CHAPTER 17

Confirmatory Due Diligence

Until now, your research and preliminary due diligence allowed you to explore and analyze the prospect’s business model. You accepted the seller’s answers to your questions with little supporting evidence. During confirmatory due diligence, you will validate your understanding of the essential elements of the business with a crosscheck of the company’s documentation and with the advice of experts such as accountants and attorneys. This is also your chance to explore other aspects of the business to be sure there are no undiscovered negatives that could affect your willingness to acquire the business.

Overview

The process begins when the LOI is signed. If your LOI specifies an exclusivity period of 90 days, you’ll want to complete the bulk of your confirmatory due diligence in the first 30 days so that you have time for negotiating the purchase agreement and finalizing your arrangements to raise debt and equity. For the first week or two, you should conduct confirmatory diligence on your own. You’ll meet with the owner, learn about the records the company has readily available, go over the financials with the chief financial officer (CFO), and then complete a proof of cash, an analysis that confirms the revenues and expenses reported in the financial statements by comparing them to deposits and payments to and from the company’s bank account.

Your next step is to involve your accountant, your lawyer, and possibly other specialists (see the sidebar “Selecting Professional Advisors” for advice on finding the best experts for your situation). But you should always sequence due-diligence tasks so that the big issues, if any, are identified early, before you hire your advisors and waste time and money on a deal that can’t go forward.

While your professional advisors will provide valuable analysis and advice, you cannot fully delegate anything: There are no such things as accounting issues or legal issues that you completely turn over to others. You should be at the very center of all due-diligence activities because they tie so closely to the deal you will ultimately strike and to how you will operate the business. To decide if your advisors have confirmed particular facts to your satisfaction and can move on to the next task or if new questions are raised by their findings, you should have regular discussions with your advisors—perhaps every day—as they complete pieces of work. Like so many parts of becoming an entrepreneur through acquisition, it is an iterative process that you guide.

As you proceed, there are six fundamental areas you need to assess to make sure you are actually buying what you think you are buying:

  The character—and specifically the honesty—of the seller

  The company’s accounts and finances (accounting due diligence)

  The company’s contracts and legal affairs (legal due diligence)

  Customer perspectives

  Employee perspectives

  Any further specialized due diligence

Honesty and Character

Character assessment is the most basic of the due-diligence building blocks: Before you go any further, evaluate whether the owner of the business you are buying is truthful. If you feel that the seller is not an honest person, move on to another deal. No matter how thorough your due diligence, sellers always have an information advantage over buyers; your odds of outsmarting a dishonest owner are low.

You have had several conversations with the seller since you first identified the prospect, and you probably met face-to-face during your preliminary due diligence. You should have a good gut sense of the seller’s character, but confirmatory due diligence gives you new information to update your evaluation in three ways:

• Throughout the due-diligence process, you will see whether your independent verification of facts about the business unearths negative issues that the seller didn’t volunteer frankly. If you present the owner with a negative fact discovered in due diligence, how does he or she explain not having previously reported it to you? Truthfulness is a habit—if a seller has covered up one thing, it is likely that the seller has covered up other things that you haven’t found.
• When you interview customers, ask them how they view the firm’s or the owner’s integrity. Have disputes or misunderstandings been resolved fairly? Does the company deliver what it promised, or more, but never less?
• When you examine the company’s business practices—billing; customer refunds; quality control; and employee pay, benefits, and evaluations—are all parties being treated fairly? How owners treat their customers and workers is a good indication of how they will treat you.

Accounting Due Diligence

The work of accounting due diligence is shared between you and a hired accountant. Start by taking a first pass through the material from a business perspective. This first pass can reveal deal killers; finding them early means you won’t have paid accounting fees on a deal that will never close. In addition, your familiarity with the company’s financial information will enable you to guide your accountant’s work. Then the accountant can focus on a more detailed review of the financials—particularly any area in which you felt something might be awry.

