Why Is Due Diligence Important?

Would you buy a car without taking it for a test drive?  Or an old house without having it inspected? 

Of course not! 

You would perform your own due diligence to make sure the item being acquired met your requirements and expectations.  When provided with evidence from the seller that everything is in working order, you would still test this assertion for yourself. 

Likewise, prudent investors will perform sufficient research and analysis of a potential merger or acquisition target before they expend considerable resources and are ready to close the transaction.  This risk mitigation helps to identify conditions with the potential to impact transaction terms or to scuttle the transaction entirely.

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UNDERSTANDING THE ROLE OF VALUATIONS AND DUE DILIGENCE FOR A SUCCESSFUL TRANSITION

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Due Diligence Explained

Due diligence procedures typically cover a wide number of topics and often are performed by a professional team including accountants, attorneys and other professionals.  These procedures look deeply into financial, legal, technological, and other matters.  

Often, analysis is performed on a company’s quality of earnings, revenue and expense trends, capital needs, budget and forecast assumptions, and key resources (e.g., people and technology).

A common starting point for due diligence is to obtain a company’s financial statements.  But this should not be where financial analysis ends.  Because the foundation for many valuations is company earnings before interest, taxes, depreciation, and amortization (EBITDA), it is important to evaluate the nature of the revenue and expenses contributing to this valuation. 

For example, revenue that is recurring and sustainable is generally preferred to unusual or non-recurring revenue.  Overall earnings may also be affected if the company has not properly valued its assets and liabilities or has been inconsistent in its accounting methods.  And financial statements usually do not adequately describe other important considerations such as the company’s customer churn, key market and economic drivers, and nonfinancial trends that may impact the sustainability of the company’s earnings. 

Likewise, it takes additional analysis and interaction with the company to get a full sense of other qualitative information that may impact the transaction valuation – for example, an understanding of the company’s key systems, controls, processes, and management team. 

Further, you should consider factors such as the company’s current cost structure and how it may differ after a merger or acquisition, and the strength of the company’s working capital in relation to its forecasted capital needs as you evaluate the company’s full financial picture.

If you are buying or selling a business and would like assistance with performing due diligence on your transaction, the M&A team at SVA can help you avoid potential pitfalls as you work to close your transaction successfully.