6 Mins
Due diligence is a critical part of an acquisition process and can include many streams, including financial, legal, commercial, tax, IT/cyber, management and operational. For a buyer, it is a risk management tool that informs good decision making, identifies risks and how to mitigate them, which allows the buyer to plan their integration post deal. Having advised on many acquisitions, it is apparent that some buyers don’t fully appreciate the value that can be added during the process beyond just checking the numbers. If you are thinking about an acquisition, here are some of the key areas to think about.
Understanding Financial Due Diligence
Financial due diligence (“FDD”) is a key component of any deal and generally involves a review of the historic trading activities of the target company and current financial position. Often, a purchase price is agreed based on a multiple of earnings, and the FDD focuses on the historic financial performance to determine what the underlying profits of the company are relative to what the buyer has been told leading up to making an offer. It can also influence the multiple that is being paid, for example, by assessing the quality of earnings or the extent to which revenue is recurring or “sticky”.
FDD may also focus on the forward-looking projections and how they align with the historic trading performance. Revenue projections can be substantiated by reviewing historic trends, customer profile, sales pipeline, terms of any current contracts and findings from the commercial due diligence review if undertaken.
It can substantiate the current financial position of the target company. It is not an audit but is designed to identify over-stated assets and under-stated liabilities and any contingent risks associated with the company. As an output from the diligence process, I always aim to provide a concise report with appropriate analysis and a clear executive summary highlighting the key risks, sensitivities and recommendations.
Adding value through FDD
FDD can provide substantive evidence to either confirm the purchase price or support a price adjustment. In the extreme case, if red flags are identified that cannot be resolved before deal completion, this may result in the deal being aborted. Recommendations may also result in a change to the deal structure e.g. change from being a share deal to being an assets deal, or inclusion of a hold-back amount or other retention.
There is a strong link between FDD and the financial elements of the sale and purchase agreement (“SPA”), being the main contract between buyer and seller. FDD may highlight areas where warranties or specific indemnities are recommended to manage financial risks. My experience shows that the relationship between the financial adviser and the legal adviser to the deal is key to ensuring that the financial risks are adequately covered in the legals.
Good FDD reviews can also highlight operational issues that need to be addressed post deal and whether they have any impact on the price, e.g. has the seller manipulated the operational structure or business processes to optimise profits leading up to a sale. It may also highlight areas to improve working capital management & optimisation and inform potential synergies between the two parties.
Enterprise to Equity Bridge
The Enterprise Value is often calculated by applying a multiple to maintainable earnings before taking account of how the company is financed. This is often the headline price on a cash and debt-free basis and subject to there being a “normal” level of working capital. The Equity Value is the net purchase price attributable to shareholders after adjusting for any cash and debt-like items and adjusting for an abnormal working capital position. The difference between the Enterprise Value and the Equity Value is sometimes referred to as the Enterprise to Equity Bridge.
FDD will focus on the items that make up this “Bridge”, which can often make a significant difference to the net proceeds received by the seller. In simple terms, this exercise aims at allocating the target balance sheet into three components:
- Cash or debt like items which generally result in a £ for £ adjustment to the purchase price,
- Working capital, which may result in an adjustment if the net working capital at completion varies significantly from the normal working capital position, often determined through FDD by averaging the last 12 months adjusted balances, and
- Non-adjusting items, e.g. fixed assets.
Some balances clearly fall into one of these three categories, however, there are some areas of uncertainty, e.g. deferred income, deferred tax, dilapidation costs, bonuses, etc. A good FDD will provide robust arguments that the buyer can use to negotiate these subjective items in their favour. The chart below illustrates how a headline price of £10.0m can translate into a value to shareholders of £6.0m after deducting debt and debt-like items. I like to make sure that the key Enterprise to Equity adjustments are highlighted in the heads of terms before diligence to avoid surprises, but often they are not and need to be picked up or confirmed during FDD.
FDD will also review the accounting policies of the target to ensure that they comply with standards and no adjustment is required (a) in the completion accounts or (b) in aligning the policies adopted by the buyer.
Final Thoughts
At Henderson Loggie, we aim to add real value to the acquisition diligence process and are not afraid to provide opinions and stand behind our findings. Ultimately, it is the client’s decision whether they progress or change the structure of the deal, but they should expect clear recommendations from their diligence provider.
In my opinion, good financial due diligence reviews have the following characteristics, which we aim to achieve for our clients at Henderson Loggie:
- Is scoped out properly and focuses on the key areas.
- Includes strong recommendations, including “walk-away” if appropriate.
- Provides clear, concise and appropriate analysis.
- Aligns with other diligence workstreams.
- Provides the buyer with justified “ammunition” to negotiate if desired.
Corporate Finance Partner
I have enjoyed many years advising business owners on their succession plans or working with them to achieve their growth ambitions through acquisition or raising growth capital.
My focus is always on exceeding clients’ expectations, be it on value or running an efficient process. Having spent some time in industry in “C-suite” positions myself, I really appreciate the journey business owners experience as they develop their company whether it be through exit, expansion or restructure.