There are two separate streams of accounting due diligence. In a proof of cash, you verify the accuracy of the company’s historical accounting reports. With a quality of earnings analysis, you assess the makeup of the company’s historical revenues and earnings to determine whether they are representative of future performance and likely to recur.

First pass of financial statements

In your first pass through the company’s financial statements on your own, look for any significant inconsistencies or inaccuracies in historical revenue and EBITDA. These can be common; most small firms do not have audited financial reports or robust internal financial reporting systems. And while simplified accounting may be adequate for the entrepreneur to operate a business, the reporting errors that accompany such a system don’t work for a buyer, because they can result in misleading historical results that affect your purchase price.

A common problem, for example, is timing errors in revenues and associated costs: If costs are recognized in the first year of a project and revenue is recognized in the second year, the company will seem much more profitable in the second year. If the second year happens to be the year of sale and you based your purchase price on the reported EBITDA from that year, this timing error may make your acquisition price too high. Because the company is small, the scope of misreporting doesn’t need to be very large to have a material effect on profits and purchase price. As you initially familiarize yourself with the company’s accounts, ask about the causes of large year-to-year fluctuations in revenue, expenses, and EBITDA; these can be the result of inaccurate accounting records.

Proof of cash

Checking accounting statements for accuracy also calls for comparing different forms of documentation. One important confirmatory comparison of documents is a proof-of-cash analysis. Imagine, for example, that your acquisition candidate’s financial reports show that, in each of the last three years, sales were $10.0 million and EBITDA was $2.0 million and that, of the $2.0 EBITDA, $0.5 million was used for capital expenditures and $1.5 million was distributed to the owner.

You can perform a simple first-pass test on the accuracy of these reports by taking the company’s monthly bank statements and adding up all the deposits and all the payments. The deposits ought to roughly equal the $10.0 million made in sales; the payments ought to roughly equal the $10.0 million of the year’s revenue that has been spent or distributed to the owner. Identify and add back the owner’s distributions, and the remaining payments should come pretty close to $8.5 million. You have just confirmed that the company’s financial reports showing $10.0 million of revenue, $8.5 million of expenditures, and $1.5 million of cash flow is supported by $10.0 million of bank deposits and $8.5 million of checks written to third parties.

This won’t be a precise analysis: Accounts receivable and accounts payable will be growing and shrinking, and inventory might have changed—but the numbers shouldn’t be far off. If you perform this test on the previous three years of bank statements and the EBITDA-less-capital-expenditure number you keep coming to is closer to zero than $1.5 million, then you approach the seller for an explanation before you bring in your outside accountant.

There are different ways to validate your target’s financial statements. Greg Geronemus and David Rosner’s commonsense approach was based on the idea that no one reports a higher income to the IRS than they actually earn. As the two men did their due diligence on SmarTours, a group travel service to exotic locations, they compared pretax income reported in the company’s financial statements to the pretax income reported in the company’s federal income tax returns. They had some reconciling to do since income tax calculations are different from income statement calculations. But the match between income from the tax return and income from the financial statements was a pretty good first-pass test on the accuracy of those statements.

As you review the financials, keep an eye out for various discrepancies:

  Timing between the reporting of revenues and associated costs (resulting in inaccurate EBITDA during the period on which the sale price is based)

  Actual cash flow as shown in bank statements versus reported figures for revenue, expenditures, and owner distributions

  Pretax income as reported in financial statements versus that in tax returns

  Big fluctuations in year-to-year revenues, expenses, and EBITDA

Once you have done a first pass on the basic accuracy of the financials, it is time to bring in your accountant to review the financials more thoroughly. You should also ask your accountant to report on the competence of the company’s accounting department. Is the CFO adequate for the job? Is there proper separation of duties to avoid fraud or stealing by employees? Finally, your accountant should also provide a quality-of-earnings report and an assessment of any tax risks, which we’ll discuss next.

Quality-of-earnings review

Even correctly prepared statements do not tell you everything you need to know. This is because you’re interested in whether historical revenue and profit will recur in the future, while accounting statements only reflect the past. That is where the quality-of-earnings analysis comes in.

