Are you deal ready?

Insight /  6 May 2024

Danny Malone, Corporate Finance Senior Manager at UNW, outlines the due diligence process and how vendors can best prepare in order to minimise disruption and maximise value.

First, understand the objectives of buy-side due diligence

A vendor going through a potential disposal process may encounter many forms of due diligence, ranging from legal, property, commercial, IT & cyber, HR, environmental and, not least, financial. In the context of financial due diligence, this process involves the detailed scrutiny of a business’s finances with the aim of identifying value drivers and potential red flags. Buy-side financial due diligence looks to establish a business’s maintainable level of earnings, the amount of working capital required to run the business, how the business is financed and any challenges facing the business that may impede future trading or growth plans.

Ultimately, a potential acquirer or investor is buying into future performance. So whilst the historical results are important, these are primarily used to frame the fundamental value drivers of a business and inform post-deal expectations.

Buy-side due diligence provides the acquirer with clarity regarding revenue and profit sustainability, cash generation and the balance sheet composition with reference to the agreed deal completion mechanics. All these aspects determine the purchase price, which is often set out in an offer letter before any detailed due diligence has taken place and is therefore subject to findings from the due diligence exercise.

Get your ducks in a row

Depending on your management team and finance function’s previous deal experience and capacity, buy-side due diligence can be an intensive process and disrupt the day-to-day running of a business. A vendor that takes pre-emptive measures, such as appointing advisers during the early stages of a possible transaction, inevitably puts themselves in the strongest possible position.

By appointing corporate finance advisers at the start of the deal process, vendors can avoid potential pitfalls that can adversely affect deal value. Advisers can perform transaction readiness assessments and sell-side due diligence exercises (e.g. vendor assist and vendor due diligence) that can streamline the subsequent buy-side due diligence process, identify and mitigate potential deal breakers and put vendors on the front foot in negotiations.

Other preparatory and practical considerations include: compiling a complete set of management accounts covering the profit and loss, cash flow statements and balance sheet (last three financial years is usually sufficient); preparing a budget, preferably underpinned by a sales pipeline; briefing key management personnel, including your finance team, while emphasising the importance of confidentiality, determining your core earnings, excluding any exceptional or non-trading transactions; ensuring filings at Companies House are up to date; having preliminary discussions with your auditor or external accountant; and appointing lawyers, who will set up a virtual data room to facilitate information exchange during due diligence and guide you through the process.

What does ‘good quality’ information look like?

Businesses that are audited or have a well-established finance function will typically not have difficulty producing good quality management information. However, for smaller owner-managed businesses that are below the audit threshold, there can be a disparity between the extent of information required as part of a deal process and information required for the normal running of the business. The information requirement should not be underestimated by vendors as poor-quality information can lead to increased adviser costs, misunderstandings with counter parties, increased time to completion and deals being aborted.

Compared to a statutory audit, financial due diligence places greater emphasis on management accounts and underlying management information – essentially the information used by management to monitor the business. Management accounts are the cornerstone of the due diligence process. Having management accounts that are prepared on a consistent basis and can be reconciled to the year-end accounts is critical.

To minimise follow-up queries, management accounts should be presented down to a granular level and any supporting schedules should agree back to the management accounts. Large unreconciled differences and errors in management information can often signal a poor control environment and raise further doubts.

Are you effectively telling your story?

It is important that vendors consider which key performance indicators should be collated and presented to supplement the primary financial statements. These KPIs are often sector specific and of particular importance for PE-backed transactions and trade buyers.

Key metrics and data analytics can provide useful insight into the loyalty of the customer base, capacity, the extent of volume-driven growth, staff utilisation, etc. KPIs will help tell the success story of your business in a way that using pure financial information can often overlook.

Vendors may only ever go through a business disposal once in their lifetime, therefore it is important that the due diligence process is capably navigated. Good quality information and insightful KPIs are powerful tools that vendors can leverage to ensure the business’s success story is sufficiently captured and factored into the purchase price.

If you would like more information about the topics discussed in this article, or any other due diligence related matters, please get in touch with dannymalone@unw.co.uk. UNW’s Corporate Finance team provides buy-side, vendor assist and vendor due diligence services to clients.