It goes without saying that getting due diligence right can make or break your M&A transaction. Cutting corners and not getting professional advice can cost you your very investment when you’re already in too deep in the acquisition process. The best way to learn these things is to listen to the advice of those who have been there. Your go-to M&A expert, Domenic Rinaldi, devotes this episode to give you a roadmap on how to approach due diligence so that you can understand the totality of the process. He discusses the best practices that successful deals in various industries share in common. He also provides a high-level checklist of specific tasks that you have to undertake during diligence so that you can increase your chances of success while minimizing cost at the same time.

Download our free due diligence framework resource on how to approach, conduct, and execute on a diligence plan for an acquisition. This framework includes best practices and a checklist of items to be considered when conducting diligence:

Download here: www.k2adviser.com/resources/

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How To Conduct Due Diligence During Acquisition: Best Practices And A High-Level Checklist

In this episode, I’m going to cover the best practices in a high-level checklist for conducting due diligence during acquisition. As you can imagine, having a plan and a construct for approaching diligence will give you peace of mind that the contemplated acquisition is deserving of your capital investment. Too often, I see inexperienced buyers fall into the trap of becoming enamored with a company, all too willing to cut corners, and overlook significant issues that may require time and expense to research.

I will give you a high-level roadmap, some specific tasks to undertake during diligence, a way to minimize the expense associated with diligence, and the critical starting point for all diligence work. In addition, I will be making this checklist available on our websites under the Free Resources section. I urge you to download this checklist before you launch into any acquisition diligence. You can find this resource on either of our websites, SunAcquisitions.com or K2Adviser.com. Thank you for being here and I hope you enjoy this episode.

It goes without saying that getting due diligence right can make or break the success of your transaction. The cost of cutting corners, not getting professional advice, or misinterpreting data can leave you scrambling to salvage your investment. If you follow the construct that I’m going to give you, you’ll have a roadmap on how to approach diligence and understanding of the totality of the process. You’ll also know how to set the proper expectations for you, your advisors, and the seller in the transaction. Most of all, it’s going to give you peace of mind that when you do decide to make the acquisition, that you’ve done it in the context of a comprehensive diligence process. With that said, let’s get into this episode.

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Diligence Best Practices

I’ve mentioned in the intro that there’s a clear starting point for all diligence that can set the table for everything that follows. That clear starting point is the letter of intent. Diligence starts the day that you make an offer on a business. When you tender your letter of intent to the seller, you’re also outlining in that letter what you anticipate happening in diligence, the items and the elements of diligence, the timeframes, what’s going to be involved, what your expectations are from the seller, your desired outcomes, how you want the business operated during diligence. You might say that you want certain things to happen in the business while diligence is being conducted. Having a good letter of intent that’s drafted by a professional M&A attorney with real thought to the diligence process and post-closing issues will set you up for success.

It’ll set the table for the diligence process and ensure that things can move smoothly, on time, and that you’ll have unfettered access to all the information that you need so that you can get through the process as quickly as possible with the least amount of disruption to the company and yourself. You don’t want a company disrupted while you’re doing diligence. You want that company to continue to operate, move forward, and perform while you and the owner or the management team of that company are performing the diligence and getting through the process.

That said, once you have a proper LOI with all the good elements in there for the diligence process, the other things that need to go into place, and the best practices for approaching diligence are your advisers. There’s probably no one more important thing that I can recommend to you than surrounding yourself with good M&A advisers, a great M&A attorney, a great M&A accountant, M&A intermediaries like ourselves, and people who understand M&A and can guide you through the process. The process is fraught with pitfalls and all sorts of speed bumps.

Acquisition Diligence: You should always be taking the first cut of diligence yourself. It allows you to discuss anything that stands out in the deal with the owner before you bring your professionals in.

Having people who have done this before many times will help you save money. In some cases, they may keep you from making big mistakes like moving forward with an acquisition when you shouldn’t be moving forward. Surround yourself with the right advisers, line them up well in advance of any transaction, have your plan in place, and know-how you’re going to leverage those advisers once you do find the right company. Once you have that, assuming that you get to an agreed-upon letter of intent on a business, I always recommend to buyers that the first stop on the train tracks is to start diligence by yourself. I know it’s a little contrary to what I said about surrounding yourself with great advisers, but let me explain why.

You should always be taking the first cut of diligence yourself. It doesn’t cost you any money to do it yourself, and you might find some things that are material or substantial that you might want to get understood and explained by the seller before you start to spend lots of money on advisors. A high-level cursory review of the financials, the operations of the business, and some pertinent company information will allow you to understand if there’s anything that stands out that you should be discussing with the owner before you bring your professionals in, the meter starts running, and you start racking up substantial dollars during diligence. Conduct some diligence and make sure you’re comfortable. If everything looks good, then you can open up the diligence to your professionals and start spending money.