The quality-of-earnings analysis is a quantitatively based assessment that uses historical financial results to estimate the future performance of the business. As part of your preliminary due diligence, you studied the historical financials and EBITDA to understand how they have fluctuated. Now is the time to examine any fluctuations more fully because you now have access to detailed financial records that should allow you to confirm your understanding.

Your accountant should take the lead in this work, but you’ll be fully involved. Start by taking the last several years of financials, and ask the company’s CFO to show you the components of each line item. Break out revenue by major customer and by product. Do sales concentrate with a few clients? If so, check the patterns of their purchasing in each of the last few years. Are the major clients steady and recurring, or do they come and go? Were there any large pieces of business that only happened once? Did the business get a new customer? Did it expand operations?

Don’t just look at revenues: Examine the individual cost categories that make up each expense line item. Is there a reason to think that any big cost is likely to go up? If payroll is a big component of total expenses, it’s a good idea to check that employees are currently being paid a market rate and not below. If rent expense is a big item, check the remaining term of the lease and whether the rate is likely to change substantially at renewal. Did the company reduce costs by delaying annual maintenance on machinery? The purpose of this work is to prove to yourself that the historical revenues and expenses, and therefore the historical pretax profit performance you are buying, is likely to recur.

Also look at add-backs. If you accepted the seller’s representations about the add-backs when you decided on your offer price for the prospect, you should reexamine those carefully now. You will need to look at the records and decide whether these are truly appropriate to be added back. You will need to gauge whether certain expenses are really personal or whether a onetime expense is truly not going to recur under your ownership. It’s typical to negotiate over the type and amount of included add-backs.

Tax risks

Most smaller firms are organized as flow-through entities for income tax purposes, meaning that their income tax liability flows through the company and is an obligation of the business’s shareholders rather than of the company itself. This means you don’t have to check that the company correctly calculated and paid prior year income taxes; if there is an income tax audit and additional taxes are owed, the obligation flows through to whoever was the owner in that year, and it is their responsibility to address any errors. Sometimes the company you are buying was established as a C-corporation (the type of structure in the United States; similar structures exist in other countries), and the company itself is the taxpayer and not its shareholders. Your accountant will then need to carefully examine prior annual income tax returns for accurate reporting because if the tax authorities audit a prior year and assess more tax, the company owes that back tax even though you, the new share owner, didn’t own the company at that time.

There are other types of tax underpayments that stay with the company you purchase even if it is a flow-through entity. The largest of these payments are payroll taxes and sales taxes. Suppose your target uses 45 independent contractors to sell its products, paying them a fee each time one of them makes a sale. Because the salespeople are independent contractors and not employees, the company pays no Social Security tax, no federal or state payroll tax, and no unemployment insurance taxes. But do these salespeople meet the guidelines for independent contractors, or are they actually employees? The rules are complex and subject to some amount of judgment. But if these contractors are later deemed to be employees, the company will face a significant increase in payroll tax expense. Even worse, there could be a liability to the company for prior years’ payroll taxes that should have been paid but weren’t.

Here is another potential problem: Imagine that the company you are buying provides services across 30 states and numerous municipalities. Does it collect sales and use tax as prescribed in each of these many jurisdictions? Many smaller firms are simply unaware of their sales and use tax obligations in other jurisdictions. You had nothing to do with the company’s past practice, but if you buy the company, you could find yourself assessed for sales taxes that should have been collected over the years—as far back as the founding of the company.

This tax analysis will all be done by your accountant without much involvement by you, as it requires specialized training and experience. Meanwhile, you can focus on other confirmatory diligence.

Legal Due Diligence

Almost every business has contracts that are important to its operation—a lease on its headquarters, a distribution agreement on its largest-selling product, or employment and noncompete agreements with several key salespeople. You need to read all of the company’s important contracts and make sure they are consistent with your plans for the business. You’ll need to understand which contracts require consent from the other party to transfer the contract to you, and what kind of performance or payment guarantees have been made. Most commercial contracts are straightforward and easy to understand. But if a particular contract is critical to the business, or if you read one but don’t understand it, have your lawyer review those as well.

