In the fourth chapter of How to Buy a Digital Business, we look into the ins-and-outs of comprehensive due diligence and preparing pro-forma financials. This discussion should help you create your own due diligence checklist and evaluate risk. If you want a more professional looking and complete e-book with images and graphs, you can download the PDF.
4. Due Diligence and Pro-forma Financials
Once a letter of intent or similar document has been signed, the next steps are for the buyer to conduct a more formal due diligence and to develop pro forma financials. The main goals of due diligence are to confirm that the target company is in fact as presented, and to gain a clear understanding of the risks and opportunities associated with the business. The high-level areas of focus for due diligence are legal, financial, business operations and market. Gaining a clear understanding of these items will allow you to develop a thoughtful set of pro-forma (forward-looking) financials, so you can get a read on how the business’ financials will look post-transaction.
Depending on the size of the business and the skill sets you have personally, it may be advisable to hire others to help with due diligence. For larger business acquisitions, an attorney will typically drive legal due diligence and a CPA will drive financial due diligence. You might also consider engaging a broker, buy side advisor, financial advisor, or industry consultant to help you assess business operations and build knowledge of the industry.
When choosing team members, look for individuals with mergers and acquisitions experience and with as much specific knowledge of the space as possible. In addition to becoming knowledgeable about the business operations and industry, you will be the project manager through due diligence. Create a master list of all items you wish to address through due diligence, assigning them to team members and checking them off as they are accomplished. Professional assistance is expensive, so use your team members judiciously to get the information you need.
The purpose of legal due diligence is to assess whether the company you are acquiring is in good legal standing and whether there are items that could present future risk to you as the new owner. The key areas to address include:
- Corporate Structure – review the corporate structure, capitalization, organizational documents and general corporate records of the company in order to ensure that everything is in order.
- Taxes – review historical income tax liabilities and assess any tax carry forwards and their potential benefits.
- Intellectual Property – understand the company’s technology and intellectual property, as well as its protection.
- Assets & Liabilities – scrutinize the value of the assets that will be transferred with the sale, whether tangible or intangible, as well as all debts and liabilities against them. Your attorney can help with a lien search.
- Contracts – review all contracts and commitments of the company. Remember, if you are purchasing the company’s assets (vs. it’s stock) you may need to update the contracts to reflect your new corporate entity as the signatory.
- Compliance & Litigation – probe any pending, threatened, or settled litigation, arbitration, or regulatory proceedings involving the company and whether the company has faced any regulatory or compliance issues.
Similar to an audit, the purpose of financial due diligence is to verify that financial statements presented are accurate, and to gain a clear understanding of items that could impact the future financial performance of the company. For larger acquisitions, a CPA or other third party can prepare a Quality of Earnings (QoE) report to detail the components of the company’s revenue and expenses. The extent of financial diligence performed, and the quality of information available will vary considerably with the size of the company being acquired. Some exercises that can help gain clarity on the business and its financials:
- Review 12 months of monthly and 3-5 years of annual profit & loss, balance sheet, and cash flow statements.
- Examine 3-5 years of tax returns.
- Trace bank statements to bank reconciliation, and reconciled statements to tax returns / general ledger; if possible, trace affiliate statements and/or merchant processor statements to bank statements.
- Review past Accounts Receivable and Accounts Payable balances against subsequent deposits and payments.
- Study customer and supplier concentration risk by reviewing sales and profit by customer and supplier.
- Perform a trend analysis of sales, COGS and expenses by category and year over year to understand trends and fluctuations.
- Confirm tax and payroll filings are current.
- Assess sales and use tax requirements and confirm compliance.
TIP: Verify what has been presented and potential risks to the business.
The purpose of business operations due diligence is to gain an understanding of the business’ people, assets, technology, and processes. For online businesses, some of the most important assets are often the business’ sources of traffic, its platform, and its reputation.
- Most importantly, can the seller of the business be trusted? You might consider a background check to determine if there is a criminal record and to confirm the validity of education, employment history and other activities from the owner’s past. Determine what duties the seller performs at the business and whether you or your staff will be able to assume these.
- If the size of the business warrants it, create an org chart for the company with a short bio for each employee. Are there areas where experience is thin, potentially requiring future investment in training or additional staff? Are there areas of overlap with your skills? What changes do you envision over the next 5 years and how might that impact the financials? For larger businesses, you will want to review policies and procedures, assess employee benefits, plans, compensation and bonuses, and make sure the business is in compliance with all HR related requirements. With larger businesses, you might want an HR expert to help with this effort. Finally, work with the seller to understand all contractor relationships and make sure you have their contact information. Remember, if you create a new corporate entity, you may need to put new employee and contractor agreements in place for your new corporation.
Digital Assets –
- Traffic – A key component of due diligence for an online business is understanding the nature of its traffic. Start with Ubersuggest, Google Analytics (GA4) or other similar tools to analyze the traffic coming to the site. Google Search Engine Console is a good way for webmasters to check the indexing status of the site and its visibility. How many users does the site have per day, month, year? What is the engagement rate (ideally >50%), user behavior, site return rate, and how have these numbers changed over time? Where is traffic coming from and are the sources paid or unpaid (e.g. direct search, paid search, social media, referral, organic)? Make sure you understand the backlink profile, the specific sources of referral traffic, whether the sources are paid or unpaid and whether paid traffic is appearing on the company’s financial statements. An untrustworthy seller could take advantage of a buyer by paying for, and not accounting for or disclosing, traffic and backlinks, artificially improving the site’s search engine ranking.
