Due Diligence Prep: Deal-breaker or Trust-builder

In episode 26, we discuss due diligence for business transactions. Our experts break down the due diligence process, explaining why it's crucial for ensuring smooth and successful business deals. Learn how proper preparation, organization, and transparency can help you avoid pitfalls and build trust with potential buyers or sellers.

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TRANSCRIPT:

Welcome to Integrated Insights with ICCG. For more than 30 years, our team has partnered with small business owners to prepare for and navigate the business transaction process.

Pull up a chair as we share stories and insights from our experience on all sides of the M &A table. All right. Well, welcome back, guys. Welcome back. Welcome to Integrated Insights.

I'm your host today, Andrew. Diligence extraordinary.

And today we talk about due diligence, right? And so I will go ahead and Mason, I'm going to ask you, can you explain what due diligence is and why it's important in transactions?

Yeah, absolutely. Due diligence is a period of time where a buyer has put in an offer and that offer has been accepted.

And so now it's a time of due diligence. And they basically just take a look under the hood. They want to know the business. They want to understand the business. And in a lot of ways, they want to validate their offer as well.

So some of the things that they're going to look at are taking a deeper dive into the financial statements, looking at vendors, who are their vendors, understanding the corporate history,

items of requests, and it's just, it's that time where they just want to know everything about your business. And it's important just because,

you know, the offer kind of rides on what they find. And so it's, it's important to have everything organized and just be prepared during that time.

Yeah, I would say just from a standpoint of a clarification, you know, our role as intermediaries is not actually to do the due diligence for our clients, but our role is to coordinate it,

right? We're communicating to the seller who is giving up the information and we're putting it into, you know, we're making sure that the right,

that the requests of the buyer are being fulfilled and a lot of times that is outsourced right to a QV firm we'll get into quality of earnings in just a bit but um you know they're they're trying to just as mason said they're trying to justify their offer based on the information they made the offer based on the information limited information um but but based on information that they now get to prove to prove up.

Gotcha. So if it's about that information that they've got to prove up, right? I'm assuming, and I'm assuming that there are a lot of times or there can be times where there has been some inaccurate information.

And during that due diligence, you kind of find out. And so how do you deal with inaccurate or even maybe some incomplete information during the due diligence process.

I think that, you know, having us using an intermediary that can walk through and help them navigate those areas is really important. And so if something's incomplete,

we're going to make sure that it gets complete. We're going to make sure that the buyer gets exactly what they need. If it's inaccurate, we want to make sure that the dialogue is open and that gets put out on the table very quickly because that just builds trust with the buyer.

And so recognize the inaccuracy, but don't withhold it. Don't try to hide it. Just bring it out onto the table so that it's known. Yeah,

I think for the most part, it's inaccessible by the seller. In other words, he just doesn't know how to get that information. And so one of the things that we bring to the table,

Mason and I just went through this on a deal where we knew how to get the information a different way. And the buyer is going, give me, give me, give me, give me, and the seller's going,

I don't know how to get that information and we just we knew how to get it and so we kind of walk them through and like mason said the longer you wait to give them the information the more suspicious they get and they want to dive deeper and and all that kind of thing i think delivering inaccurate information i don't know that we've had a whole lot of clients in fact i can't think of one that intentionally um you

know change numbers during due diligence like oh there's a bunch of non -documented workers or something like that where you you want to disclose that as quickly as possible right um the more you the more you volunteer the information the less lack of trust there is like mason said and you know you don't want to get caught hiding information or even with the suspicion that you're hiding information.

Interesting. So can you come up with the, what example have you come across that has been more about critical information that is maybe discovered,

maybe was maybe some sort of mistake or I know it may not be, it may not be intentional to share wrong information, but just some critical information that was uncovered or discovered that changed the outcome of the deal.

Yeah, there was a manufacturing company up Northwest U .S. that on the face of it, there wasn't really a concentration of sales.

But when the due diligence was done by the buyer, they realized that 10 of those customers were centrally controlled by a common owner.

And so although the decision making was made decentralized, it could have been centralized real quickly by the parent company,

and so essentially you've got a concentration of sales, and they had to work around it and try to figure out how to mitigate their exposure to that risk.