Financial, it’s important to know that in most privately held companies and small businesses, you’re not going to be looking at gap compliance or audited financials. When that’s the case, it’s hard to recreate sometimes what’s going on in the business because the owner might not be categorizing expenses properly. There might be a lot of personal expenses buried in the business. I always tell people that the best starting point is to take the corporate tax returns, and start to pour through the corporate tax returns to make sure that you can get back to what the owner has stated is the adjusted EBITDA of the business.

That’s not to say that the other financials aren’t important. They are. You need the P&Ls, the balance sheets, and all of the other things that go into the financials, but the tax returns are what the owner of that business has reported to the government. These are the documents that you’re going to use to secure debt financing, lender financing, and the lenders are going to rely heavily on the corporate tax returns. If the tax returns tell a different picture than the internal P&Ls and balance sheets, you need to spend some time understanding where those differences are, whether or not you can normalize the tax returns to get them to match what the internal say. If you can’t, then you need to have a conversation and figure out why not. Hopefully, you can get them to match so that when you do bring the package to a lender, you’re going to be able to explain where the cashflows and the adjusted EBITDA of that business are. You can secure the debt facilities and the working capital lines if you need them to acquire the business.

The next best practice is to be curious. If you’re not a curious person, this is now the time to develop that skillset. This is not the time to make assumptions. I recommend that you vet everything carefully. Ask as many questions as necessary. When you ask a question and don’t get the answer to that question, keep asking it. Maybe you need to ask it in different ways but you should be curious. You should get all of your questions answered to your satisfaction. If not, you need to dig deeper and find out why you can’t get the answers. You need to get the answers, be curious, and get as much information as you possibly can.

Data room is my next recommendation. Oftentimes, people will enter diligence and they will enter into an email exchange with an owner about all sorts of things. This is not a best practice on how to conduct due diligence. Our M&A advisory firm utilizes online secure data rooms where information is uploaded into the data room like financials, company information, answers to questions that were asked. That information is uploaded by the owner of the business, the management team, the owner’s advisors into the data room. You and your advisors have one central repository to see all of the information and review all the information.

This does a couple of things. One, it makes sure that things don’t get lost in the shuffle, that you don’t miss an important email, or the owner says they sent you an email and maybe they didn’t because they forgot to hit the send button. Make sure that all the information that you’ve requested in diligence gets delivered to you. It also creates a platform for dispute resolution after a transaction. If the owner provided certain information to you that once you make the transaction that you find to not be the case, you have the only platform you reference to go back and find out what information was translated to you, and whether or not that matches with what you’re seeing after you made the acquisition. You hope you don’t have to go down this path but believe me, I’ve seen diligence run directly between people with emails and faxes. Things will get lost in the shuffle. The best practice here is to manage a data room. As an intermediary firm, we do that for our clients. It’s important. This is the best way for your advisors to help you through the transaction.

The next best practice is about the people. I often say on my show and to my clients that there is no more valuable asset that you are acquiring than the people in a business. The people are what makes that business thick day in and day out. They know the clients. They understand the service and the ecosystem of how that business operates. Without those people, the business will lose tremendous value almost overnight. It’s important that you have a plan. While you may not be talking directly to the employees because most owners will not want you to do that. You need to have a plan to understand how the people operate, how they do their jobs, how they’re incented, what the culture of the business is. There are plenty of ways to do that without speaking to employees directly.

This is a critical phase. This is a phase where people don’t give this enough time and effort, or they only speak to 1 or 2 key employees, and they believe that represents the entire business. Trust me, that doesn’t. You need to understand down to the lowest levels of the business, who are the people? What are their skillsets and capabilities? Can you grow the business with the existing people? Do you believe that they’re compensated at market rates? Are they undermarket or overmarket? Building a plan for understanding and doing the diligence around the people or the human resources in a business is critical.

The next best practice is to line up lenders. I say lenders plural for a reason. When you have an acquisition that you’re looking at, you want to make sure that you’re bringing that package to at least a couple of lenders. Not all lenders approach transactions the same way. You want to create a bit of a horse race here between lenders. There are a number of factors. It could be rate, interest rate, the terms and conditions of what they’re expecting, your capital infusion, assumptions that they’re making about the acquisition that may impact your lending capability. What kind of working capital lines are different banks willing to give you? It’s important that you line up multiple lenders. Send them the packages so that they can vet the business, and come back with a loan package for you so you can look and see which ones make the most sense for you.

