Seller’s Market: Financial Due Diligence Questions to Ask

Financial due diligence (FDD) has become an integral part of the mergers and acquisitions landscape. This article targets business owners who are considering selling their business (or a part of it) within the next five years to help them potentially assess the readiness of their business through the key FDD questions. A buyer can also use the same information to identify red flags in a potential target. Please refer to the glossary at the end for terminology clarification.

We will go through a general questionnaire designed to help a potential seller to assess how ready their business is for FDD (and thus for a sale). This article is not a substitute for comprehensive, tailored financial diligence, nor is it meant as financial advice. The intention is to get the vendor’s management to start thinking about the sale process and share my experience with the FDD process. FDD is not an audit or assurance engagement and cannot guarantee full protection against outright fraud and management misrepresentation.

Are You Ready for Sale?

Think carefully about the seven questions below. Score each question as per the scoring guideline (a maximum of 10 points per question). If selling only a part of the business, consider the part as a “standalone” business:

1. Does the target have a strong finance director?

What is the key question?
How strong is the target’s finance team?

How does it help?
It demonstrates seriousness about numbers and signals the target management’s commitment to quality of accounts.

What do you mean by a “strong finance director”?
An experienced (at least five years) finance director, preferably a qualified accountant from a top accountancy firm/similar business.

Example
I worked on the FDD of a mid-sized business (business A) which did not have a finance director; the business had grown rapidly but the finance department had not kept pace. We faced great difficulty getting consistent sets of information, which translated into red flags (e.g., quality of data was labeled poor, leading to pressure on sellers to back up their numbers with legally binding management representations and clawback clauses). The business finally sold on a strategic basis, but not before the buyer extracted a significant discount (the cost of having a suitable finance team was put in as a Quality of Earnings adjustment and remedy clauses in the SPA).

Exceptions and remedies
If the target is very small and cannot afford the cost of a senior hire at the current state of development, it would help to at least have somebody on the team with a strong financial background for 2-3 years, hopefully through to the expected deal time, or hire experienced part-time consultants to help develop thinking about the sale, improving the quality of financial numbers, and preparing for the deal.

Scoring Guideline

2. What is the existing strength of finance data and the underlying systems?

What is the key question?
Is there enough good-quality data for advisors to form an opinion?

How does it help?
Lack of quality data will give buyers negotiation leverage and can even kill the deal. Conversely, good-quality data would strengthen the seller’s hand.

What do you mean by “strength of finance data”?
Consistent, meaningful, and relevant numbers in sufficient detail, backed by a robust IT system. For example, for a business dependent on traded commodities like metal, it is important that numbers demonstrate how the management deals with cost fluctuations or how effectively they are able to pass the costs to customers. The numbers need to talk to the sales pitch and help buyers understand the key risks.

Example
A small private equity business (business B), by virtue of having had deal experience before, had high-quality data available for the FDD advisors. This included detailed monthly numbers over the last three years, audited accounts, detailed breakdowns, and a meaningful reconciliation between management accounts and audited accounts. They were all extracted from an accounting software (vs. spreadsheets), which had tightly defined access to prevent any unwarranted manual override and thus ensured data accuracy and sourcing. This enabled us to rapidly close the engagement and come up with a clear (positive) view on the strength of data.

Exceptions and remedies
If ever there is an unavoidable choice between quality and quantity, choose quality - tight quarterly numbers are better than error-prone monthly ones.

Scoring Guideline

3. How effectively does the current management monitor the target?

What is the key question?
What are the key drivers of the business? Consider the management information and the key performance indicators (KPIs) that the management uses to keep a handle on revenue, costs, profitability, cash, covenants, or working capital.

How does it help?
Effective monitoring systems would enable the management to easily deal with diligence questions.

What do you mean by “effective monitoring”?
An awareness of and the ability to explain key trends in the business (e.g., key cost challenges, what products are growing, etc.) and an awareness of the key risks (e.g., FX, raw materials, regulations, covenants). The presence of business intelligence systems would indicate proactive management.

Example
Business B management met monthly to discuss state of play and decide on the way forward. The CFO office was supported by a highly numerate team that used Tableau to visualize data in different ways and potentially identify any unexpected changes in numbers. Predictably, when the diligence team combed through the accounts, the management was comfortable and quick in explaining key trends.

Scoring Guideline

4. How good are the business earnings?

What is the key question?
What is the correct number to use for valuation purposes?

How does it help?
One of the most common valuation techniques is agreeing on a price as a multiple of earnings. Depending on the stage of the business, this may be revenue or EBITDA. When this technique is used, the number used to drive the value is not reported, or even audited, but the number negotiated on the basis of the FDD. A $100,000 reduction in underlying earnings could result in a $1 million price reduction for a deal going at 10x earnings.

