CHAPTER 13

Preliminary Due Diligence

Once a prospect survives your filters, it is time to learn even more about it so that you can decide whether to make an offer to buy the company in the form of a letter of intent (LOI)—and determine what shape the offer will take. Gathering the information to apply your filters probably took about a day’s work and, for prospects sourced through brokers, included an initial discussion with the broker after reading the teaser and CIM and, for directly sourced prospects, included interviewing the owner and reading company financials. Now, you’ll devote substantially more time to the prospect in the focused period of rapid learning, your preliminary due diligence. The goal of preliminary due diligence is not to learn how to operate the business; it is to efficiently get to a go/no-go decision and to shape the price and terms of your offer.

Much as with filtering, you’ll begin by focusing on potential concerns that would cause you to reject the prospect. Unlike filtering, the characteristics you will focus on are likely to be less visible and will require that you reach beyond the teaser and the CIM, requesting additional pieces of information from the broker and perhaps the seller and doing your own projections and analysis. While the filtering process is about running a prospect through a static checklist of filters, preliminary due diligence is about formulating and then answering questions very specific to a particular business to get a more detailed sense of how it operates.

To minimize costs, you will do almost all the preliminary due diligence yourself. You’ll begin to bring in accountants and attorneys only after you become even surer that this is a good opportunity.

The Questions

Preliminary due diligence is about forming and answering questions. The time you invest in formulating thoughtful questions makes the process more efficient. Consider unknowns that are essential to the company’s business model. Ask yourself, What are the two or three things that would change my mind about the business? Remember, it is an iterative process so that many of the questions you focus on during this stage will be the same as those you examined during filtering. But now, you are looking to answer those questions more fully and to be more confident in your answers. So, as you create your list of the two or three most important things to focus on, also ask, How can I satisfy my concerns? What data can I ask for? What could I ask the owner? Each business is different, and you will have different questions about every one that you investigate. Here are some examples:

• I think the business has many recurring customers. But does it? What is the history of customer churn?
• I think the business has good growth potential because the current owner hasn’t done much selling. But is the growth potential real? How big is the market? How would the business compete for new customers?
• I think the business has been enduringly profitable with steady cash flows. But has it? What were its profits and cash flows during the last recession? Is it cyclical?
• I think the business does not rely on particular customers, suppliers, or employees. But does it? What is the customer concentration? What is the supplier concentration? Are there key employees?
• I think I can run this business at least as well as the seller can. But can I? Are there some key relationships between the seller and customers or suppliers? Is there some certification or expertise required? Do I need a license? Is there a preference for an attribute (veteran, women, and underrepresented minority) that I lack?

Whatever your questions, order them so that you first focus on the ones most likely to kill the deal. Preliminary due diligence is an iterative process; as you obtain answers, new questions get raised. So, as you formulate your additional questions, keep focused on those that could influence your decision to move forward or not.

As you proceed with your investigation, you will use resources beyond those that you used to filter and you will probe deeper into the resources you’ve already used.

Reading Industry Research

To learn more about broad industry trends, terminology, and rules of thumb, turn to industry research. Search the web for news stories, and read trade publications and analyst reports on any large public companies in the sector. Industry associations often offer a library of reference materials. Internet searches are fast ways to gather background information. As you investigate, gauge whether the industry is growing or is mature and whether there are emerging, competitive threats.

You are unlikely to find information that is precisely applicable to the prospect you are evaluating, because most successful smaller firms operate within narrow, differentiated niches. Still, this background information will give you a context in which to evaluate the acquisition and prepare you for your conversations with the seller. In addition, understanding the industry and who the competition is (or isn’t) can help you confirm your assumptions about the company’s business model.

Interviewing the Seller

The simplest way to get your questions answered is to arrange a telephone interview with the owner and go through your questions. This detailed call might last one or two hours and may include requests by you for additional information. Such a phone call works well for questions that can be answered quantitatively. If your concern is about cyclicity, for example, the owner can send the company’s financial results from the last recession. Similarly, the owner can provide more detailed information about customer churn and concentration. Interviewing the seller is also helpful with qualitative questions such as why customers buy from the company or its closest competitors. Of course, the owner will be optimistic about the prospect, as any seller would be. The challenge for you is to listen and then carefully assess the answers afterward; it is not a time for an adversarial call.

You may be tempted to visit the owner in person for this first in-depth interview, but a call is actually more productive and less expensive. The seller is unlikely to be able to answer your quantitative questions during an on-site visit anyway; just as with a phone call, you’ll need to wait to get that data afterward. In addition, at this point you don’t want to convey to the seller that you are overly eager.

Conducting an Onsite Visit

An onsite visit does make sense later in your preliminary due diligence, however, after your most critical questions have been answered favorably. As the chance of completing an acquisition increases, the additional investment of your time and funds makes more sense. Certainly, most owners will also want to have met their buyer in person before accepting any kind of offer or letter of intent, so you should plan to visit as you get closer to finalizing your offer.

At an onsite visit, you usually have the opportunity to talk directly with the owner about the business and its challenges and opportunities. The visit works best if it is a free-flowing conversation in which you learn a lot about the business that goes beyond the initial information you received while filtering. The conversation will sharpen your understanding of how the business operates. How are its products manufactured? Who are its important suppliers? Why do customers choose to buy from this company and not from its competitors? Which employees are the most valuable, and why?

Once you are onsite, not only can you meet with the seller, but you can also observe the business in action. You can learn about the facilities from seeing them operate and from observing the property. Is the facility neat and professional? Are employees busy and hard at work? Is there room for expansion if needed? Is the production process orderly, or is there a constant sense of confusion?

