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It looks good, it sounds good, but does it stack up?
For any of our clients considering putting their hard-earned cash into any sort of investment, we always insist that a proper program of due diligence be carried out in order to assess the risks and opportunities of that transaction.

These risks and opportunities can include:

  • Commercial – e.g. customers and suppliers, market forces
  • Financial – integrity of historic and forecast figures
  • Tax and compliance – whether the targeted businesses has paid its obligations as it should
  • Integration issues – perhaps there are synergies to be derived from the acquisition and cost savings to be made
  • IT and human resources – adequacy of resources may need to be assessed.

Due diligence involves analysis, testing procedures, investigation and general enquiry into the aspects of the business being purchased. It’s not an audit, although some of the procedures are similar. Most importantly, it should be carried out by an independent and impartial specialist - one who doesn’t have a financial stake in the outcome.

Proper due diligence reduces the need to rely on the vendor’s contractual warranties, which can be costly to pursue. There are many types of due diligence, the most common being accounting and legal. Legal due diligence would generally cover a review of the following:

  • Key contracts or preferred supplier agreements
  • Employment agreements
  • Minutes and consents of the board of directors and shareholders
  • Confidentiality Agreements with employees and others
  • Restraint of Trade agreements
  • Corporate charter and bylaws, registration of business names
  • Litigation-related documents
  • Licences and Permits
  • Patents, copyrights, and other intellectual property-related documents
  • Tax and financial documents

Accounting due diligence is more relative to the past and future trading operations of the company although there is often some overlap between the two. Accounting due diligence would look at, for example:

  • Historical trading results
  • Employees and employee benefits
  • Market share and growth, including comparison with industry standards and benchmarks where available.
  • Product and/or service lines
  • Insurance, not only over fixed assets but also directors’ liability, public liability etc.
  • Fixed assets to be acquired as well as any real estate
  • Tangible and intangible assets including goodwill
  • Customer and supplier bases including contracts
  • Taxation issues and compliance
  • The use of other professionals in recent years, such as legal and accounting advisors
  • Other risk factors associated with the business – e.g. environmental issues

Due diligence can take as many different forms as there are types of investment. They can be relatively straightforward, such as analysing past dividend returns for a small stake in a publicly listed company, or complex when it comes to looking to purchase all of an existing company or business.

This variability means that a “scope” needs to be flexible and established to suit each assignment. A scope is an agreed set of areas to be included in the due diligence, with the intended outcome being that the purchaser has the opportunity to resolve any specific queries or concerns about the business. The scope is designed to include items that are relevant to the nature of the business as well as general topics. For example, an assignment recently completed by us related to a manufacturing business in the food industry. Our scope therefore was tailored to include not only general areas to do with customers and trading performance, but also specific areas such as compliance with legislation and certification covering food handling and weights and measures, as well as stock turnover rates and seasonality of sales.

Some of the other areas that may be included in the scope are:

  • Business & Legal Structure – are you buying the shares in the company or just the business? Purchase of the shares may have consequences later on, as there may be contingent liabilities, such as workers compensation claims, that are inherited by the purchaser. A share purchase may be necessary if, for example, sales contracts are unable to be assigned but the purchaser wishes to retain those customers.
  • Intellectual Property – checking that all assets are either owned by the company or are able to be willingly transferred, and whether trademarks, copyrights and patents are properly registered or in fact have a market value. This area also covers a review of whether procedures and technical “know-how” are properly documented. When a vendor exits the business is not the time to find out that closely guarded recipes or production steps were kept in the previous owner’s head!
  • Employees – workers compensation and OH&S issues are nearly always an issue, and in fact we often recommend that a full OH&S inspection be carried out to make sure that these risks are reduced for the purchaser, especially in a manufacturing or labour intensive industry. In addition we may need to look at whether there are key employees, and if so what agreements are in place for employment and termination including severance and confidentiality agreements.
  • Plant and Equipment – as well as making sure that the plant and equipment actually do exist, this needs to be reviewed to determine whether the equipment is due for renewal. If pretty much written down, it may either not be fit for the purpose, or there may be a large repair bill looming on the horizon! Are assets properly insured?
  • Leases and Contracts – checking that any agreements are able to be transferred or renegotiated as needed. This is particularly important if the business has its goodwill strongly linked with its location and premises.
  • Financial Results – this might include not only testing the accuracy of the reported figures, but checking for consistency in performance, reliance on certain customers and/or suppliers etc. This will also generally include the preparation and review of projected trading results for the short to medium term with projections of the value of the business into the future.

Regardless of the type of due diligence undertaken, we place emphasis on taking a risk based approach to each assignment – this ensures that the highest risk areas are addressed systematically and thoroughly.

Conducting a thorough review of a business and its workings means that the parties conducting the due diligence are often privy to confidential information not otherwise available to the public. Don’t be surprised if you are asked to sign a confidentiality agreement or if you are requested not to take documents from the premises – this is normal.

We are often asked how long a due diligence should take and how much it will cost. There is no clear answer – the depth of the due diligence will depend on the perceived risks associated with the business and of course the costs will vary accordingly. Perhaps surprisingly, there is such a thing as too much due diligence – over-analysis can offend a target company to the point where they walk away from the deal. It is can also result in “analysis paralysis” that prevents you from completing a transaction or provides time for a better competing offer to emerge. Appropriate investigation and verification into the most important issues often must be balanced by a sensible level of trust concerning lesser issues.

Most purchasers conduct their due diligence before executing the sale and purchase agreement. Sometimes there are time constraints and this is not possible – in these cases prudent purchasers would want the agreements to allow them to back out of the deal if the subsequent due diligence has unsatisfactory results. Either way, sometimes the due diligence process reveals matters that need to be resolved before the transaction can be completed. If the matters can’t be resolved then the agreement needs to be renegotiated or even abandoned. While this may be disappointing for the parties, it is far better to be forewarned!

Remember, if it sounds too good to be true, it probably is.

Written by Suelen McCallum Senior Manager de Vries Tayeh

Independent Associate Member of Walker Wayland Australasia Limited, a network of independent accounting firms
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