How can you be sure that the seller is presenting you with all of the company’s contractual commitments? The purchase agreement your attorney will prepare requires the seller to list every such contract on an attached schedule. This enables you to identify and review each contractual obligation of the company before you sign the purchase agreement. If you review the schedule and it lists a contract you haven’t read, simply ask for it.

Contracts such as leases or distribution agreements often have change-of-control consents, which mean that if the firm or its assets are sold, consent is required from the other party to transfer the contract to the company’s new owner. If the business relationships with the partners as they currently stand are satisfactory, this is usually straightforward; you should just budget time for you or the seller to collect any required consents.

Building leases to smaller firms often are personally guaranteed by the seller; when you buy the company, the seller (quite reasonably) will want to be removed from the guarantee. You will need to persuade the property owner that the creditworthiness of your purchasing entity is at least as good as that of the seller. In addition, the proprietors will sometimes seek a fee or an improvement in lease terms in return for their consent.

Customer Interviews

As part of your confirmatory due-diligence investigation, you will take on a particularly delicate part of the process: interviews with customers of the target company. This can be difficult to arrange with the seller, since most owners don’t want to announce a sale until they feel confident that it is actually going to occur to avoid rumors spreading. At the same time, you absolutely must speak to customers to learn the strengths and weaknesses of the company, to confirm current industry trends, and to validate your business plan for the company.

Generally, owners permit customer interviews toward the end of the diligence period—when confidence is high that the transaction will proceed. The buyer and seller agree on a sample of customers who will be interviewed, and the seller introduces the buyer to them. Five or six good quality interviews should be enough to confirm what you have been told about customer behavior and satisfaction. Here are questions you want to ask:

• What qualities do customers look for in selecting their supplier?
• Are they satisfied with the services of the company? How is the company better or worse than the competition?
• What causes the customers to switch suppliers?
• Do they anticipate changes in the amount of business they will be doing with the company?

If you were unclear after reading the confidential information memorandum and interviewing the owner about how customers select a supplier and what keeps them from switching, you may want to move customer interviews earlier in your due diligence process. One way to get around the seller’s understandable caution in the earlier stages of the deal is to reach out not to the company’s customers but to similar consumers in a different geographical area. Early in his diligence on Zeswitz Music, for example, Randy Shayler interviewed school band directors outside the company’s service area. You will quickly learn about how customers in this business select a supplier, how they rank their current suppliers, and how frequently they switch—and you can apply all this knowledge to your target company.

Employee Interviews

You will also need to interview the company’s employees. In a smaller firm, this group is likely to contain only a handful of people: a couple of managers, the CFO, and any key salespeople. It is likely the seller has told the key employees about the pending sale at this point, if only because these employees have information the seller needs to support the confirmatory due-diligence process. Still, sellers will probably be hesitant to allow these interviews, which commonly occur late in confirmatory due diligence.

Employees will naturally be cautious in responding to your questions; it is unrealistic to expect negative revelations about the company. Your goal for these interviews is rather to assess the capabilities of your critical employees. Think of yourself as conducting job interviews: Are these the people you have confidence in? Do they understand the role of their job in the larger mission of the company, or are they robotic order takers? Do they demonstrate energy and commitment to excellence, or are they impatiently waiting for quitting time to roll around? Are they experienced and knowledgeable about the business?

Your customer interviews will have given you insights about what matters to clients. Find out if the company’s managers and salespeople are closely tuned into what their customers value or are detached from their own market.

Employee interviews give you an opportunity to learn how the company gets its job done. Try this seemingly simple question to begin each interview: “So, what do you do here?” You will learn how a customer order turns into a completed, delivered product or service. Here are a few other questions that will help you discover the capability of the company’s managers:

• What do the company’s customers care about most with regard to the service you provide?
• How well do you think you measure up to their expectations?
• Do you think there is anything the company could be doing better?

