By Clive Hyman FCA, Hyman Capital Services

A recent case with a client has reminded me that due diligence, is an art not an exact science. Whilst checklists obviously can and do play a part in the process, there is nothing which can replace experience. The feeling, and following one's nose, is important.  It is important that the principal considering the purchase of a business has both experience and expertise available to them. In my view, not enough people do thorough and proper due diligence on businesses they raise money for or consider buying. 

For example, in the case of an EIS investor, the potential investor may assume that everything has been done by the sponsor or promoter of these investments.  Sometimes this is the case, however, the expression caveat emptor (let the buyer beware) applies and people leave the investor to make their own mind up.

Sometimes hope triumphs over reality with people leaping ahead and ignoring the basics. Everyone claims to do due diligence, but my experience of this is patchy and one has to satisfy oneself rather than rely on other people's opinions, as this is a fast way to lose money or confidence in a situation.

So, before you do anything else - start your due diligence. Here is my suggested order of play, although ideally (and in reality) many of these steps will occur in parallel.

1.     First steps

You need to understand what it is you are trying to buy. Be wary of how many companies might be co-owned, or have ownership of common assets.  In family businesses, you also need to understand the relationship between the owner, her or his family and any offspring or relatives employed in the business and whether there are costs associated which need to be removed to get to the "true recurring business" profitability.  This can be difficult as the financial data which you might find in the public domain or published will not highlight this and there is no substitute for a meeting with people who understand the business and then the people who keep and prepare the management and published accounts. Today, with a prevalence for outsourced services, this may be more complicated than you think at first.

2.     Management

Whether it's a start up, an EIS investment, an acquisition, a turnaround or restructuring, you must consider the management.  Importantly what have they done to-date, what their aspirations are for the future, as well as their reputation in the business world.  Find someone who knows them, speak to them and do this for every member of the management team if you can.  Importantly the Chairman's and CEO's track record will be useful to let you know whether the team has done this before or whether they have had issues before.  Focussing in on the issues and understanding what had gone well or less well is also important.  Importantly human beings learn more when a situation has failed, providing the individual has understood what happened.

In simplistic terms, businesses fail through cash flow issues, and in many cases this can be as simple as not having an adequate sales, marketing and prospecting business process. 

3.     Heads of agreement

It's important to focus on this, and if you don't have this in place no deal can get done; and you need to get this onto the table as soon as you can, so you have a reference point.  All deals will be subject to a Sale and Purchase Agreement ("SPA") and should provide for a mechanism to deal with things which need to be adjusted for in the price, when a fact turns out to be slightly different from the reality recorded in the accounting books and records. 

Don't be surprised if the senior management have a view that is different from reality.  Their view will be based on how it may have been originally designed or envisaged, reality and how it is done now may well be different.  No one usually sets out to confuse or make it complicated, but its surprisingly common how thoroughly one needs to work through things.

4.     Financing

The other extremely important matter which will come out of the diligence is a confirmation of the financing required to do a transaction. One cannot enter into negotiations without some thought for this and it is essential to arrange appropriate conversations with banks or equity providers to ensure the capital/debt or other finance will be there when the deal need to be consummated.

It is frighteningly common for potential acquirers of a business not to have offers subject to due diligence; this is almost bordering on the insane. Sure, there will be situations where you cannot do that, but discussions with incumbent banks and also with new bankers will be important.

5.     Start up or existing business

The type of business you are looking at is also important.

If it's a start up, you won't be able to see a track record for the business.  However, companies need to make money when they are created.  It's fantastic to have a Company which people are unified around, but does it make money?  There a few tech companies I can point to where the bankers and financiers have convinced themselves that loss making companies are worth billions of dollars.  They ended up with egg on their face as the truth will often out.  So don't look at valuations achieved by tech companies which aren't making money.  Be realistic. Work out how quickly the team can make money, i.e. have they got customers ready to buy their product or service?  This is why startups are so risky, as you are reliant on other people to get a new product and service into market. Sometimes, you need to be firm and tell the startup to come back when they have made a sale. 

If you're looking at another business which is beyond the startup phase then the next few points become even more relevant to your thinking process.

6.     Results to date

For an existing business you must pay attention to the results to date and what sort of trajectory do they show for the business.  Understanding the cost base is also important as one needs to know how any cash invested might be used to drive the business forward. Inter-linking the current results to forecasts and budgets is a useful exercise. This can help you understand the reasons for any deviations.

A management team that is always near to budget is preferable to one who misses the target time and time again.

7.     Budgets and forecasts

If a company has a budget and indeed a forecast then you can assess where a management team is headed and whether they are meeting their goals. The forecast needs to take account of the plans for the business post deal - so you can again assess the financing requirements. If, however there is no budget or forecast then you'll need to look past performance and make a judgement call on how well they are doing.

The comparison between the forecast, the reality and the budgets is crucial.  You need to understand whether the team are conservative, racy or fantasists.

8.     Recurring EBITDA (Earnings Before Interest Tax Depreciation and Amortisation)

EBITDA will give you the true recurring profitability underlying all the other figures. It offers a ‘clean' figure to use for comparisons. The profitability of the business is important to understand as this will help you determine what you should pay for the business.  Understanding this and drivers of the business, and therefore the progression of the profit into the future is vital. 

9.     Plan for actions

Nothing happens in a transaction without someone heading up and driving the deal, the process and the communication between all parties. If you don't communicate no one will know what you wish to offer and what your issues are. You have to talk to people! Sometimes, I am amused or amazed or both at how many people think "well they knew I was interested why didn't they contact me". 

Finally, always be polite. Yes, business can be a cut-throat world, but there is little need for rudeness or aggression. Many years ago a strategy manager rudely ejected me from his office and lost £600 million on a sale, because the CEO of the potential acquiring company asked me what I thought of the guy - and it turned out both myself and the magic circle lawyer had had the same experiences.  So the CEO walked away from the transaction. 

In conclusion; doing your due diligence diligently will help flush-out any issues and enable you to make an informed decision about whether this deal is a go/no go and what you should (should not) be paying.


For more information visit