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Due diligence is an essential step in the merger and acquisition (M&A) process, providing buyers a comprehensive understanding of a target company's financial health, operational efficiency, and overall value.
By conducting thorough due diligence, buyers will identify potential risks, assess the target's growth prospects, and negotiate mutually agreed upon terms for the acquisition.
Investors and lenders also place significant importance on due diligence as it helps evaluate the risk associated with an investment or loan. A well-executed due diligence process can mitigate the risk of financial loss by ensuring the target company is financially sound and has a growth-oriented business model. Additionally, investors and lenders require due diligence reports as part of their investment or loan approval process.
Many buyers will insist on a Quality of Earnings (QofE) report. The QofE is like a financial detective's magnifying glass, scrutinizing everything from revenue recognition to expense accruals to uncover potential irregularities or inconsistencies. A QofE report is essential for understanding the true health of a target company and ensuring the deal price reflects its real value, not just a polished financial facade.
The overall due diligence process involves examining a wide range of documents and data. Here are the most common pieces of information requested of the seller:
Financial Performance:
Profit & loss statement (year to date): Offers a snapshot of the current year's financial performance. Compare this to the historical data to identify any significant changes.
Profit & loss statements (trailing three years): This provides a historical overview of revenue, expenses, and profitability. Look for trends in revenue growth, cost control, and profit margins.
Tax returns (trailing three years): Validates the accuracy of the financial statements and reveals any potential tax liabilities. Pay attention to any discrepancies or unusual tax deductions.
Current balance sheet: Shows the company's assets, liabilities, and equity at a specific point in time. Analyze the company's liquidity, debt-to-equity ratio, and working capital.
Bank statements (trailing twelve months): Provides insight into cash flow, bank balances, and any unusual transactions. Look for signs of financial distress or irregularities.
Accounts payable schedule: Lists outstanding debts owed to suppliers. Assess the company's payment history and any overdue balances.
Accounts receivable schedule: Shows the amounts owed to the company by customers. Evaluate the company's credit policies and the aging of receivables.
Net working capital statement: Calculates the company's short-term financial health. A positive working capital indicates the company has sufficient resources to meet its current obligations.
Pro forma budget: Forecasts future revenue, expenses, and profitability. Analyze the assumptions used in the budget and assess its reasonableness.
Operational and Legal Factors:
Contracts with customers: Reveals the terms of service agreements, customer concentration, and the company's revenue mix. Identify any high-value or long-term contracts.
Contracts entered by the company: Includes vendor agreements, employment contracts, and leases. Review these contracts for any potential liabilities or restrictive covenants.
List of employees & compensation: Provides information on the company's workforce and salary expenses. Evaluate the company's compensation structure and any potential labor issues.Employment contracts: Outlines the terms of employment for key employees. Assess the company's employee retention policies and any potential severance liabilities.
List of customers (with redacted contact info): Assesses customer concentration and purchase frequency without disclosing sensitive information. Identify any key customers or industries that represent a significant portion of the company's revenue.
Landlord approval to transfer lease: Ensures that the landlord will allow a change of ownership. If the landlord's approval is required, assess the potential terms and conditions.
List of assets: Identifies the company's tangible and intangible assets. Verify the ownership of assets and assess their condition and fair market value.
Verification of assets: Confirms the existence and condition of assets. This is particularly important for equipment and inventory.
By diligently reviewing these documents and data points, buyers will gain a comprehensive understanding of the IT services business's financial health, operational efficiency, and future prospects.
This information is essential for making informed decisions and negotiating favorable terms in the acquisition process.
Tim Mueller is an American businessman specializing in the growth of technology and communications companies. With 30 years of experience in startup, high growth and business exits, he is best known for identifying next generation technologies, assembling teams to leverage these opportunities, and building cultures for success. He has founded and sold four technology-based businesses prior to co-founding IT ExchangeNet.
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