Due Diligence – Truly a Challenge?

By Achim Neumann

“Due diligence” is commonly referred to as the process of verifying information that was previously presented in preparation for the sale of a business.  Unlike buying a car or house, justifying the price for acquiring a business entity requires financial documentation to verify the true cash flow and to support a full “quality of earnings assessment.”  Typically, it takes the cooperation of various parties, including the principals, the CPAs, the lender, and often an appraiser to conduct such a process.

“We frequently experience business owners being somewhat concerned about the due-diligence process, and thereby are reluctant to provide the various documents requested by a buyer,” says Achim Neumann, President of A Neumann & Associates, a New Jersey based mergers & acquisitions and business brokerage firm.  “However, the better the business has prepared in advance, and the better the financial records, the less a business owner needs to be concerned.” Let us take a look at these factors.

Business preparation is the most important factor..  This should include capturing all key information about the business and probing  key metrics – for example, inventory turnover relative to the industry.  Critically, preparation should include establishing a value for the business, including the development of a formal business valuation report by an accredited national valuation firm.  Further, all assets and inventory should be identified by quantity, purchase price, and acquisition date, and for vehicles, VINs.  Excessive add-backs for personal expenses flowing through the business are of particular focus to buyers and need to be well-documented in the preparation stage. The more thorough this information is prepared, the better the business seller will fare in the subsequent due-diligence process.

The second component in performing due diligence is a well-functioning financial reporting system.  With ready, off-the-shelf software packages, even as simple as QuickBooks, there are few excuses for a business owner not being able to quickly generate most every conceivable report requested by a buyer.  Of course, this requires up-to-date data entry of all financial transactions, clearing old A/R and A/P balances, keeping the inventory correct, and so forth.  Financial reports are part of every due diligence, and, for that matter, should be part of any well run business, and the faster a business seller can provide such reports, the less buyer mistrust will creep into the buying process.

“Needless to say, the financial system needs to tie into, or at least be consistent with, the inventory system,” says Frank Arcoleo, Managing Director.  “This might at times require the manual transfer of information, which is perfectly acceptable if that is the way it’s always been done.”  Reviewing such inventory and equipment (FFE) is important to the buyer to determine the expected date of replacement and the implicit cash flow requirement, commonly referred to CAPEX (Capital Expenditures).

Finally, at times and depending on the location and nature of the business, commercial real estate might be involved in a transaction, and this might trigger the need for state environmental approvals prior to a transfer.  Such early assessments are called “Phase One” environmental reports, and they are designed to uncover any potential site liabilities that need to be remediated by the seller prior to a sale.  Often, the lender of the buyer requires such a “Phase One” report before any funding can be put in place.

In sum, whereas a business seller might perceive the upcoming due diligence with trepidation, in reality, it’s merely a verification of a previously-presented business description.  Most importantly, with today’s technology, such due diligence is commonly executed off-premises with no employee involvement.

A highly qualified M&A firm like ours is well-versed to guide the business owner through the preparatory and due diligence process.  But without such guidance, the process can be quite daunting.