present a strategic fit with what the buyer is trying to do? 
• What will the integration process look like, what will it require and how long will it take? 
• What kind of overlaps are there in the two companies’ operations that can result in cost reductions and synergies?
• Are the companies a good cultural match? 
• How much of the existing staff, particularly key employees, will remain after the acquisition? 
• Do any current directors have a financial stake in the company?
• Employee benefits, salaries and contracts, including how many employees are on payroll versus being contractors or freelancers. 
• Any ongoing disputes with current or former employees.
• Any ongoing litigation of any other kind.
• Antitrust issues - especially if the target company is in the same sector or if the deal is part of a roll-up strategy. 
• What is the company’s reputation in the market? Are they looked upon well?
  

What should the seller do?

The seller can make the whole process easier before and during the process. To begin with, sellers can make sure all information - whether financial, organizational, sales or anything else - is tidy, organized and easy for prospective buyers to do their due diligence efficiently. 

They should also make sure that the finances are as up to date as possible, that their balance sheet is cleaned up and, ideally, that they anticipate buyer’s questions ahead of time and have accurate answers ready. Any big mistake, or numerous little ones, can be the difference between being able to sell the business and a failed deal, so the seller needs to ensure they are putting forward a well-run, organized and transparent business. 

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