Due diligence tips

The importance of due diligence to the success of a transaction is often underestimated. We thought it might be useful to put together a few pointers to keep in mind while running a due diligence exercise on a business you are intending to buy.

Approach the whole process with a very objective and critical eye. When you have seen a business to buy it is very easy to get carried away and marvel at your own cleverness at seeing such a good opportunity. But always remember that it is much easier to evaluate what has been presented in a memorandum of sale than to spot what has been left out.


Get the right advisers

Buying a business is a team effort and the most important members of your team are your accountant and your solicitor. Make sure that you have a good working relationship with both and they are properly instructed. If you need to appoint new advisers do so on recommendations to ensure they have the appropriate skills.


Plan it, scope it

Define the scope of the due diligence exercise and clearly mark out who is doing what and when. Work to a timeline. In order to conduct a thorough investigation you must have everything in order before the due diligence process begins. In fact, you must start your due diligence preparation and information gathering the moment you decide that you are interested in a particular business. You will need the following:

An exact step-by-step plan of the entire due diligence exercise.

All of the information and relevant items you need from the seller before you start the analysis (see section on Collect information).

A checklist of everything to complete in each due diligence area with a scheduled start and finish date and the name of who is going to be carrying out the task.

A priority table, with notes on task dependencies. This can be integrated into the checklist above.

Someone who understands financial and management accounts intimately. If that's not you, find someone who does. The financial accounts are usually one of the first items inspected.


Note: don't waste time on areas that are not likely to cause any real issues or have any effect on the final sale agreement.


Employee issues

Thorough due diligence should pick up any issues, risks and potential liabilities relating to the seller's employees. For instance, check if there are any past or present employees litigating against the business. Other important areas to look at might be the following. Do any of the employment contracts have unusual clauses i.e. over-the-top redundancy packages? What are the specifics of the pension plans? What is the bonus structure and is it rewarding performance fairly? Is the bonus structure affordable and can it be changed if necessary?
Are the areas of responsibility clearly defined? The regulations on protection of employees rights is known as TUPE ( Transfer of Undertakings (Protection of Employment) Regulations 1981). The regulations are very clear on what happens when a business is sold. The new employer takes over all rights and obligations arising from the employment contracts (except criminal liabilities) and rights and obligations relating to provisions about benefits for old age, invalidity or survivors in employees' occupational pension schemes.

The new employer takes over any collective agreements made on behalf of the employees and in force immediately before the transfer. It is therefore crucial that the employment issues are thoroughly investigated.


Move fast, top down

It is important to spot any issues early on so that the appropriate warranties and indemnities can be quickly put in place. As these are legal documents, which are meant to protect both the buyer and seller from things going wrong, they can be complex, expensive and take time to put together. Focus on major issues first. As with any aspect of due diligence, the late uncovering of issues which lead to changed warranties and indemnities at an advanced stage can reduce strength of the negotiating hand and, in some cases (i.e. pensions), even scupper the deal.


Communication is vital

The flow of communication between the buyer and his/her solicitors is of paramount importance, for if they do not work closely together, the process can quite simply fail. The buyers must communicate the key issues of concern to their solicitors; they should not just assume that all areas are of equal importance, and that everything will be dealt with in good time. The solicitor must be told what the key commercial reasons are for the purchase, which areas are high-risk and which areas should be prioritised.


Continually monitor the activity of the solicitors and accountants carrying out your diligence and make sure they are giving you regular feedback.


Don't forget the culture

Funny how the lack of understanding of the target's company culture is one of the main reasons for failed acquisitions, yet has been notoriously ignored in the due diligence process. Don't make the same mistake. This is usually one for the purchaser's management to consider, rather than delegating to legal or financial advisers. Map out the management styles of your business and the target business. Look at the core values of each and analyse the differences. How do the communication structures and styles differ? In a recent survey conducted by the Hay Group ( see Business Sale Report January 2008 Issue ), 58% of respondents admitted that over-prioritising of systems integration over intangible assets and cultural compatibility had been a key reason for the failure of mergers and acquisitions to increase value.


Collect information, then analyse

Don't let any of your advisers analyse whilst collecting the information. These are two distinct activities within the due diligence process. First find out where the required information is, then collect the information, recording its source and noting whether it is fact or hearsay. Then start an objective analysis. It is also important that whilst collecting information the buyers team is alerted immediately to areas where there is information missing.

Finally, make sure you differentiate between fact and opinion. Information that is presented as fact should be signed off by the target company's directors.


Don't panic, take your time

A focused but comprehensive approach is better than taking shortcuts in order to reduce costs. Often the buyer discovers that 'thin areas' of diligence need to be covered again in more detail, ultimately consuming extra time and costs.

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