Every investor who’s got his eye on a company would like to know what’s going on behind the scenes, which is why he carefully scans the company’s business model, financial statements, tax situation and contracts. The past and the future are both on trial, and thus so are the forecasts for the company’s development. One proven way of accomplishing this is by a due diligence process. Due diligence investigations shine lights in dark corners, make sure that everyone has access to the same information, and identify and evaluate risks in a systematic fashion. Properly preparing due diligence is half the battle – and that applies equally to purchasers and sellers. There are four types of due diligence: commercial, tax, legal and financial.
Commercial due diligence
Commercial due diligence puts the strategy and market position of a company to the test. It deals with the specific circumstances of the market and competition: What are the company’s strengths and weaknesses, how is its marketing strategy working, what are the barriers to market entry, which business processes are value drivers, which are critical for success? And above all: are the target growth rates and gross earnings expectations realistic?
Tax due diligence
Tax due diligence analyses the company’s tax situation: have there been any essential changes in structure? Are there holding periods that need to be observed? Are there any tax loss carry-forwards that could be lost because of the planned transaction? It also provides a basis for deciding how a possible investment can be optimized for tax purposes.
Legal due diligence
Legal due diligence is about contracts and agreements that are important to the company and ranges in scope from the evaluation of license and supply agreements to the analysis of liability and warranty risks. The main issues to be dealt with in the purchase agreement are also prepared during the due diligence phase.
Financial due diligence
Finally, financial due diligence deals with the company’s figures. Beginning with a solid analysis of its past that examines such historical features as its earning potential, cash flow situation, working capital development, and adherence to budget, financial due diligence scrutinizes the company’s current development along with its plans for the next three years. An expert opinion will be given on the plausibility of the plan’s premises, the management’s handling of the plan, and readiness of the books to provide the necessary numbers and facts for planning.
Risk factors in a due diligence investigation
Especially in the case of investment projects, financial due diligence focuses on the question of whether business planning seems realistic. The following pitfalls have proven to be the most common in practice.
Hockey stick projections forecast double-digit growth rates for the future even though past growth rates for both revenue and earnings have been modest. In such cases, the management needs to be able to explain what facts they’re basing their high hopes on.
Another possible pitfall is the lack of a positive trend in the current fiscal year. While a positive trend in order intake or productivity indicates that the following year could turn out just as well, the opposite trend or even a slump in essential key figures serves as a clear warning signal. Management needs to be prepared to give solid counterarguments.
It is also common for future costs to be underestimated. In such cases, it’s important to come up with a plausible and detailed calculation. Expanding into new markets requires capital and time. Credible business planning needs to include both start-up costs and lead times.
Finally, certain necessary investments are often not (sufficiently) taken into consideration: especially the acquiring of new means of production creates a substantial need for financing. This needs to be reflected in balance sheet and cash flow planning.
The need for available financial resources should also not be underestimated. Expanding a company’s operations usually leads to an increase in receivables and inventories and ties up working capital – an area in which companies often plan too optimistically.
And last but not least, the quality of financial management and accounting is important: professional reporting that yields reliable figures every quarter is not something for medium-sized companies to take for granted. Today’s financing banks tend to place higher demands on reporting, and the accounting of many mid-sized businesses is not prepared to meet these demands. Many companies do their own day-to-day bookkeeping and leave the annual financial statements to their tax advisors. It pays off here to get the books in order in advance by bringing in external consultants. Otherwise, due diligence won’t be able to provide investors with a sufficient basis for making a decision, and it may also take some time after a transaction before the investor is able to implement a functional accounting system again. Until that happens, the company will find itself flying blind – sometimes with fatal consequences.
In order to recognize and deal with these risks while conducting corporate transactions, both buyers and sellers need an experienced advisor by their side. We know the needs of investors in midsized companies and we develop our analysis and reporting along those lines. In conjunction with our clients, we define the scope of the investigation according to the particular goals, occasions, and situations that they are dealing with. The approach of our transaction specialists can be described as hands-on, pragmatic, and to the point.