What do you mean by “good business earnings”?
Revenues and costs that are earned/incurred pursuing the defining commercial activity of the business, are not one-off, relate to the correct year, and are sustainable.

Example
A retail business that I diligenced had a sharp increase in sales in the current year, which was fuelled by an end-of-year scheme for suppliers encouraging them to buy a high amount of inventory upfront. This, however, effectively transferred the revenue from the following year to the current year as the suppliers would not purchase for longer than usual due to the high level of purchase (classic channel stuffing). The buyer successfully obtained a deduction to reflect the sustainable amount of revenue in the current year.

Exceptions and remedies
Businesses that are not valued on earnings or cash need not worry too much about this. This could include high-tech startups that primarily derive value from their patents, web startups valued on impressions/clicks/users, asset-heavy businesses where assets are more valuable than the income stream, or asset management businesses where assets under management may be key. The key thing to think about is what drives the valuation of the business. If it is not the revenue, cash, or the profit made by the business, it makes little sense to worry about earnings diligence. If your business falls in any of these categories, give yourself a score of 10.

Scoring Guideline
For each of the questions below score 1 if the answer is readily available or the target management is confident it can be prepared rapidly; 0.5 if you are not 100% sure but think you can do it with some effort; and 0 if it appears too hard with the current systems or is not available:

1. Is the revenue growing/declining? Why?
2. What is the revenue outlook going forward and why? Do you expect it to keep growing/declining?
3. Can we see revenue by division/product/geography?
4. Are revenue changes driven by volume or price? (you would need to quantify, and probably specify segments)
5. How much revenue was due to organic growth of the business and how much due to acquisitions?
6. What is the customer churn/stickiness?
7. How has the profit margin evolved in recent years? What were the underlying drivers?
8. How has product mix changed and what impact has it had on profitability?
9. How much of revenue is recurring/backed by contracts?
10.  What were your one-off costs and income in the last three years (think acquisition costs, legal cases, fines, disputes, discontinued operations, act-of-God losses)? You would need to be able to identify both the impact on P&L and any related postings within SOFP.

5. Can you articulate the underlying performance of the target beyond macro factors?

What is the key question?
Is business improvement driven by management competence or macro factors?

How does it help?
Everything is relative. A 10% growth in a sector growing by 20% is sub-optimal, but in a sector growing by 5% is phenomenal. This would have a direct bearing on the negotiation on multiples. The buyer would also like to understand how much of the performance is driven by currency rate, how effectively the business is able to pass through changes in raw material prices, and how such risks are managed.

Example
During the FDD on a large UK-based publishing business spread across 40 countries, my team discovered that the impressive business growth was largely driven by the significant devaluation of the British pound caused by the Brexit uncertainty. A constant currency analysis actually indicated a sub-optimal growth. This led to a reduction in both the number used to drive the valuation and the multiple offered.

Exceptions and remedies
Part of it is not applicable to small businesses dealing in a single currency and not into manufacturing.

Scoring Guideline

6. How sophisticated is the target’s Net Working Capital (NWC) management?

What is the key question?
Is the buyer getting a sufficiently capitalized business?

How does it help?
A deliberately undercapitalized target whose receivables and inventories have been run down while creditors stretched out would need a significant cash injection from the buyer. Any differences from a “normal” level of working capital would be deducted from the price.

Everybody knows what NWC is, right?
Deal working capital is not the same as regular working capital. Investopedia defines working capital as current assets less current liabilities. This includes cash. From deals point of view, working capital generally excludes all cash-like items and comprises SOFP balances directly related to running the business (e.g., trade debtors, trade creditors). As a rule of thumb, balance sheet items that would unwind above EBITDA would be considered NWC in the deals world.

Example
My team conducted diligence on the part of a large manufacturing company that the management wanted to carve out and sell. The management had not considered in detail how to delineate specific inventory, receivables, or payables related to the division so as to determine what comprised a normal level of working capital. This helped buyers to negotiate favorable adjustments for the level of NWC required.

Exceptions and remedies
Generally, there is no escaping NWC completely. However, depending on the type of business, certain categories could be less important than others (e.g., raw material and inventory would not be as important for a technology business but may be critical for a manufacturing business).

