The benefits of effective financial due diligence
Following acceptance of an offer to acquire a business, the prospective purchaser should be given access by the seller to conduct its due diligence investigations on the target company. This investigative process covers a wide range of areas including legal, financial and operational matters. The full extent of the procedures required under each area will vary depending upon the size and nature of the individual transaction.
A typical financial due diligence review will not only look at the historical financial performance of a target business but also assess the forecast financial performance for the company under its current business plan and consider the reasonableness of such forecasts. Financial due diligence should not be confused with an audit, which seeks only to provide an opinion on whether the historical financial statements represent a ‘true and fair’ view of the company’s operations. A financial due diligence review should investigate reasons for any trends observed in the results of the target company over an appropriate time period and report on this in terms of relevancy to the proposed transaction.
Clearly, the scope of each financial due diligence project will be unique depending upon the nature of the transaction and the size of the company or business operations being acquired. Whilst theoretically due diligence should have as wide a scope as possible, in practice, due to time and budget constraints and a need to maintain the momentum of the purchase (and the goodwill of the seller) it will be focussed upon those risk areas of the business which could have a material effect on the target’s value to the buyer.
The financial due diligence review will typically be undertaken by independent external accountants having experience of this type of work, or alternatively, it can be conducted by the acquirer’s own finance team. Ideally, the financial due diligence process should commence as soon as possible when negotiating to acquire a company or business. In practice, once the Heads of Terms have been drafted setting out the structure of the deal, the financial due diligence may begin.
It is normal for the target business to be taken off the market during the due diligence investigations, and for any and all discussions with other potential buyers to cease. This is known as a period of exclusivity and the logic behind the seller granting it to the buyer is twofold – a deal has been agreed in principle between the parties and the buyer is now incurring costs to investigate the seller.
It is essential that sufficient time should be allocated to the financial due diligence process, as the outcome of the review may provide valuable information required to ensure a fair purchase price is agreed upon and, where necessary, that appropriate guarantees and conditions are put in place.
The information required to complete the financial due diligence investigation will depend upon the scope of work agreed along with the reporting capabilities of the target company. The main sources of information for the review include:
- Historical financial data (including statutory financial statements and detailed management accounts)
- Current financial data (such as year-to-date management accounts)
- Forecast financial information (including business plans, budgets and cash flow forecasts)
Depending upon the scope of the work undertaken, a financial due diligence review should provide answers to the following questions:
- Is the information provided by the target/seller reliable?
- Are the historical earnings of the target company sustainable?
- What are the potential future earnings of the target company?
- What are the possible synergies associated with the proposed acquisition?
- What are the immediate and future tax consequences of the proposed acquisition?
- Is the purchase price fair given the results of the due diligence process?
- Based on the outcome of the due diligence are there any potential deal breakers?
- Is the proposed structure of the acquisition appropriate?
- Should any warranties and guarantees be included in the legal documentation?
When done properly a financial due diligence review provides valuable information to support the proposed acquisition and to identify early the nature and extent (and potential impact on value) of any material risks in the target business, any issues which will need to be addressed (and the associated costs to do this) and whether acquiring the business will add real value to the purchaser. Over recent years there have been numerous high-profile examples which have proven that the costs of performing thorough financial due diligence far outweigh the costs of making a bad acquisition.