But I mean, that's basically what due diligence does, is it's not really trying to figure out if the company is worth less or worth more. The idea is to cover risk?

What are the things that could make this a bad deal? And so that's why the focus of due diligence is always different by industries.

So in one industry, maybe it doesn't really matter if you lose 10 customers because each customer is a nominal amount because they have millions of customers.

In some industries, maybe you lose one customer and it hits your bottom line like a brick. And so every industry is different.

Every revenue model is different. And so the focus of those due diligence processes are different. For example, we just went through a highly regulated industry.

Mason and I had to deal with licensing and that kind of thing. And so, Hmm.

So, so break, can you break that down as far as what, what, what industries focus on what and, I mean, I know we will do a lot of different types of machining,

fabricating kind of companies. We'll do landscape, fence, those, we call them field services. There are healthcare deals that we'll do. So what, can, can you give some tangible examples of industries where,

hey, the focus on health care is this, you know, provider service. I know we'll do freestanding ERs, primary care, dentists, all those. What does that look like in that industry versus maybe a machining company?

Yeah. Generally, I mean, in medical, for example, you know, insurance reimbursement rates, right? They differ all over the country,

and they differ by zip code and not just by payer. And so that's why when we just did a deal in the healthcare industry,

they focused on a quality of revenue, not really a quality of earnings because expenses are easy to do due diligence themselves. where there's a chance of deferred revenue or customer deposits.

So the amount of money that's paid is like maybe 50 % up front, for example, and then 50 % on delivery.

Well, the question is, when do you recognize the revenue? And some of your less sophisticated accounting systems, they recognize the revenue when they receive that customer deposit so they don't have a liability on the balance sheet and software software service companies for example will have a lot of prepaid subscriptions that they will record as revenue but it's not really revenue until they earn those subscriptions so

you've got so due diligence goes in there and they go wait a second here you know you got this amount of money, but you recognize it revenue,

but you really haven't earned it yet because you haven't delivered the product yet. And so it's really not revenue. And so, you know, in accounting terms,

they call that revenue recognition, quality earnings will always, or due diligence process will always go into how and when do you recognize revenue and those kinds of industries,

that's a big deal. You've got, you know, one thing we haven't mentioned is just legal due diligence, right?

And one of Mason's baines in his life is, is, you know, he'll get this huge list of due diligence from the financial people.

And then the lawyers will send him a list that's, you know, 75 % the same thing. And, and so, you know, you got to, you got to give it to the lawyers as well.

I don't know why the lawyers want financial statements, but because they can't read it anyway. But I think, you know, I think, you know,

I think, you know, legal due diligence is very different by, by industry as well. I mean, there's obviously the normal, I guess,

you know, entity type due diligence is the entity even in good standing. Are we dealing with all of the shareholders? All of those things are industry agnostic,

but you still have to look at the compliance and, you know, whether who has authority to sign and all those kinds of things.

And then, you know, the legalities or the different industries are very litigious.

And so you'll have a lot of lawsuits or a lot of legal issues and maybe they don't amount to much and you don't care. but you have to make sure that in those we start that process before we even get any offer.

So once we are engaged, we're accumulating information. Even when we, you know, want to do a package to market the company,

we're accumulating the information in formats that we know are going to be required in due diligence. So we've already started that process. And then we continue to do that.

Even in the due diligence process, we know that some of that information is going to go on schedules into, in the final legal documents. And so,

and so we're accumulating that information constantly and organizing, and this is what Mason does, is he organizes it in a way that make sure that we're not,

we're reducing the burden on the seller to produce information and then information the second time and information the third time because that happens all the time.

They ask for the same thing 20 times. And so just organization and actually accumulating it ahead of time helps the process go quicker,

helps the buyer understand the business quicker and make decisions on whether to go to legal. That's great. Yeah, that's great. Well,

thank you guys for joining us on this due diligence episode of our podcast. And so I'm looking forward to seeing you guys next time. And that wraps up another episode of Integrated Insights with ICCG.

Be sure to subscribe and stay tuned for more stories from our team. We love hearing from our listeners. If you have any questions or topics you'd like us to cover, please send us an email in the show notes.

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