Are you thinking about buying a business to start your journey into business ownership? Looking at acquiring another business to expand your existing one? Or wanting to add another product to your product line? If you answered ‘yes’ to any of these questions, you need to know about the due diligence process and how it can better inform your purchasing decision.

In our previous blog we discussed the importance of all parties to a potential M+A transaction entering into a non-disclosure agreement and what those agreements should include.

Usually, once the parties have entered into the non-disclosure agreement and/or a heads of agreement, the next most important aspect involved in any M+A transaction is conducting the due diligence investigations on the company or business being purchased.

 

what is ‘due diligence’?

Put simply, due diligence is an investigation into the business or product you are interested in purchasing. The purchaser may conduct their due diligence investigation prior to completion to verify if the acquisition is worthwhile. If this is the case, before committing to the transaction, the purchaser will want to ensure they know what they’re buying and what obligations they are assuming, the nature and extent of the target business or product’s contingent liabilities, problematic contracts, litigation risks, intellectual property issues and much more.

If the purchaser elects to conduct their due diligence prior to a formal agreement being entered into, it is highly recommended the vendor provide to the purchaser an exclusivity period wherein they can go ahead with the purchase after they have finalised their due diligence investigations.

Otherwise, when entering into a formal agreement for the purchase of the company and business, the purchaser will want to make sure there is a comprehensive due diligence clause included in the agreement, to allow them to conduct their due diligence investigations for a period of time after entering into that formal agreement, but also allows them a termination right if their due diligence investigations are unsatisfactory.

 

due diligence from a purchaser’s perspective

Due diligence allows the purchaser to feel more comfortable that his or her expectations regarding the transaction are correct. In any transaction, purchasing a business without doing due diligence substantially increases the risk to the purchaser.

 

due diligence from a vendor’s perspective

Due diligence is most often conducted to give the purchaser confidence. However, sometimes vendors carry out a ‘vendor due diligence’ prior to sale. This is common in competitive bid processes, where the vendor undertakes this exercise to encourage purchasers to make bids [by lessening the need for purchasers to conduct their own due diligence]. This exercise may also benefit the vendor, as a closer financial examination of the business or product may reveal that the fair market value of the vendor is more than what was initially thought.

 

So, what is involved?

When conducting the due diligence, key areas of the business or product are investigated including profits, financial risks, legal issues and potential deal breakers.

 

types of due diligence

1. legal due diligence

The purpose of a legal due diligence is to enable a purchaser to assess the legal risks associated either with a business or a product in order to make an informed decision as to whether they will proceed with the transaction and, if so, on what terms.

What are the main items and issues that might be covered in a legal due diligence?

This will all depend on the nature of the transactions i.e. whether the purchaser is purchasing a business, purchasing the assets of the business, or whether they are purchasing the shares in a company that owns the business and assets. For the full details on how these transactions play out, check out our blog on structuring an acquisition deal.

If purchasing the business, the due diligence questions will usually be focused on the assets being transferred, rather than the liabilities. Other than employee liabilities, the business liabilities usually will not be transferred across to the purchaser as part of the sale.

On the other hand, if purchasing all the shares in a company, you will be acquiring all the assets together with all the liabilities as they exist. In that case, the legal due diligence will be more comprehensive as it will need to consider the liability side as well.

Download our checklist below to see the other areas to consider when conducting a legal due diligence investigation on a company sale transaction.

download the legal due diligence checklist

 2. financial due diligence

Further to the legal due diligence process, it is paramount a purchaser also has their accountant undertake a financial due diligence on the company and business to provide the purchaser comfort and understanding on the financial drivers of the company and provide a historical glimpse into the cashflow and potential tax liabilities of the company. This area of due diligence may be very extensive or less so depending on the purchaser’s risk appetite. Typically, the things to be looking out for are:

  1. Reconciling accounts – reconcile the management accounts of the business against the accountant’s financials to see if there are any variances and to ensure those variations can be explained.
  2. Debtors + creditors – review the aging profile of debtors and creditors, because this has a large impact on the working capital. You want to know how much money is outstanding, on what terms the money is paid, and get a sense of any risks around that customer portfolio from a financial perspective.
  3. Cash flow profile – usually start by looking at the bank statements of the business’ trading account on a monthly basis and go back one to two years to see the flow of funds in and out of the business to determine how it has tracked from a cash flow perspective.
  4. Identify trends and anomalies – review business/trading trends and importantly, identify any non-reoccurring revenue. A purchaser will need to understand if the performance of the business is subject to any once-off non-recurring revenue lines. This investigation will also assist a potential buyer to identify high-value customers which may lead to a detailed review of their engagement agreements.
  5. Superannuation and employee entitlement – An area of a lot of attention through a due diligence is any potentially unknown and undisclosed employee liabilities like super and leave entitlements. Also, watch out for any potential payroll tax risk!
  6. Taxation – finally, look at a range of tax due diligence aspects. These relate to making sure the business has met its taxation liabilities correctly over the years and looking at the Business Activity Statement [BAS] to match them up against reported sales and expenses.

 

we’re here to help!

Due diligence helps investors and companies understand the nature of a deal, the risks involved and whether the deal fits with their overall strategy. Essentially, undergoing due diligence is like doing “homework” on a potential deal and is essential to making informed investment decisions.

If you’re looking at purchasing a business, business assets or shares in a company, please reach out to our team at businessDEPOT Legal through our email legal@businessdepot.com.au or give us a buzz on 1300BDEPOT to find out what you need to do next.

In part 4 of this M+A series, we cover getting the contract right [and where things can go wrong]. You can check out our full merger and acquisition blog series here.

 

Originally authored by Amanda Gleeson. 

 

general advice disclaimer

The information provided on this website is a brief overview and does not constitute any type of advice. We endeavour to ensure that the information provided is accurate however information may become outdated as legislation, policies, regulations and other considerations constantly change. Individuals must not rely on this information to make a financial, investment or legal decision. Please consult with an appropriate professional before making any decision.