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Due diligence – A Jargon free guide on what it is, and how to do it properly

March 13, 2017

Due diligence is a term bandied around quite a lot. However, not many people understand what it means or how it’s can be used to help.

If you ever consider buying or selling a business, or investing in a business, then you’ll need to know precisely what due diligence means, what the process involves and how to conduct due diligence properly.

What does ‘due diligence’ actually mean?

Let’s break the term ‘due diligence’ down.

‘Due’, means appropriate. And when I explain the term a bit more fully you will understand that it means whatever the circumstances dictate.

‘Diligence’, means to approach something with careful thought, and in the context of the words taken together, it means, proving to one self that whatever fact one is considering there is some form of independent evidence available to corroborate or support the fact or information being reviewed.

Examples of conducting ‘due diligence’

So let me give you some simple examples to show what I mean:

If you are verifying a potential new recruit’s employment record – then you need to speak to someone who previously employed the person. If their former employer won’t speak with you, then asking them for some form of written reference will suffice.

Let’s assume you wish to buy a business; you need to understand everything about the management team of the business – the people’s track record and their previous achievements.

You cannot rely on Linked In as there are many fraudulent profiles on there and you also have no way to verify what is being said. Speaking to people who know the management team, assuming they happen to be agreeable to discussing the people with you is the best way to go.

The challenge for most people in buying businesses, which is where the term due diligence is often used, is they may well have not undertaken such activity before. It’s very hard, and the smart thing to do is to talk to people with experience. Yes, there will be a bill associated, but it’s the kind of thing where if your serious you need to be prepared to spend money, or you will fail because of a lack of experience and make mistakes which will cost you dearly.

You would not buy a house without doing a survey on the property. So regard due diligence in the same way as you would a survey on the house.

9 Key steps to successful due diligence

Due diligence is often shrouded in jargon and can therefore be a bit of a mystery to many business owners. So, here is a jargon free way to understand the key points on due diligence:

1. Handbook/Instructions

Like with any new thing, you need a handbook and set of instructions as to how to make it work properly.

In a transaction to buy or sell a business you need something called a Heads of Terms. This is a simple document which sets out who the parties are involved in a deal and what the deal is. A list of bullet points is a good way to start. You don’t have to do all this yourself, you can use a lawyer to help.

It is a very simple exercise and no matter how few bullet points there are it needs to be done, as it will focus the mind on what is important.

2. Contract

As in buying a house, there is a need for a sale and purchase agreement, except in this case its one for buying a business or a company.

It is the same kind of mentality required to make sure that you get what you pay for and also that you do not take on liabilities you are not aware of.

In addition, its vital that you understand the way the contract is put together, the timescales involved and what deadlines there are. In many cases people forget about how the price of a transaction is to be finally determined, particularly if some reference point has been used.

What’s a reference point I hear you ask? It’s something used as a proxy to measure the business and can be used to determine the price.

In some cases, this can be based on net assets or an agreed multiple of the recurring income of the business. The usual multiple for such a business is based on somewhere between 3 and 6 times earnings.

3. Money

It is very important to have worked out how one is going to pay for the acquisition. This will avoid embarrassing delays and issues which can cause frustration and unnecessary stress for everyone involved.

If you need to arrange bank finance, then it is important to get the wheels moving before the transaction gets too far: sure you need information to present to the bank, however, determining a final price and how to make the money move is important.

Funds will usually be collected in a lawyer’s client account so that when the deal is ready to be done, when the documents and transfers have all taken place, the money can be released.

I have seen several cases during my career when monies have been released and the transfers have been badly or wrongly executed. This stage in a transaction is very fraught with risk and needs careful management.

Whatever you do don’t let go of the funds until you have your hands on the keys to the company and bank accounts. I have seen a case recently where this wasn’t done. Can you imagine post your transaction not having control of your bank account?

4. Management of the business

It is important to understand how the business is to be run after acquisition. Do you need to keep the management in place? It would be a shame to buy a company and remove the critical success factors if that is the management.

In some cases, this might not be an issue. However, if there are critical customer and/or supplier relationships involved then it might be important to retain the existing management of the business so that an orderly transition of relationships can be undertaken.

It is also quite common if management wish to retire to structure part of their purchase consideration into a consulting agreement so that they are on hand to help when issues arise and the relationships they built need their input. People are important in any transaction.

5. How has the business done?

It is important to work out how the business has performed in the past. The accounts filed at Companies House are always a useful start, however, the management accounts produced on a regular basis – be that monthly, quarterly, bi annually will be a good source of information.

The level of profitability of a business is important to understand and to verify. The owner will want to talk about the run rate, and this will be the expected turnover or profit for a business into the future.

It’s important to realise that the historical performance of a business is indicative of the potential moving forward. It’s important to figure out how the business may grow.

6. Future prospects

The potential for a business is dependent on a number of features: its existing customer base, but also with the sales and marketing activities. Most businesses struggle with ensuring the right marketing mix and sales activities are undertaken. It’s very important to understand what these are and to see, based on normal conversion ratios, whether the activities are sufficient.

The vendor will want to talk this up as much as possible and could very well cause an issue as they are likely to be over optimistic. Therefore, be careful how you agree a price.

Don’t buy into future earnings unless the consideration involved is to be withheld and only paid over when the business performs according to expectation.

7. Lawyers and deal doers

A lawyer’s expertise is vital in a deal, as is a Corporate Financier/Deal doer. These people are invaluable in guiding you through what can be a complicated maze.

Please don’t underestimate the work involved and the resources and experience you may need. It is vital you understand that you need to budget for professional fees in any calculations of funds required.

Some people always leave engaging professionals until the last minutes, however, if you use their skills properly they will save you money. Do yourself a favour and engage people with the right skills for what you are doing.

8. Completion

The way a deal completes will take a lot of crafting and will depend on the due diligence findings. The mechanism agreed is vital to understand, so that the remedies available are understood if matters turn out to be different from that which was expected.

Indeed in complex cases, the completion and contractual terms can be re-agreed by both parties if mistakes have been made and are accepted by both sides. However, it would be foolish to rely on this.

Completion should also be regarded as when the flag is dropped i- ensuring you have the future management of the business understood and arrangements in place. Planning for this should be undertaken well before completion.

9. Conclusion

In conclusion, one needs to take ones time doing deals. If people are in a hurry, it’s either because they have a pressing financial issue or there is something terribly wrong. Your instincts need to guide you. If you get a bad gut feeling about a situation walk away.

Do your due diligence, slowly and diligently and invest in the help you need to make a deal that will serve you well as you develop your newly acquired business.

About the author

This guide has been written exclusively for ByteStart by Clive Hyman FCA. Clive is the founder of Hyman Capital Services, a company offering expertise in due diligence and managing change in business including raising equity and debt capital, mergers and acquisitions, interim management, board management and governance, deal structuring, and company turnaround.