- Platform – It is important to gain an understanding of the platform upon which the business is built to ascertain whether it is a viable solution for the business as it grows. This requires an assessment of the platform itself as well as the plugins and extensions used. Is the technology likely to be viable and supported over the long term? Will the current set up allow for growth? Similarly for software and SaaS businesses, you should have the code reviewed to ensure that it is proprietary and of high quality.
- Reputation – Understanding a business’ reputation, both online and offline, is a critical component of due diligence. Check out reviews, message boards and other online venues to see what customers are saying about the business and its products/services. Sometimes owners will allow a buyer to conduct a customer survey, perhaps posing as a marketing consultant. The seller may be persuaded to allow this if you agree to provide a written report of the results and remind the seller that the information will be useful to the business whether or not the transaction consummates. Similarly, are there posts from current or future employees about working at the company? This can be valuable information. As a final step prior to closing, the seller may allow you to meet with the employees. If you receive this permission, you can inform them about the sale and determine if they plan to continue with the business post-transaction.
- Other Assets – While we have emphasized traffic, platform and reputation given our online focus, there are of course a wide variety of assets that can be conveyed as part of a business acquisition – tangible and intangible. Whether inventory, equipment, real estate, patents, domains, or insurance policies, you should have a clear understanding of the items included in the sale, their value, and confirmation that the seller is the owner of the items. For larger businesses with inventory, it is common for a third party to conduct an inventory assessment to assess its quality and whether its value has been captured accurately in the financial statements.
- Technology – In addition to the business’ platform, you will want to understand the broader technology infrastructure, and the level of IT investment that will be required to maintain and grow the company. This means an assessment of the company’s network, software, databases, computers, mobile devices, outsourced relationships, subscriptions and other IT-related items. With larger businesses, a third party assessment can be helpful. With smaller businesses, it is important to understand the seller’s role in maintaining the IT infrastructure. If you are stepping into the seller’s shoes, is this a role you are comfortable doing?
- Processes – Lastly, you will want to ensure you have an understanding of the business’ internal processes, both to assess whether they present any risks to you as the new owner, but also to equip you with the knowledge you will need to run the business. Questions will vary widely depending on the type of business you are acquiring, but examples of questions include: How does the company acquire customers? How are products sourced? How do customer orders flow through the company’s systems? How are orders ultimately fulfilled and recorded? What is the flow of customer communication? How is financial record-keeping handled? How are employees’ schedules managed? How are personnel issues addressed? Consider gaining an understanding of company procedures by interacting with the company as a customer – order a product, send an email to customer service, or subscribe to the newsletter.
Market due diligence is unlike other aspects of due diligence in that information is gathered from outside of the company rather than from within, with the purpose of understanding industry trends, the competitive landscape, and the buyers and vendors in the market. When buying an online business, it is important to investigate the underlying market, not just its category. For example, if you are conducting due diligence on an eCommerce business that resells fridge and HVAC filters, your due diligence should include learning about the market for fridge and HVAC filters. What opportunities or risks might be on the horizon? How, for example, will “smart” refrigerators and IoT connected HVAC systems impact the market?
In addition to conducting secondary market research from written reports and materials and on the web, you will benefit greatly by conducting primary market research – talking with individuals who are intimately involved in the market and can answer your questions. For example, you might reach out to staff members with an industry association, individuals who work with similar (non-competitive) companies, consultants in the space, or visit a trade show to meet industry participants. What changes are happening in the market? Are there competitors that could pose a threat? What opportunities might not be obvious?
Similarly, you can learn a lot about the competitive landscape in a market by understanding the customer’s perspective. Try ordering a fridge or HVAC filter from Amazon and Lowe’s and compare the experience with that of ordering from the company you are evaluating. What are the positives and negatives of each experience? Lastly, research the company’s suppliers. Are they large, reliable vendors, or is there product availability risk? Are there substitute suppliers, or do they hold power over their customers?
An important exercise for any buyer, regardless of the size of the business being acquired in an m&a deal, is to develop a set of pro-forma (forward looking) financials. The goal of pro-forma financials is to assess your income, cash flow and balance sheet after the transaction, taking into account the new expenses you will have as a buyer and removing expenses that are no longer relevant after the sale. Your pro-forma financials will ideally include monthly figures for the first year, and annual figures for 2-4 years following. It is important to include monthly figures for the first year, as that is when the business is at its most vulnerable from a cash flow perspective.
While you are learning to operate the business, you may also be paying off debt, making investments, and perhaps paying the seller under a consulting agreement. Your pro-forma financials will help you assess the amount of debt you can afford to take on with the purchase, understand the amount of working capital you will need, and gauge your return on investment under different assumptions. You might consider working with your CPA on pro-forma financials as part of your financial due diligence exercise. A few items to think about when developing the document:
- Start with the company’s historic financials – add back expenses no longer pertinent (e.g. the former owner’s salary) and include new expenses (e.g. your salary).
- Include your debt service – interest payments should be included as a pre-tax expense while principal payments are an after-tax expense.
- Take into account the timing of cash flows, particularly for the first year – when will you actually get paid and when will payments actually be made?
- Include your expected capital expenditures.
- Make sure fixed and variable expenses are properly categorized.
- Develop conservative, moderate, and aggressive forecasts.
- Include a row on the spreadsheet that tracks your cumulative cash to assess the months and years in which the company is at its most vulnerable – ensure you have sufficient working capital (money) to cover these stretches of time.
Takeaways: How to Conduct Due Diligence
What professionals will assist me during the due diligence process?
What due diligence can I conduct myself and what do I want a professional to do?
How will I recognize a red flag in the process?
What do my pro-forma financials tell me about the business I’ll be running?
Read the next chapter, How to Finance an Acquistion or download the complete e-book: How to Buy a Digital Business.
Images from Pixabay