Why A Due Diligence Review Is Essential In A Business Acquisition

When you consider acquiring a business, it is essential that you engage a professional with the necessary expertise and experience to perform a due diligence review (DDR). This will always significantly reduce your risk. In a recent discussion with James Phillipson, a founding Principal of Mastermind Solutions Inc. he said “I have, on many occasions, found sufficient evidence in the review process that resulted in my clients withdrawing from the deal. My findings convinced them of evidence of potential loss of their entire investment. In addition, there is often additional information that warrants an adjustment to the purchase price and the terms in the letter of intent.”

The letter of intent (LOI) sets out the key terms of the offer that includes the right to do a DDR. Even where the LOI is binding on the purchaser, a DDR is essential, as it provides the purchaser with a wealth of information about the business that reduces the risks in every acquisition and enables the purchaser to plan for the numerous aspects of the business they will soon be managing.

Your lawyers’ review of the legal documents and agreements should not be considered equal to or be replaced by a DDR. A DDR is much more comprehensive and reviews many strategic areas of the business.

What is included in a DDR?

A comprehensive DDR will cover all aspects of the business that are likely to entail risk for the purchaser. The reviewer team leader will discuss with the purchaser the scope of the DDR, i.e., the aspects of possible concern that are to be covered or excluded. An extensive checklist will be utilized to ensure that nothing material is omitted.

It is not uncommon for purchaser’s staff to participate in the DDR. In some cases specific technical expertise is necessary to perform the review or, detailed information will be obtained to facilitate transition after closing. Also, the purchaser may want to include staff to manage the cost of the DDR.

The DDR commences with obtaining a list of documents and other material that can be anticipated. During the process, the reviewer will review documentation and provide copies thereof for the purchaser’s lawyers and other specialists, in preparation for the agreement of purchase and sale.In addition, the reviewer will often adjust the normalized earnings that have been used in the calculation of the purchase price and refine any forecasts that have been prepared by the purchaser of future earnings, cash flows, working capital required and other key metrics.
In my discussion with Phillipson he stated “The savings in costs, combined with the benefits of having a list of issues that need to be managed, will exceed the cost of the DDR.”

What happens when a DDR does not run smoothly?

The reviewer may find significant and unexpected issues that the vendor cannot quickly resolve. The purchaser will be provided with a report setting out the issues and the expected impact, along with possible steps to mitigate, e.g., renegotiate the purchase price or abandon the acquisition.

How the vendor responds to issues found can have a material impact on the result as the items accumulate. The risk of the DDR continuing for a longer period than anticipated usually has a much bigger impact on the seller. It is common for the vendor and their senior staff to neglect day-to-day operations of the business, as they attend to the issues that arise out of a DDR.

A DDR that extends over a period will maintain a vigilant eye on the key performance indicators of the business and if they start slipping will provide fodder for the purchaser to renegotiate the purchase price to reflect those lower results and the increased risk to the purchaser.

Conclusion

A DDR is an essential part of the process in acquiring a business. A professional reviewer will always find issues by digging through the records and using their business experience. The result of the review will impact the purchaser by providing information to be used in finalizing the acquisition and facilitating a smooth transition and mitigating risk.