Preparing for a Due Diligence

The last six months has seen a significant increase in activity in the business sales, mergers and acquisition space and we’ve been lucky enough to be involved in a number of due diligence assignments.

Due diligence is simply the process of checking a business out to make sure it is what it appears to be and that nothing is lurking in the background that will come out and bite a new owner.  It can be compared to someone getting a mechanical check on a car and also checking if money is owed on it, before they hand over the cash and drive it away.

The last couple of due diligence assignments we’ve completed have really highlighted the importance of the vendor being fully prepared for the due diligence process.  In one case, the purchaser walked away at the last minute simply because they lost confidence as a result of issues we uncovered. In my view none of the issues were deal breakers, but collectively they were enough to spook the purchaser and kill the deal.  Had that business been prepared for due diligence, I suspect the deal would have gone through.

A lot of what is done in the due diligence process is specific to the individual business, but the following are quite generic parts of the process that are quite easy to prepare for:

• Expect the last two years of GST returns to be analysed.  These will be checked to IRD records and reconciled to the annual accounts of the business.  Do the sales and expense figures in the GST returns match to the financial statements?  If not, why?  It really pays to find any problems before the due diligence team find them, and be prepared with an explanation.
• The last few years of PAYE returns will also be put under the microscope in much the same way as the GST returns.
• Expect all employment contracts and related files to be checked, with salary information verified to the most recent payroll.  Are the files up to date and accurate? Do they include full job descriptions?  Are holiday pay obligations accurately recorded?  Make sure you have job descriptions prepared for the working owners as well as for the rest of the team.
• The last three to five years of annual financial statements will be requested, as will the related tax returns.  Make sure that profit figures provided in negotiations can be reconciled back to the financial statements.  If you’ve made adjustments for ‘discretionary’ expenses that may have slipped through as being tax deductible, then be prepared to fully justify these.
• Are leases on your premises properly documented?  If there are issues to resolve with the landlord, sort them out well before due diligence begins.
• What security charges do other people hold over the assets of the business?  Check PPSR records and get rid of any out dated charges.
• Have trademarks and logos been properly registered and is ownership of them in the correct name?
• Look at your reliance on key customers and key suppliers.  A purchaser will generally want to see what percentage of your turnover has come from each customer over the last few years.  Be prepared to explain any loss of key customers and also explain what strategies are in place to maintain relationships with them.
• Expect your accounting system to be checked back to source records. Can lists of payables be matched to supplier invoices?  Can wage payments be matched to payroll records? Are your bank reconciliations done regularly and accurately?
• If you don’t have an operations manual, start putting one together.  It shows that the business is well organised and can run even if key employees are unavailable.
• Make sure you are meeting all health and safety requirements and that all legal obligations relating to your specific industry are also being met.
• If inventory or work in progress are significant assets, makes sure your records are squeaky clean.  Any problems in this area will automatically put doubt on the profits recorded in financial statements.

This is by no means an exhaustive list, but it should get you off to a good start if you’re preparing to sell.  Even if you’re not looking to sell, it is sound business practice to have all the above covered off. You never know when you may be forced to put your business on the market due to unforeseen circumstances.

When preparing for due diligence, if you find issues, and it’s too late to put them right, then be upfront about them.  Disclose them early in the process and explain the situation fully.  There is nothing worse that the purchaser finding problems during the due diligence process. Even if the issues can be explained, they chip away at the purchasers’ perception of the business and destroy confidence.

There are many studies available that categorically show that businesses that have prepared well for a sale will achieve a premium price, so get your house in order now and reap the benefits when it’s time to move on.

If you are looking at or even considering a new business purchase and want to find out how Hayes Knight can assist you with the due diligence process, contact your Hayes Knight adviser or Tristan Dean direct.

Tristan DeanBusiness Advisory Director
T +64 9 414 5444
E tristan.dean@hayesknight.co.nz