You should know when you prepare for due diligence that this is a prospective buyer’s appraisal of your business. The due diligence includes 5 major areas: (1) the commercial due diligence; (2) the technical due diligence; (3) the financial due diligence; (4) the human resource due diligence and (5) the legal due diligence.
The commercial due diligence, and if relevant, the technical due diligence are the two corner stones along with the valuation that make or break a possible transaction. The purpose of the commercial due diligence is to determine the growth potential and the market position of a potential target company. A key milestone decision if to proceed or not is often scheduled once the commercial due diligence comes to finalization.
The Chief Financial Officer and the Auditor of the target company are often key resources but the financial due diligence is sometimes over emphasized. Although important, the commercial due diligence and the technical due diligence are key to any successful transaction.
The financial due diligence is commonly known amongst entrepreneurs. More often so then the commercial and the technical due diligences. The financial due diligence includes a deep dive into the financial records of the target company. The purpose of the financial due diligence is to understand the financial position of the target company. Internal quality such as processes, routines and documentation will also be important. Inputs from the financial due diligence is used as data input for the valuation and business planning that comes from the commercial and technical due diligences.
Finally, the human resource due diligence is a mapping of key individuals, human resource processes and any remuneration program that may exist. Any key individual dependency is of particular importance to understand in a human resource due diligence.
The commercial due diligence is key:
- An understanding of the relevant market.
- The companies market position and market potential.
- The business model, the pricing model, price position and gross margins.
- Major customers, contracts and supplier dependencies.
- Review and assessment of the contract register, of individual major contracts, important terms, conditions and internal understanding. This also includes an overall quality assessment of internal processes and documentation.
The business plan together with a market potential analysis usually forms the basis for the commercial part when you prepare for due diligence. Interviews with industry professionals is also common during the commercial due diligence. Professional investors can spend several weeks and sometimes months together with their advisors to finalize their commercial due diligence.
A technical due diligence includes:
- A mapping and understanding of leading technologies, trends and outlooks.
- A review of the target company’s technologies, architectural design, platforms and/or modules.
- Understanding of any proprietary technologies, patents or processes.
- Product review from a customer point of view including performance, life-cycle cost, etc.
- Review of the design, engineering and operations process.
- Technical organization mapping and review.
It is not uncommon that less mature businesses lack design documentation, architectural documentation and processes documentation. An investor needs to know if there are certain design processes in place, if scalability is built into the technical DNA of the business and that chosen technology is as future proof as possible. Sometimes there is a valuation gap surfacing owing to lack of future-proofing the core design of the products or services offered.
The financial due diligence includes:
- Summary and review of the last 3 years financial records.
- Tax, duties, internal pricing and other statuary charges.
- Understanding of normalized EBITDA, working capital and cashflow.
- Te operating expenses including staff, premises and travel expenses.
- Understanding of the capital expenditures and how those has been accounted for.
- Analysis and appraisal of the budget, financial forecasts and business plan assumptions and projections.
Don’t forget the human resources due diligence:
- Description of key processes and the organization.
- Review of key positions including importance, current staffing, strength and weakness.
- Analysis and appraisal of any key individual dependencies and possible mitigation actions.
- In depth Management team and leadership review and assessment.
- Contractual terms and conditions review including any union agreements or framworks.
- Culture assessment.
The legal due diligence includes:
Understanding the formal position of a business is important to a buyer that comes new to a it’s customer relationships, supply chain and product development, to name a few. Current owners and entrepreneur may operate some parts of the business based on hand-shake relationships and years of practise but all of that may fade away with new owners, hence the need for a solid contractual and legal ground.
These are the areas you shall prepare for due diligence from a legal point of view:
- All contracts and amendments with major customers and suppliers. A potential buyer needs to know they exist in writing but also if they include any restrictions in operating the business, any guarantees and terms of payments to name a few.
- All employee contracts to understand terms and conditions, in particular with key employees.
- Any asset related contractual obligations such as leasing or financing contracts.
- A confirmation that there are no legal, regulatory or tax provisions or litigations, or other, that prevent a normal operation of the business.
- A confirmation that no major environmental obligation exposures exists.
- There is also a need for a schedule outlining any significant import or export restrictions or duties that relate to the business.
Why preparation is important:
These 5 due diligence areas can be overwhelming from a seller’s point of view. Certainly, when the scope of these 5 major areas are not fully understood when you prepare for due diligence. Unfortunately, most potential transactions fail already even before they came to the hart of the negotiation because prospective buyers find out early that the commercial due diligence or the technical due diligence will fall short of expectation. To be well prepared and well documented on the commercial and technical side is time and money well spent in building and operation any business even if a potential transaction will not be finalized.
The financial due diligence is important but has the characteristic of a tick in the box. Sometimes the financial due diligence is understood as the only due diligence to be carried out, which is a clear miss-conception although understandable since the Chief Financial Officer, the Auditor and the Financial Advisor are often key individuals planning and carry out a transaction.
The part of the human resource due diligence that is most important is the leadership assessment and the key individual dependency analysis.
A well-structured due diligence process helps both prospective buyer’s and investors as well as the target company to either stop a transaction before the work goes too far, or succeed with the transaction.