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Buy-Side Due Diligence: Report Checklist and Guide for M&A and Other Transactions
Caveat emptor. That's really what buy-side due diligence comes down to, protecting you and your stakeholders' collective backside from an investment that goes sideways. And as many buyers will tell you, there are plenty of ways for a purchase – even one that sparkles at first glance – to quickly become a corporate albatross.
But an M&A deal doesn't have to be such a risky endeavor for buyers. After all, that's why buy-side due diligence exists in the first place – to look over a potential transaction with a hyper-discerning, sometimes even judgmental eye to help you avoid excessive risk or flat-out bad deals.
So to ensure you, a possible buyer, are making a fully informed decision, Embark is sharing some insights from our Transaction Advisory team on the due diligence process, along with a handy checklist to boot. Use these tips and checklist as a guide to help make sure your M&A process eliminates unwelcome surprises lurking in the post-LOI shadows.
Buy-Side Due Diligence Report Overview
Whether you're looking to buy an entire company or just a component or two, it pays to approach the transaction with heaping cups of professional skepticism.
That's the perspective we take when preparing a buy-side due diligence report for our corporate and private equity clients, as well as the basis for our accompanying checklist. In fact, we’re giving you a peek into our preparation process through these insights.
That said, we’re not going to give away the farm and spill all of our secrets, of course. Still, whether you choose to use our Transaction Advisory services, another outside due diligence team, or attempt to chart the terrain on your own, the research and resulting report should focus on and include specific areas of analysis, including:
- Executive Summary
- Quality of Earnings
- Working Capital
- Debt and Debt-like
- Income Statement and Balance Sheet
- Supplemental Analysis
Just remember, these reports are meant to shine a revealing light on revenue, EBITDA, and other key KPIs, not to adhere to GAAP standards.
Also, there could very well be a sell-side due diligence report completed and ready to go. However, this is yet another area where skepticism serves a business acquirer well. Even if it comes from an extremely reputable group, it’s prudent to question the accuracy of numbers that a potential seller provides.
For example, investment bankers can play an important role in the process, but their approach usually comes from more of a marketing angle than nuts-and-bolts analysis. Therefore, although we prefer not to paint with such a broad brush, remember to look for instances where:
- An investment banker might have embellished or exaggerated points in a confidential information memorandum (CIM), or;
- A sell-side due diligence report might have taken an overly aggressive stance when quantifying EBITDA adjustments.
Likewise, don’t forget you're often dealing with companies that aren't audited, maybe just reviewed. Either way, we treat these buy-side reports as an opportunity to better understand the numbers and create a picture of what's really going on under a company's hood. And as we begin, we usually find ourselves stepping into one of three general scenarios:
- The seller has basically done nothing in preparation and the financials are scattered to the winds
- There's already a good starting point in place, particularly when the sell-side due diligence is complete and in fighting shape, so we begin by validating management adjustments and working from there
- The company may have an audit/review or a parent company that necessitates the need to track certain non-recurring or one-time scenarios, but their work is incomplete or not sophisticated enough.
Of course, due diligence projects don't always fall into such neat categories but, generally speaking, these are the three most common environments you’ll walk into on the buy-side. What's always most important, however, is a buyer's comfort and peace of mind with the accuracy and transparency of the financials.
Obviously, when the financial data is in good shape to start with, it's going to make structuring a sound deal – and your life – much easier. But that's exactly why we created the accompanying checklist – to make the buy-side due diligence process more efficient and streamlined, helping to ensure the transaction is in your best financial interest.
So on that note, let’s dive into the individual report sections.
We’re not going to spend a lot of time here since the intricacies of an executive summary are pretty straightforward and well-understood. Just remember to be concise yet thorough enough to provide a clear picture of what the remainder of the report will include. Ultimately, you want your executive summary to drive discussion on high points and key findings, also summarizing the forthcoming financial analysis – QofE summary, recast P&L, net working capital summary.
