The Art of Due Diligence

Do this before you hire a pro…

Picture me sitting at my desk, or more likely, with my feet up on the couch. I have a spreadsheet open on my laptop, a pile of tax returns on my left and maybe a second screen for notes, even an old-fashioned legal pad and pen. I’m starting to drool like a hungry teenager sneaking out of their bedroom to devour an entire chocolate cake at midnight. (Your house, too?) That’s how I feel about due diligence. It’s so delicious I cannot wait for that first bite!

Like baking, there is both an art and a science to financial due diligence. A hard side and a soft side, so to speak. The hard side or science of DD involves all the ratios and number crunching, cash flow analysis, quality of earnings, working capital analysis, etc. It’s tedious and expensive work but it should be seen as an investment, yes, an investment, in both you and your future business. You probably want to leave that to the pros, but there is a lot of preliminary evaluation work you can do prior to bringing in the big guns. And you should. You should be practicing this softer side of DD, what I refer to as the art of due diligence. Getting a feel for the company and the industry, evaluating the surface view of the strength and worthiness of the target co, determining if it’s even worth moving forward on, worth writing a Letter of Intent, worth the investment in professional due diligence. (Side note: this will also help you solidify your deal criteria.)

So, you’re eager to do this groundwork, right? It feels good to be evaluating a few businesses, keeping the pipeline full. But you contact the broker or owner and ask for…what exactly…the P&L? Do I need to see a Balance Sheet? I don’t know anything about taxes. What do I do there? This article will give you the confidence to perform your own preliminary due diligence by breaking it down into three phases, with specific actions outlined in easy-to-follow bullet point format for each phase. Keep reading for your checklist of general knowledge and free resources, documents to request, and exactly what to do with them all. This is the same way I start each of my DD projects.

A few words of caution before you get your calculator out!

· The problems you find should not be automatic deal breakers. They can often be opportunities for improvement, ways for you to add value to the business. But don’t buy potential! You’ll be doing all the hard work of making those improvements a reality, so you’d be in effect “paying” for them twice, once in an inflated price and twice in time and effort.

· Anyone can spot patterns. Don’t be daunted by the math. You’ve got this!

· When you do get to the point of hiring a professional, they should be just that, professionals, professional deal facilitators that is, not deal breakers. Their job is to protect your investment, not destroy your deal. Consider using problems uncovered as negotiation points. That doesn’t mean you never walk away, but don’t let your advisors get stuck on minor details. (I once lost a buyer over random points of a non-compete that I didn’t even care about, but my broker got too aggressive. )

· Sellers are always selling for a reason, and I don’t mean simple retirement or spending more time with the family. There is some type of problem within the business, or within the owner, that they can’t or don’t want to fix. Maybe they need a capital injection for inventory to keep pace with rising demand, or maybe the business has outgrown the owner’s management capabilities, or perhaps an online presence needs to be added but the owner doesn’t have time to learn those skills. The question becomes this:

Do you bring those missing skill-sets/resources to the table?

(Find a business that needs what you have to offer.)

Now, let’s get started!

Phase 1-Gain general knowledge: of the components of due diligence and of the industry in question. Tax returns are key! Familiarize yourself with the layout of the business tax return. Check out a blank S Corp return,  Form 1120S here .

Key items found on page 1 of the S Corp return include

1. Number of shareholders

2. Revenue

3. Cost of Goods Sold

4. Gross Profit

5. Compensation of Officers

6. Salaries & Wages

7. Repairs & Maintenance

8. Net Income

Key items found on page 4 of the S Corp return, the Balance Sheet

1. Cash

2. Accounts Receivable

3. Goodwill, if relevant

4. Liabilities or debts

5. Retained Earnings

Key item found on page 5, Schedule M-2

• Distributions

Other important items include:

1. Bank reconciliation report- shows both cleared items and uncleared items, as well as the date the reconciliation was done. I recently reviewed a year’s worth of bank recs and noticed all 12 of them had been completed on the same day last month. Suspicious!