Specialized Due Diligence

The first five building blocks of due diligence (character, accounting, legal, customers, and employees) apply to any company that you consider buying. Sometimes, however, you’ll need to hire an expert to examine a specific business asset, liability, or risk. Most commonly, this specialized need will fall into one of four areas:

• Machinery and equipment may be key assets of the business, but you probably do not have the expertise to assess their remaining useful life, the needed upgrades or repairs, and whether any equipment is obsolete from a competitive perspective. Hire engineering consultants to evaluate plant equipment and answer these questions.
• Software systems may be central to the company’s operation. Retain a software consultant to review software documentation, security, the need for upgrade investments, and other factors that affect system reliability or the requirements for additional investment.
• Environmental hazards are a potential risk if the company cannot practically move from its facility and particularly if it owns the underlying real estate. Have an environmental consultant check the usage history of a property. If there were prior industrial activities using hazardous chemicals, the consultant will perform soil tests to ensure that no environmental liability attaches to the company. Note that lenders may also require that this work be done and presented to them in advance of providing a loan.
• Regulatory compliance and rules changes are critical in certain businesses such as health care, waste disposal, broadcasting, and many others. If the company operates in a highly regulated field, arrange for a compliance review by a lawyer specialized in this area (different from your acquisition attorney). This expert will confirm that the company has all the required permits and is operating in compliance with rules, and he or she will advise you on any regulatory changes that might affect the business.

What to Do with What You Learn

You may be able to tell quickly from your confirmatory due diligence that the owner painted too rosy a picture in your initial conversations, but this doesn’t need to spell the end of the deal. Randy Shayler’s acquisition of Zeswitz Music is a prime example: During confirmatory due diligence, Randy discovered that the size of the company’s instrument inventory was 15% smaller than reported and that current-year EBITDA was 20% lower. Zeswitz’s owner hadn’t been trying to mislead; as with many smaller firms, the company’s financial reporting systems were basic and its accounting staff was spread thin. Rather than giving up, Randy negotiated the purchase price to reflect the lower, more accurate performance numbers and successfully purchased the company in the summer of 2013.

At the conclusion of your confirmatory due diligence, you will take one of four actions:

• Close the deal as agreed. The due diligence confirms what you have been told and what you believe about the company.
• Adjust the price. The financial performance was different from how it was represented, but the differences are small enough that the buyer and seller can compromise through a price reduction, a shift of dollars from fixed purchase price to earn-out, or other means.
• Change contract terms. You change the contract terms when you discover a specific liability or risk. Typical ways of addressing an identified risk include having the seller indemnify the buyer for that risk, requiring that a larger amount from the purchase price be held in escrow, or restructuring the deal to acquire assets instead of company stock so that the seller retains certain liabilities instead of passing them on you.
• Walk away. The historical financial performance is significantly worse than represented; the company’s future prospects look poor; big investments are needed; or other materially adverse factors are discovered—in other words, whenever the company’s condition is dramatically different from what you had previously understood.

A last word of advice: Throughout the process, don’t become bogged down in the details. It’s easy for mission creep to set in: You ask a question and get the answer; the answer raises more questions. You may be curious, but you shouldn’t pursue those new questions unless they truly affect the choices you are making. Keeping due diligence moving forward rapidly and in a tight, disciplined manner is even more important than knowing everything there is to know about the business. Momentum gets deals completed, whereas a slow-paced, excessive focus on unimportant details can make them fall apart. And even if the deal does close, it is very common for the financial performance of an acquired company to decline between the LOI and closing, perhaps by as much as 2% per month, as the seller gets distracted. The longer you take, the greater the chance that the seller will become fatigued by all the questions and negotiating. Under these circumstances, another buyer can jump in, or your investors might start working on other matters and become hard to reengage. Instead, stay focused on findings that would kill, change, or confirm the deal.

Next Steps

As you complete the bulk of your confirmatory due diligence, you will begin to simultaneously focus on other acquisition-related activities: borrowing money from lenders, raising equity from an investor group, and drafting and negotiating the purchase agreement. In the next three chapters, we discuss each of these activities.