The next best practice is around integration and communication. Why do I talk about integration and communication when we’re in the diligence phase? That’s because this is the exact time to be building what the integration and communication to all the constituents in a transaction is going to look like. The time to be building all of that is while you’re doing diligence. Build your plan on how you’re going to get integrated into the business. Are there changes you’re looking to make? If so, how is that going to impact the employees, the clients of the business, the vendors? How are your compensation systems going to work?

Do you have to merge systems together? Are you changing compensation in any way? There’s a whole host of things that you need to contemplate while you’re in diligence. You should be talking to the current owner about your ideas and thoughts, and getting their feedback. They’ve run this business for a long time. They should be able to give you good feedback about whether something will work or maybe a different way to approach integration in the business. It’s important to be addressing this issue right up front.

Acquisition Diligence: There is no more valuable asset that you are acquiring than the people in a business.

Communication plans, how do you plan to communicate the acquisition to the employees? Will you be communicating the acquisition to clients? Sometimes it’s not appropriate to have broad-based communication with clients. Sometimes that’s better done in a one-on-one or over time. How are you going to approach vendors and let them know what’s happening? Are they going to want certain information from you? In some cases, you may need to be talking to vendors in advance of the transaction closing, but having a consistent communication plan across all of those constituents is important.

The next best practice is to set a return on investment target. Many buyers go into an acquisition and don’t have the goal line in mind. Not that owning a business should have a goal line, but your investment should have a goal line. What are you trying to achieve? What return on investment are you looking for? When I counsel buyers, I like to use a cash-on-cash return on investment. If you’re interested in learning more about that, please reach out to me directly and I can talk to you about that. I believe that a cash-on-cash return on investment is a great way for you to measure day one. After 1 or 2 years, what did that investment return to you based on every dollar that you invested in acquiring it?

The last best practice is to expect a bumpy ride in diligence, as well as post-transaction. Let me talk about diligence. I’ve been doing this for a long time. I’ve been involved in hundreds of diligence processes. I have yet to see a smooth deal go through from beginning to end without issues popping up. You are going to hit issues. The only question is, are they material issues that should force you to leave that investment opportunity, or are they issues that you need better understanding around that you can work through with the owner? These are issues that are going to pop up, and they happen all the time so be prepared for that. Be prepared for a bumpy ride after your close. Even the best diligence can’t uncover everything. You’re bound to find stuff after you close a transaction. Be prepared for that. Hopefully, this construct gives you enough of what you need, so you don’t miss anything major. It’s important to be prepared for that bumpy ride.

High-Level Checklist

With all that said, let me shift about the checklist itself to give you some categories of things that you should be looking at. I want to stress to you that this high-level checklist is not a definitive checklist. This checklist should change depending on the type of business that you’re acquiring, the size of the business, and maybe some of the histories in the business. This is where having the proper advisors on your team matters. Pull together the right team so they can help you refine this checklist. Pull together what should be your definitive checklist so you can present that to the owner of a business.

The first item on the checklist is the organization patient itself, and whether or not it’s in good standing. In this phase, you want to be making sure that you’re getting copies of the articles of incorporation, that you’re getting org charts. You’re making sure that the business has a certificate of good standing with the secretary of state in whatever state that the company is operating in. The list of all of the shareholders and members, copies of all licenses and permits, anything related to the organization and the articles are so important.

Financials, we already talked about tax returns, but you’re going to need P&Ls, balance sheets, monthly bank statements, credit card statements if appropriate for that business, projections, forecasts, capital budgets, schedule of all liabilities, accounts receivables and AR. You want to get as comprehensive a view of the financial picture of this business so that when you do bring in your advisors, they could see everything. They don’t have to come back and keep asking you for information. Get as much as you possibly can upfront. Make it available to your advisors so that they can get through all of this as quickly as possible.

Assets, it’s important to get a definitive and comprehensive list of all of the assets that exist in the business, including assets that the owner intends to exclude from the business. Sometimes this item is overlooked. It should be addressed in the letter of intent. In case it’s not addressed in the letter of intent, you want to make sure you get to it in diligence. If the owner intends on excluding anything, you want to know it and then you’re going to want to ask some questions. You’re going to need a list of all the inventory in the business. You’re going to want the inventory broken down by what is current, what’s obsolete, and what’s slow-moving inventory.

The next part of the checklist is around employees and employee benefits. At a minimum, a list of all the employees, their positions, their pay, any contracts, employee handbooks, descriptions of all the policies, you want to know if there have been any employee problems in the last three years. Wrongful terminations, harassment, discrimination, worker’s comp claims, unemployment insurance claims, all those sorts of things. You also want copies of all noncompetes and nonsolicit that may exist.