Quality of Earnings
The Quality of Earnings (QofE) section of the report is really the beginning of the quantitative analysis for the buyer. In looking at the QofE, we start by diving into any existing due diligence reports and reviewing management EBITDA adjustments to validate the accuracy of those calculations.
With this comprehensive review, we'll adjust those existing adjustments when necessary, or agree with them when our findings align. Such adjustments typically include income and expenses that are non-recurring or out-of-period, along with any other items that aren't a part of the company’s normal operations.
Whether or not the seller provides any due diligence, we'll always construct our own QofE, giving the buyer and all interested third parties the most complete and accurate image possible.
Working capital will always be under an especially harsh spotlight during buy-side due diligence, and rightfully so. After all, unless you're buying a company for intellectual property, trade secrets, or perhaps a specific piece of real estate, the cash flow to cover short-term obligations is essential.
When working capital falls short of industry standards, the buyer often has leverage over the purchase pricing. Therefore, it only makes sense to scrutinize every line and ensure the working capital is up to snuff.
That's why we place so much importance on looking for any missing liabilities in the financial reporting, verifying proposed management adjustments – and fixing them when needed – as well asmaking sure the seller can actually collect aged accounts receivable balances. Since most M&A transactions are structured on a cash-free, debt-free basis, drilling down to the entity's true working capital is essential for figuring out what to expect at closing and post-transaction.
Debt and Debt-Like Items
As a potential buyer, wouldn’t you prefer to be the party not carrying the debt bag after the transaction? Probably so. And by probably, we mean definitely. But that’s exactly why most transactions are on a cash-free, debt-free basis.
Basically, this means the seller pays off all debt with the proceeds of the sale, and then keeps the remaining cash. Therefore, we first have to figure out the seller’s net debt – the company’s debt position after taking cash and cash equivalents into consideration (i.e., debt minus cash).
We calculate net debt at a single point in time by aggregating the target’s short and long-term debt accounts, then subtracting cash and cash equivalents from the figure. Depending on negotiations between the buyer and seller, the net debt calculation can also include debt-like items outside of the debt accounts. In this case, a debt-like item is essentially a future cash outflow that:
- Doesn’t provide any – or at least very little – benefit to the buyer, or;
- Is for a future purchase of something a buyer would normally expect to be in place, or;
- Represents a liability that isn’t a component of typical working capital.
At Embark, we usually suggest the buyer negotiate for the seller to assume liabilities associated with debt-like items, also retaining them post-transaction. Alternatively, the buyer can require the seller to leave enough cash in the business at closing – in the form of a reduced purchase price – to cover debt-like items. Some of the more common debt-like items include:
- Accrued interest on outstanding debt
- Legal liabilities, both current and potential
- Deferred compensation – earned and unpaid bonuses/commissions, pending severance agreements, earnout payments, etc.
- Deferred revenue
- Unfunded or underfunded retirement/pension plans
- Environmental and restructuring reserves
- Deferred rent
- Loan guarantees
- And many, many others
Income Statement and Balance Sheet
The report's Income Statement and Balance Sheet sections are pretty straightforward, providing more nuanced details on financial statement line items that might otherwise get overlooked.
On the income statement, you're looking for insights to help verify the different sources of revenue, thus, explaining the company's COGS and operating expenses. If the seller is carving out a part of the company, be specific about the important stand-alone considerations in your go-forward operations, including:
- Facilities costs
- Accounting and finance operations – billing/collections, purchasing/payables
- HR function
- IT and software operations
- Business insurance coverages
- Professional fees (audits/reviews, tax filing, legal, etc.)
Aside from these essential considerations, other items like warranties, employee benefits, and workers’ compensation matters could also be a factor in your operations after purchasing a carve-out.
The Balance Sheet section can vary according to what a buyer is looking for, particularly regarding analysis surrounding accounts like inventory. Sometimes, our clients want us to physically inspect inventory to make certain the seller has accurately recorded it on the balance sheet.
