When buying a business, whether it’s a small enterprise or a large corporation, you want to make sure that you’re making a sound investment. To achieve this, performing due diligence is essential. Due diligence involves thoroughly investigating a business to uncover any hidden risks, liabilities, or potential opportunities before finalising a purchase.
There are three main types of due diligence that play a critical role in the buying process: financial due diligence, legal due diligence, and operational due diligence. Each type serves a unique purpose, helping you evaluate different aspects of the business. In this post, we’ll introduce and discuss the key differences between these three forms of due diligence and why each is important.
1. Financial Due Diligence
Financial due diligence is perhaps the most well-known form of due diligence. It focuses on the company’s financial health, analysing its historical performance, current financial status, and future projections. The goal is to ensure that the business is financially stable and to verify that the price you’re paying reflects its true value.
Key Aspects of Financial Due Diligence:
- Financial Statements: A review of the business’s profit and loss statements, balance sheets, and cash flow statements. This helps to determine whether the business has a healthy revenue stream, manages its expenses effectively, and maintains a stable financial position.
- Debts and Liabilities: Investigating any outstanding loans, debts, or other financial obligations. Uncovering hidden liabilities is critical to avoid unexpected financial burdens after the purchase.
- Profitability and Margins: A detailed analysis of profit margins and the sustainability of earnings over time. This will show how well the business generates profit from its operations.
- Working Capital: Examining how efficiently the business manages its working capital, including stock levels, accounts receivable, and payable. This can reveal liquidity issues or inefficiencies. Unsure what working capital is? We pulled together a helpful summary which you can find here.
- Revenue Projections: Reviewing the company’s financial forecasts to assess whether the projected growth is realistic and based on sound assumptions.
The outcome of financial due diligence will give you a clear picture of the business’s financial health and help ensure that you’re not overpaying. It also helps to identify potential risks, such as declining revenues or unsustainable debt levels.
2. Legal Due Diligence
While financial due diligence focuses on the numbers, legal due diligence is all about making sure the business is in compliance with laws and regulations. It involves reviewing legal documents, contracts, and agreements to ensure there are no legal issues that could affect the transaction or the ongoing operation of the business after the purchase. The legal process can be intense, and it is important you understand the legal aspects of selling a business long before you start the process.
Key Aspects of Legal Due Diligence:
- Ownership and Title: Verifying that the seller legally owns the assets or shares they are selling. This includes reviewing the title to any property, intellectual property (IP), and other assets that are part of the transaction.
- Contracts and Agreements: Examining key contracts such as customer contracts, supplier agreements, leases, and employment contracts. The aim is to identify any clauses that could pose a problem, such as automatic contract termination upon change of ownership.
- Litigation and Disputes: Investigating any past, current, or potential lawsuits or legal disputes involving the business. This includes employment disputes, regulatory issues, or intellectual property infringements.
- Regulatory Compliance: Ensuring that the business complies with industry-specific regulations, environmental laws, and health and safety standards. Non-compliance can lead to fines, legal action, or even business closure.
- Employment Law: Reviewing employee contracts and ensuring compliance with employment laws, such as minimum wage regulations, holiday entitlements, and pension obligations. This also includes identifying any collective bargaining agreements or union contracts.
Legal due diligence is essential to avoid any nasty surprises that could turn your purchase into a legal nightmare. It helps to ensure that the business operates within the law and that there are no hidden legal liabilities that could be passed on to you after the transaction.
3. Operational Due Diligence
Operational due diligence dives into how the business functions on a day-to-day basis. It focuses on assessing the company’s operational processes, management, and overall efficiency. The aim is to ensure that the business is well-organised and has the capability to sustain or grow its operations after the acquisition.
Key Aspects of Operational Due Diligence:
- Business Model: Analysing the business model to ensure it is viable and scalable. This involves looking at how the business generates revenue and whether it can adapt to market changes or expand into new areas.
- Management and Staff: Evaluating the strength of the management team and key employees. This helps to determine whether the business can continue running smoothly post-sale or if new leadership will be required.
- Processes and Systems: Reviewing operational processes, supply chains, and IT systems to assess efficiency and scalability. Are there outdated systems or processes that need upgrading? Can the business handle increased demand?
- Customer and Supplier Relationships: Examining key customer and supplier relationships to identify any risks, such as over-reliance on a single supplier or client. Operational due diligence ensures that these relationships are stable and can continue after the sale.
- Product and Service Quality: Assessing the quality and reliability of the products or services offered. Are there any quality control issues that need to be addressed?
- Competitiveness and Market Position: Analysing the business’s competitive position within the industry, including its market share, pricing strategy, and customer loyalty. This helps to determine whether the business has a strong position or faces threats from competitors.
Operational due diligence is crucial because a business might look good on paper, but if its operations are inefficient or poorly managed, it may struggle to deliver on its financial promises. This type of due diligence helps you understand how the business runs and whether it can continue to be successful under your ownership. For the buyer, operational due diligence is essential in helping to plan for post-sale integration.
Why All Three Types of Due Diligence Matter
Each form of due diligence—financial, legal, and operational—provides a different perspective on the business you’re considering buying. Focusing on just one aspect could leave you exposed to risks in other areas.
For instance, a business might appear financially strong, but if it’s entangled in a legal dispute or its operations are poorly managed, it could still be a risky investment. Conversely, a business that runs smoothly but is burdened with debt might not be worth the financial risk.
By conducting all three types of due diligence, you get a comprehensive understanding of the business’s true value, potential risks, and growth opportunities. This enables you to make an informed decision and negotiate better terms, knowing exactly what you’re getting into.
Conclusion
In summary, due diligence is an essential process when buying a business, and it involves more than just looking at the financials.
- Financial due diligence ensures you understand the company’s financial health and risks.
- Legal due diligence confirms the business is legally sound and free from regulatory or contractual issues.
- Operational due diligence provides insight into how the business runs on a daily basis and whether it has the capacity for growth.
By thoroughly examining each of these areas, you can enter the transaction with confidence, knowing that you’ve covered all your bases. The key to a successful business purchase is understanding not just the numbers, but also the legal framework and operational realities that underpin the business.
A corporate finance advisor can help sense check the data that is being shared for Due Diligence purposes, and guide how it may impact the deal. The more astute sellers will appoint a corporate finance adviser in advance to undertake a pre-due diligence process or due diligence readiness process, whereby the relevant data is prepared or pulled together in advance of selling the business. This can help expedite the sales process and assist in maximising the value achieved for the business sale.
If you need support of a corporate finance adviser, please contact us.
