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Why Pay for Due Diligence? What is the Value Proposition?

Performing financial and other types of due diligence prior to an acquisition is often the critical success factor on any completed transaction.  While large public companies engage in due diligence services as more routinely than private enterprise, the value proposition is equally applicable. I understand that for smaller investors, the cost of due diligence services may be prohibitive to the value of the deal. However, in my experience, whether the transaction is large or small, engaging professionals to perform financial or other due diligence is always a good investment and always leads to a cost effective transaction solution.

In my over 20 year’s transaction experience, entrepreneurs and industry experts often miss key issues that make the difference between accretive success and continued cash flow losses. Most people would not purchase a house without a home inspection or purchase a car without a once over by your mechanic. Why? Because most entrepreneurs or business people are not in the business of buying and selling a house or a car. It is not what you know that causes a transaction to fail, it is what you did not know.

Here is an example from my own experience:

My client was an entrepreneur in the electronic distribution industry. He was looking to acquire a mid-size electronic importer that provided TVs, audio and other electronic products from overseas to local big box stores. From the initial analysis, the deal was clearly accretive and the cash flows were excellent. Earnings were high and growing along with strong cost control over the past three years. Our mandate as transaction advisors was to “kick the tires and make sure there was no big issues”. Clearly, our investor client was not expecting us to find anything.  After two weeks of analysis or “kicking the tires,” we discovered that the primary driver of the company’s steady growth and earnings was actually changes in the exchange rate that was recorded with the cost of the sales. Furthermore, the cost cutting by the company was with key infrastructure services that would have to be replaced post transaction. Overall, the initial information presented to the investor did not address the drivers of the growth and improved operating results. On a post- acquisition pro-forma basis, the results of the acquisition would not have been accretive to earnings and would have been an increased cash burn for the investor.  With our advice to the investor, he continued to the close the deal for less than half of his initial offer. His purchase price reduction allowed for the acquisition to be a success both financially and operationally.

Financial due diligence has the following overall value proposition:

  • Identify the underlying drivers of operational performance to better understand the quality of earnings;
  • Identify the non-recurring, non-cash related, soft income and expenses included in EBITDA;
  • Identify pro-forma cash flow and operational issues to consider post transaction;
  • Identify transition issues to consider post transaction which will help to assess the cost and timing of integration;
  • Assess the quality of historical, current and expected working capital and cash-flows of the company;
  • Identify current and expected commitments and contingencies not considered by the investor;
  • Assess the utilization and efficient use of resources including human capital, capital assets, cash flows, etc.; and
  • Work with other due diligence teams such as legal, tax, human capital, technology etc. to further identify exposures to the investor.

While these are some of the value propositions of financial due diligence, other areas of due diligence such as legal, tax, structuring, technology, human capital, etc. should also be considered by the investor depending on the size and investment of the transaction.

While performing financial and other forms of due diligence services are not cheap.  It is however, in almost every instance in my experience, cheaper than the issues and repercussions of issues not identified pre transaction.

At BGD LLP, we can provide financial, tax, technology and structuring due diligence services as well as valuation and transition and integration services as part of our transaction advisory services.  We understand the financial constraints in the private enterprise and we are happy to work with you to ensure that your needs are being met and you enter into a good deal that meets your expectations.  While you may be an expert in your field, we are experts in transactions and we want to make sure you are as successful as you can be.

Rohit Prajapati is a Partner at BGD LLP and leads the Transaction Advisory Services Group.

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