The Supplemental Analysis section is another area where the report flexes to the needs of the buyer. For example, we might calculate and analyze several specific KPIs for an especially savvy buyer, including, to name a few:
- Revenue bridge analysis
- Key customer matrix
- Cash proof of both revenues and expenses
- Price-volume analysis
- Summary of the top vendors and material contracts
We usually start the analysis on a monthly basis to identify trends, fluctuations, and unusual items, building from there. By providing such additional analysis, we're using our experience to reveal areas of concentrated risk and key value drivers for the buyer. These are the types of insights that don't leap out of a standard set of financials but are obviously crucial in determining if a purchase is the right move.
Ultimately, for both the Supplemental Analysis and the entire due diligence report, our work depends on the intent of the due diligence. Sometimes it's simply a matter of checking certain boxes, while other times, it's proving out a business case for an investment committee or banker. Therefore, a buy-side due diligence report can require a minimal amount of time, an extended period of work, or anywhere in between.
Buy-Side Due Diligence Best Practices
When it comes to purchasing another company, it's almost impossible to be too careful and meticulous. So, to that point, along with our buy-side due diligence checklist, we also have a few best practices to help guide your due diligence efforts.
The Sniff Test Goes a Long Way
Sometimes you don't need an elaborate set of reports to figure out a particular company isn't a good fit for you. As you're going through an initial run of the buy-side checklist, if there are glaring issues at even the highest levels of analysis, then the target company is already failing the sniff test.
Simply put, if the company's business plan will require massive restructuring or the current state is a mess with scattered financials and chaotic operations, there's a good chance a plunge into buy-side due diligence is time and money you can better invest elsewhere.
Focus on What’s Most Important First
There’s a hierarchy of needs and wants when it comes to due diligence, with information requests to sellers ranging in importance from must-haves to nice-to-haves. Yes, you want to be thorough and cover every item on the checklist, but that doesn’t mean all of the points are created equally. Figure out what items are most important and start from there. This approach ensures everyone’s time is being used as efficiently and effectively as possible.
Don’t Make Assumptions
Effective due diligence means dotting every i and crossing every t. Thus, making assumptions without factual data supporting them flies directly in the face of what you’re trying to accomplish in the first place. As the old saying goes, when you ‘assume,’ you’re making a…donkey…out of you and me.
Long story short, you need to verify everything that falls within the transaction’s perimeter, while also coordinating with the buyer's legal counsel and other diligence providers to ensure everyone is on the same page. Mind you, that means not making assumptions on the transaction perimeter itself. Otherwise, you’re risking an unwelcome surprise obligation down the road from an entity you might’ve assumed was outside the scope of the deal. And that’s never fun.
Identify Leadership and Coordinate on the Sell-Side
Even if a potential buyer's financial due diligence goes flawlessly and the transaction is successful, those are still just the initial steps in an ongoing journey. You're likely going to need the legacy management team to run the show, at least temporarily.
Thus, as you're going through your due diligence, keep an eye out for key employees within the purchased entity that can help make the transition as smooth as possible and maximize synergies. That also includes proactively coordinating with tax departments, legal teams, Human Resources, and other related parties.
Get and Stay Organized
Depending on the scope of work on the buy-side of the fence, a headstart on the data front can be a helpful wind in your due diligence sails. Even better, if a sell-side report is already complete, that means a data room already exists.
Use this centralized resource center to get and stay organized with the financial and operational data you'll be using throughout your buy-side due diligence procedures. Also, don't forget to send out a financial information request list based on data you already have and what you still need.
Now, with everything we’ve discussed today, does it all seem like an awful lot to do for a buyer? Yes, indeed. But as we said, it's tough to be too organized and meticulous during your due diligence. The good news, though, is that you're not alone, especially with Embark's mergers & acquisitions expertise at the ready. With our Transaction Advisory team leading the way, you can be sure you’re making a fully-informed decision.