2. Gross margin-a great basic book is Accounting for the Numberphobic.

3. Secretary of State website. You can see  Indiana's here . You can discover tidbits such as:

1. Entity status

2. State license status

3. Date of entity creation

4. Names of officers

4. County real estate site. You can see  Allen County, Indiana's here . This will show information such as:

1. Building ownership and transfers

2. Taxes paid, or NOT!

3. Assessed value, which may or may not be close to market value.

5. Industry research- know 3-5 important factors of your target co's industry. For example, I was looking into a chocolate factory a while back. I discovered that the Food and Drug Administration requires inspections of all food production facilities. I scored “brownie” points when I asked the sellers about their FDA history.

Phase 2-Documents to request: Your seller may or may not be terribly forthcoming prior to LOI. Try to get as much info as possible. Don’t worry, this should all be pre-assembled in their data room prior to going to market. Off-market deals will be more challenging to get data from. You’ll need to be patient yet firm with your information requests. Try to get the following docs.

1. Tax returns- 5 years

2. Balance Sheets and Profit and Loss Statements for the same period

3. Bank statements AND reconciliation reports for last 12-24 months

4. Accounts Receivable aging report

5. Accounts Payable aging report

6. Employee payroll report, employee count

Phase 3-Search for patterns and anomalies. Like anything else, this takes practice. I always start with the tax returns.

1. Does the Balance Sheet balance? Sounds silly, but it does happen. If the Balance Sheet doesn’t balance, it’s going to be hard to trust any of the data. You can read a previous article I wrote  here  for more insight into Balance Sheets.

2. Look for patterns by making a simple spreadsheet. Start with the oldest tax return and work your way forward. Put the tax years at the top of the spreadsheet and the following accounts along the side of the page. You can always add other accounts that jump out at you.

• Number of Shareholders- can indicate how many decision makers there are. If that number has decreased, are there any outstanding obligations to that shareholder?

• Revenue-is it trending upward or downward?

• Cost of goods sold-is it moving with revenue? Is it moving at the same pace as revenue?

• Gross margin=gross profit/revenue. This varies by industry, but generally, GM should be around 45% or higher.

• Compensation of Officers- is owner/operator paying themselves a reasonable wage?

• Salaries-is payroll moving with revenue?

• Repairs and Maintenance- for equipment heavy businesses especially. Are they maintaining the equipment? Also check out the equipment rental account.

• Ordinary Business Income- (aka profit) Is profit increasing or decreasing? Does the change in profit seem reasonable compared to the change in sales? Listen to the Acquisitions Anonymous podcast above, especially at minute 28:20, for a crazy example of how patterns can point to problems.

• Cash- we all know cash is King!

• Accounts Receivable- this is the amount of money people owe the company. Are there many clients with past due balances? Are the past due balances of a significant amount? Check the AR aging report.

• Debt-is total debt increasing or decreasing? Also look at the number of loan accounts. Have they been scurrying around begging for a few bucks anywhere they can get it?

• Retained earnings- this is income that has not yet left the company.

• Distributions- money taken out of the company for personal use. How does it compare to profit?

• Goodwill- it may not exist, but if it does, it indicates that this company bought another company at some point. Ask if there are any outstanding obligations related to this transaction.

3. Other items to consider include:

• Revenue per employee.

• Profit per employee.

• How much cash is required for a single payroll?

The next step is to review your findings with the seller. This is not to be an interrogation, but an easy flowing conversation. Instead of drilling him or her on issues you find, consider starting with "I'm curious about... this thing I noticed. It appears as though..."

This list is totally doable, right?

It’s by no means a complete due diligence checklist, but it will provide you a great starting point. It should give you an idea of whether the deal is worth pursuing or not. It should offer enough interaction with the owner to know how easy or difficult they will be to work with. And the best part of all, it will give you an increased level of confidence in your business buying journey. Feel free to reach out with any questions or comments.