Scoring Guideline
Consider how easily the target can prepare the following 10 pieces of analysis (score 1 if it is readily available or you are confident can be prepared rapidly; 0.5 if you are not 100% sure but think you can do it with some effort; and 0 if it appears too hard or is not available):

1. Monthly numbers for NWC line items over the last 12-24 months. If your business is changing rapidly, monthly forecasts over the next six months. For very small businesses, quarterly numbers may suffice.
2. Detailed breakdowns for period-end balances (especially for accruals and provisions, but also for prepayments, other debtors, other creditors) that reconcile to a summary listing.
3. Evolution of KPIs like DSO, DIO, DPO in the last few years and reason for any key changes. All of them may not be relevant to every business (e.g., DIO may not be very relevant for a services business engaged in short-term projects, or DPO may not be relevant for a small business required to pay all creditors in cash).
4. Aging analysis of trade debtors, trade creditors, and inventory
5. Provisioning policy for debtors and inventory
6. Amounts actually written off in the year for debtors and inventory
7. Breakdowns by key customers for trade debtors
8. Breakdown by key suppliers for trade creditors
9. Balances for any creditors related to capital expenditure, corporation tax, and debt
10.  Daily cash numbers over the last year, marking out any payments related to items that crystallize below EBITDA (e.g., payments for corporation tax) or relate to items that are typically not seen on SOFP (e.g., monthly salary payments)

7. How much net debt does the target hold?

What is the key question?
Will deal value cover net debt, and are there any nasty surprises?

How does it help?
Deals are often valued on a debt-free and cash-free basis so that the value of debt is taken off the final price, and the amount of cash is added. Additionally, it covers any potential off-balance sheet liabilities disclosed by management, tax advisors, legal advisors, pension advisors, and any regulatory bodies.

Everybody knows what debt is, right?
Again, deal net debt is NOT the same as regular net debt. Investopedia defines net debt as:

1. Debt that is due in 12 months or less (short-term bank loans, accounts payable, and lease payments) PLUS
2. Debt with a maturity date longer than one year (bonds, lease payments, term loans, notes payable) LESS
3. Cash and liquid instruments that can be easily converted to cash (certificates of deposit, treasury bills, commercial paper)

In the deals world, anything trade related will not be in net debt. Additionally, it would also consider any contingent liabilities and any major cash outflows post deal date. On the other hand, any cash deemed necessary for running the business (cash in tills, rent deposits) may be considered working capital. The rule of thumb is that if it will crystallize to cash (out or in) without significant hindrance, it is net debt.

Example
In 2018, Sports Direct bought House of Fraser. It looks like either their diligence team did not pick everything or they engaged in limited diligence and now face a £605-million bill from the Belgian tax authorities. Such items would typically be picked during tax diligence and flagged within a net debt analysis.

Exceptions and remedies
The analysis is of limited use for cash-rich companies with an immaterial level of debt. Nevertheless, I would not discount this analysis in most scenarios.

Scoring Guideline
Consider how easily the target can prepare the following 10 pieces of analysis (score 1 if it is readily available or you are confident it can be prepared rapidly; 0.5 if you are not 100% sure but think you can do it with some effort; and 0 if it appears too hard or is not available):

1. A summary of outstanding debt summarizing key debt terms including term, interest, currency, break fee, and change of control consequences
2. Detailed covenant requirements and calculations
3. How much of the reported debt balance is capitalized debt fee?
4. How much of the loans to shareholders and related parties would be settled in cash upon acquisition?
5. Any contingent and off-balance sheet liabilities that the management is aware of, including any legal or tax disputes the business is involved in with an estimate of likely resolution and expected cost to the company
6. How much of the cash would the management consider trapped or earmarked for the daily running of the business (e.g., cash stuck in jurisdictions with restrictive controls, cash earmarked for regulatory purposes/deposits, cash in till)?
7. Breakdown of cash by country and currency
8. Breakdown of exceptional costs and where the related liability is posted on SOFP
9. Details about any proposed transaction bonuses
10.  Details about any interest rate hedging

What’s in a Score?

If you scored above 50 points on the above FDD questions, super. The chances are you have a tight handle on the ship, understand transactions, and don’t even need any advice or help on the FDD front from experts such as Toptal’s.

If you were below 30 points, you would need to act fast if you hope to run a smooth sale process. Consider working on the highlighted questions, hiring a finance director with transactions experience, or engaging consultants to help articulate a tailored plan of action.

If you are between 30 and 50, I would advise you to carry on building on your existing progress or engage consultants to articulate a tailored plan of action.

Are We Done?

Up to you! I hope this article helped you consider how ready you are for a potential sale. For the more technically oriented heads who would like to further understand the rationale for the questions above and get into the nitty-gritties, we will delve into technical details in future articles.

Glossary:
Target: Business or part of a business being sold
Vendor: Entity selling the target: can be shareholders, management, administrators, etc.
Buyer: Company or entity trying to buy the target
VDD: Vendor due diligence: when the vendor conducts pre-emptive investment due diligence on target to ease the sale process. In this article, VDD refers to financial due diligence only.
SOFP: Statement of financial position/Balance sheet
P&L: Statement of comprehensive income/Income statement
SPA: Sale and purchase agreement: the actual legally binding agreement signed between the seller and the buyer
Key question: The potential buyer’s question you answer/understand for better deal value