Proceeding with due diligence Featured

11:02am EDT April 21, 2006
Few home buyers would consider closing a residential real estate deal without calling in a qualified home inspector to tap on the pipes, check the roof for leaks and generally expose flaws — and hidden costs — that may have escaped even the keenest buyer’s eye. Business buyers emulate home buyers by hiring specialists to conduct inspections before closing on acquisition deals.

Called due diligence reports, the information compiled therein provides buyers a detailed financial portrait of the potential target and an objective opinion regarding the target’s virtues, drawbacks and potential, says Matthew Reiter, senior manager in the Assurance & Advisory Services Group Practice of the accounting/consulting firm Whitley Penn LLP.

Smart Business spoke with Reiter to learn how business buyers can benefit from due diligence reports before they sign on the dotted line.

What constitutes due diligence relative to a business acquisition?
Due diligence means assessing all key financial aspects of a potential target, including areas such as significant contracts, agreements, concentrations in customers or vendors, potential financial risks related to the target’s assets and liabilities, financial analysis of historical trending, contingencies and exposures, cash flows and significant revenue and expense areas.

Another key component is an evaluation of expected future cash flows. This analysis provides the buyer useful information regarding pro-forma adjustments necessary to portray a realistic estimate of future earnings.

Additionally, any other areas of concern that the buyer may require additional information about can be attained through this process.

How does due diligence accomplish that?
By interviewing the target company’s personnel and reviewing, first hand, its evidential matter. Through this process, an extraordinary amount of verbal and written data is gathered about the company and is then analyzed to extract key information that is beneficial to the buyer. The buyer receives summarized data on all the key information and commentary on potential issues or concerns.

Additionally, the process looks for anomalies in the company’s detailed financial records and forecasts that may indicate issues that should be addressed through the negotiation of the purchase. In many family-owned businesses, a family may receive a salary that is in excess of market rates, or the business may buy product or lease facilities or equipment from a related party vendor. These types of transactions are the types of information that should be brought to the buyer’s attention.

Is the information technology environment encompassed in this report?
In many circumstances, an evaluation of the potential target’s information technology environment determines if it’s going to meet future needs. This includes interviews with key personnel and a physical inspection of hardware and software, as well as obtaining information regarding the overall general information technology environment.

If, during the due diligence process phase, the buyer doesn’t assess the age, scalability and capabilities of the information technology, this can lead to additional hidden costs to the buyer.

Does due diligence examine tax structure?
Depending on the structure of the transaction, taxes can be an integral component of the due diligence process. This includes examining historical tax documents and issues as well as identifying the optimal strategies on a prospective basis; for example, structure and state of incorporation.

How can the resulting due diligence be used by the buyer?
This report is a useful tool to summarize key information in a proposed transaction in an organized manner. The purpose of the report is to provide the buyer with useful analysis and insightful commentary regarding the potential target. It can be used by potential investors of lenders to provide them with sufficient information to assist them in making informed investment decisions.

Additionally, the information will assist with negotiating terms of a transaction.

Who compiles a due diligence report?
Generally, the buyer engages an external professional to conduct the financial due diligence review as an advocate for the buyer. Most companies cannot afford to maintain a full-time due diligence team, so outsourcing this process is a means for a company to obtain quality resources with experience without overburdening the company. The professional brings objectivity and specific skill sets to the process, such as a strong financial background, knowledge of potential areas of concern, and a team of specialized professionals.

Similar to the house-buying example, the optimal time to perform these services is when the buyer has a serious interest in the prospect and has reached a letter of intent with the seller. It is the time that the buyer wishes to confirm the information that has been requested and identify other issues not previously communicated.

MATTHEW REITER is a senior manager in the Assurance and Advisory Services Practice of Whitley Penn, LLP, CPAs and Professional Consultants in Dallas. Reach him at (972) 392-6610 or matthewr@wpcpa.com.