The next piece of diligence that’s important to dive into is the growth prospects of the business. I’ve never met a buyer that wants to buy the business and keep it for what it is now. Every buyer wants to take the bills to the next level. You want to understand what are the growth prospects for that business. What are the top three strategies that that owner would deploy if they were going to continue to operate their business for the next ten years? What do they think the investment might be to go ahead and execute against those strategies? What do they think the returns might be for those strategies?

The next part of the checklist is sales and marketing. It’s important to understand what the company has done from a marketing perspective, what’s worked and what hasn’t worked? What are their digital and social media assets and strategies? What’s the cost of acquiring a new client? What’s their client churn look like? Do they have client satisfaction surveys or some way to measure client satisfaction? What’s their level of repeat business or recurring revenue? Are there ways to generate additional recurring revenues?

The next on the checklist is competitors. It’s important to understand the competitive landscape. Who are the top three competitors in the marketplace? What are the trends from a competitive perspective? When the business loses to competitors, why does it lose business? What do they see happening with competitors? Had there been some that have been sold recently, shut down, liquidated? The next part are the leases. Getting your hands around what’s happening with the property leases, real estate leases, any amendments, extension, any personal guarantees on any of the leases, equipment leases, copies of all of it, and amendments to anything that’s happened so you and your team can pour through all of that information. Are these leases transferable, or do you need to go get them new leases? Are there buyouts? Would you consider a buyout? Is the owner going to buy out these leases? Are there warranties that go forward as a result of these leases. Are warranties kept after the business is transferred?

Material contracts. This is where you want to get your arms around any client and vendor contracts, any other material contracts, any amendments to any of those contracts. Understand all the fine print in those contracts. One of the important things to look for is to see if anything happens in a change of control, whether or not you need to go get the permission of clients and vendors to take over those contracts, or if the owner of the business can transfer those contracts to you without requiring any of those permissions. It’s critical to understand.

Acquisition Diligence: Deals are done by people. If the people like each other in a transaction, they’re going to get through any issues.

The next is your legal review. Any litigation, anything from a legal perspective that you need to know about. A schedule of all general liability, personal and property liability, any insurance claims, any litigation that’s happened, whether it’s been resolved or not. You want to know what’s happened in the past because even if there’s been litigation that’s been resolved, you want to understand what originated that litigation and how it was resolved, and whether or not you think that can be repeated in the future.

You want the list of the company’s professionals, what law firms have they used, what accounting firms, consulting firms, any other professionals that have been providing advice or services to the company over a 3 to 5-year period. You want to get a complete checklist of all of those professionals and understand if there are some that are no longer doing business with the company, why not? Who does the owner value in that little professionals and why? Whether or not maybe continuing some of those relationships into the future might make sense for you.

Operations, getting a list of all of the operational processes, operations manuals, how the business processes are developed, maintained, and changed on an ongoing basis. Where the businesses had issues in their operations and how they’ve resolved that? A list of all the operational vendors if there are any. The last on the list is technology and security. What are the technology platforms for the company? How does the company secure the data that they have? Had there been any breach of any of that data? If so, where were the breaches and how were they cured? Were there any liabilities? Are there going to be any ongoing liabilities in the future? Can you merge those technologies into your technologies if you’re a company that’s acquiring another business? It’s important to get your arms around the technology and how you would integrate the technology.

The last piece I’m going to mention that is not part of the checklist but so important is the relationship that you have with the owner of the business. It’s important that rapport is developed with the owner from day one, and that rapport continues throughout the process. Deals are done by people. If the people like each other in a transaction, they’re going to get through any issues. Unless they’re material and major, there are going to be speed bumps. If there are rapport and trust between the principals and the transactions, you’ve got a high likelihood that you’re going to get that deal done. Maintaining rapport and understanding that this is a delicate time for the owner of the business. They’re turning over a business that maybe they built from scratch, or it’s been in the family for a long time. Understanding what emotional things that the owner may be going through, and that this is much more than just a financial transaction for them is critical.

I hope that this overview of best practices, checklist and construct has given you a frame of reference and a way to move forward when you’re looking at your own transactions. If you need more help, please reach out to us. You can reach out to me directly at [email protected]. Go to our website, there are tons of free resources. If you like the content here in this show, subscribe. We’ve got tons more content coming your way that can help you through any transaction that you’re looking at. I wish you the best in all of your transactions. We’re always here to help. Please remember that this best practices, construct, and checklist is going to be available on our websites. If you want to download that information, you can access it in either SunAcquisitions.com or K2Adviser.com. Thanks and have a great day.

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I hope you enjoyed this episode. If you enjoy our content, please remember to subscribe and review our podcast. I look forward to seeing you again on the next episode. Until then, please remember that scaling, acquiring or selling a business takes time, preparation and the proper knowledge.

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About Domenic Rinaldi

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