Due diligence is a similar process for everyone, but it’s not the same process. The depth of your analysis will depend on your appetite for risk, the particular business you are looking at and your specific requirements for a business.
It involves assessing your expectations of a business proposition against the target acquisition to determine if it measures up and where there might be gaps, risks and issues in a transition to ownership.
The following 5 high-level areas of focus will usually be considered to some degree in every due diligence process.
1. Customers and markets
Portfolio of customers
Think about a business’ customers as being a portfolio of earnings potential.
Ask yourself:
- What is the strength of that portfolio?Is it skewed to one type of customer, one particular geography, one particular product line?
- What does the pipeline of business with potential customers look like?How many quotes are there, how many orders, what’s the work in progress look like?
- Where does the business come from?If I’m buying a retail store, does the business comes from the footpath? Other than that, does it come from interaction with a customer database? If I’m buying a wholesale leisure goods business, where do the referrals come from? What are the networks? Where does that business effectively originate from?
- What do the customers think of the business? This question is about brand and loyalty, and the service and value proposition.
Operating environment
The operating environment involves considering the trends and issues faced by the business in the market and how they might materially impact the business you’re looking to purchase.
2. Inventory and suppliers
Inventory levels
Often people look at a business’ product or service range but don’t necessarily look at the corresponding inventory levels.
Imagine the business you’re looking to purchase is selling air conditioner model XYZ. XYZ is one of the business’ top five sellers and for the past two years the business has averaged 55 sales per year of this model. The current inventory level of XYZ is 78 units, with each having a wholesale value of $5000.
You now need to consider what impact this inventory level will have on your working capital position. Your due diligence may have confirmed that you have a strong chance of selling 55 units per year. Do you want to buy 78 air conditioners on day one, when you will likely only sell 55 per year? You will be holding a surplus of 23 units – that is $115,000 of extra working capital you will be outlaying on day one.
Obsolete and slow-moving stock
We talked about inventory management in detail in our eBook Managing Cash Flow and Working Capital and one of the topics discussed was obsolete and slow-moving stock.
When assessing inventory levels in due diligence it’s important to recognise the difference between overstocked items – like air conditioner XYZ – and obsolete and old stock items.
Be careful not to wind up paying face value for stock you may have difficulty moving.
Supplier relationships
Due diligence in this area also requires pressure testing the value of relationships with key suppliers.
It’s just like customers: think of the suppliers as a portfolio of relationships that have elements of value to bring to the table i.e. products. They may each be operating under different terms, which you will need to understand.
They will also have their own views on the business you’re buying, so engage them in early discussions to understand their perspective on the business:
- Where are the weaknesses?
- Where are the strengths?
- What are the opportunities?
Stocktake
The final piece of this section, if inventory is part of the sale process, involves doing a stocktake. This usually comes after all of your other due diligence and just prior to completion.
Stocktake is an important part of the due diligence process because any ‘red flag’ issues you identify regarding inventory levels may necessitate a price renegotiation or discussions on other remedies.
3. People and process
People
What you’re trying to do in this stage of due diligence is understand the quality of the team you have available upon transfer:
- What are their strengths?
- What are their weaknesses?
- How are they performing?
- What are their roles?
- Do they have defined position descriptions?
- What are their expectations of their roles?
- What are their employment conditions and entitlements?
- What is the risk of losing key staff when you take over?
- How involved is the current owner in key roles and how will that impact the success of transfer?
Processes and procedures
This issue is very important for a successful transfer and you will want the following information:
- What are the key processes in the business?
- Are they documented?
- Are they standardised or very 'people-reliant'?
- Who is responsible?
Once you have an understanding of the processes you need to consider to what extent those processes have potential areas of failure that could impact the financial position of the business.
For example, how do those processes mitigate the risk of poor or inconsistent pricing in quotes, or even the risk of fraud?
4. Contracts, licences, registrations and agreements
Legal due diligence is a very important component of due diligence and is covered in more detail in Chapter 3 of our eBook, How to conduct due diligence on a business purchase.
One important part of this process is looking for formal or informal agreements or understandings between the business owner and key people or organisations. These people may be customers, suppliers or collaborators.
The agreements could be anything from the actual premises lease documents and what’s required in terms of lease obligations, assignment and transfer, to a verbal agreement with a sub-contractor to provide product installation services on an hourly rate basis, with no documentation at all.
When buying a business as a going concern, the legal contract will help protect you from some obligations, but you will still find yourself approached by people with views on your commitments to them, and you’re going to need to know what they are and whether they’re appropriate.
5. Business and financial performance
When thinking of due diligence most people think of numbers.
This area of due diligence may be very extensive, or less so, depending on your risk appetite and also on the work you’ve already done in getting to the stage of due diligence. It’s also about comparing financial performance to the physical and non-financial aspects and trends impacting the business to identify trends or breaks.
Typically there are a few things we like to look at here, including:
- Reconciling accounts– We like to reconcile the management accounts of the business against the accountant’s financials to see if there are any variances and to ensure we can explain those variances. If we can’t, and they are material variances, that gives rise to consideration of remedies.
- Debtors and creditors– We like to look at the ageing profile of debtors and creditors, because this has a large impact on your working capital. We want to know how much money is outstanding, on what terms the money is paid, and get a sense of any risks around that customer portfolio from a financial perspective.
- Cash flow profile– We usually start by looking at the bank statements of the business’ trading account on a monthly basis and go back one to two years to see the flow of funds in and out of the business to determine how it has tracked from a cash flow perspective.
- Taxation– Finally, we look at a range of tax due diligence aspects. These relate to making sure the business has met its taxation liabilities correctly over the years and we also look at Business Activity Statements (BAS) to match them up against reported sales and expenses.
From the JPAbusiness archives
Refreshed and checked for accuracy April 2017
Buying a business will be one of the more significant investments you make in your lifetime. To ensure you are fully aware of the risks, issues and opportunities your target acquisition presents, consider engaging an experienced business advisor to assist you in conducting due diligence.
Call the JPAbusiness team on 02 6360 0360 for an obligation-free, initial discussion.
James Price has over 30 years' experience in providing strategic, commercial and financial advice to Australian and international business clients. James' blogs provide business advice for aspiring and current small to mid-sized business owners, operators and managers.