You will also learn more about the seller. You’ll get a feel for the seller’s capability and integrity. You’ll glean more information about the owner’s commitment to sell the business and the ease of the postsale transition by observing how involved the seller is in the day-to-day operation of the business. Importantly, you will also discover if the two of you will be able to develop a mutually satisfactory relationship.

One thing that won’t happen during an initial onsite visit is a meeting with the management team. Sellers typically keep a sale process quiet until it is more certain. Sometimes, sellers might want to meet with you on weekends or evenings so that the onsite meeting happens without the knowledge of the management team. Other times, you might not be introduced fully or at all. The seller isn’t being rude; he or she is just being understandably secretive about the impending sale.

Building a Financial Projection

A financial projection is a numerical expression of your evolving beliefs about the business and how it will perform over time, depending on any changes that you decide to make. The projection should reflect your estimates for revenues, expenses, and EBITDA, typically over five years. You will return to the financial model repeatedly throughout your preliminary due diligence and beyond. As you learn more about the prospect, you’ll incorporate that information into the model so that you can gauge the financial consequences of your increased understanding about the business.

To give you a concrete example, we will apply the use of a financial projection to Randy Shayler’s acquisition of Zeswitz Music. (We have changed some details to protect Randy’s privacy and that of the seller and to make the example clearer.) As described earlier, Zeswitz rents musical instruments to schoolchildren. Excerpts from the teaser for the prospect were presented in chapter 8, “Sourcing Prospects Using Brokers,” and Randy’s filtering process was described throughout part III, “Finding the Right Small Business to Buy.”

Generally, you’ll begin your financial model by examining the financial information you received from the broker in the CIM or from the seller for a directly sourced prospect. To do so, create a summary of the business’s operating results like the one in table 13-1, listing its revenues, cost of goods sold (COGS), margin, operating expenses, and other financial data year by year. The financials contained in table 13-1 are from the Zeswitz CIM, which provides detailed financial results for the previous four fiscal years and a projection for the next year. The CIM doesn’t provide detail on the components of COGS, but Randy assumed these were largely the cost of the musical instruments that were sold to customers.

Note that in addition to revenues and expenses, the summary contains two sets of adjustments to EBITDA, or so-called add-backs. The first set includes expenses that the seller wants the buyer to consider extraordinary. The CIM explains that these were onetime expenses unrelated to the ongoing business. Randy accepted those additions at face value but recognized that he would need to learn more about them if the deal moved forward. The second set of adjustments is the broker’s projections of synergies if the company were to be purchased by a larger strategic acquirer; these numbers were irrelevant to Randy because the synergies wouldn’t exist in his case, since he would operate Zeswitz as a stand-alone business.

As a second step in building a financial model, you need to analyze the historical results by looking at each key component of the financials (revenue, COGS, gross margin, operating expense, etc.) as a percentage of revenue, creating a document like the one in table 13-2. The first thing to notice is that 2011—the last full year before the company went on the market—was an especially good year for Zeswitz. Every component of cost was at its lowest percentage of sales. The same was true for capital expenditures. If the 2011 results were sustainable, Randy reflected, Zeswitz was a fabulous prospect. But he wondered if assuming that the future would be like the company’s best year would make his projections too optimistic. So, he computed the company’s average margins (the last column of table 13-2) as well.

Next, use this analysis to create a first pass at projections of how the company will perform in the future (table 13-3). Because he had yet to obtain detailed information about sales to new schools, Randy started with an assumption that total revenue would grow by a modest 5% annually, knowing that he would want to return to that assumption as he learned more. For the other items, he decided line by line whether to use the 2011 results or the average, or something in between. He set the COGS percentage of sales at the 2011 percentage largely because it had been steady at 16% for the last two years. He set the total operating expense as percentage of revenue at 48%; the average was 50% but it was much lower in 2011 at 43% and was on track for 42% for 2012, so he picked a number in between the average and recent results. He noted that learning more about these expenses would be a key due-diligence item. Finally, he set capital expenditures at the average level of 15% of revenue because he guessed that the swings in yearly expenditures had more to do with the availability of capital than with the needs of the business. Again, he would need to learn more.

As he studied his results, Randy noted that the EBITDA during each year of the projection period except for 2017 was lower than the 2012 result and that free cash flow was much lower than 2012, largely driven by the especially low capital expenditures in 2012. Still, the EBITDA margin (EBITDA/total revenue) was a healthy 36%. So, while Randy’s first version of his model raised several questions, he remained optimistic about Zeswitz and therefore continued with the iterative preliminary due diligence to get answers to those questions.

Of course, it’s difficult to forecast the future, and the test of a financial model is not that it predicts with exact accuracy. A financial model enables you to play with your key assumptions to see the effects on other parts of the business: For example, if sales increase or decrease, in contrast to your plan, what is the effect on cash flows? Gradually, as you adjust the important assumptions in your forecast, you develop a sense of the likely range of performance of your business. For example, if the 2011 ratios for Zeswitz were sustainable, the financial projections would improve substantially: EBITDA in 2016 would be over $1.7 million, and free cash flow would be $1.3 million. Your financial modeling provides insights on whether the business, as you understand it, is enduringly profitable and then identifies the critical assumptions that you need to explore further during the preliminary due-diligence process.

Next Steps

If your preliminary due diligence—including your initial financial model—reinforces your view that the prospect would be a good acquisition for you, the next step is to determine an offer price and other important terms of your proposed acquisition. We discuss this step in chapter 14, “How Much Should You Pay for a Small Business?,” and chapter 15, “Deal Terms.”