The first installment in this series covered the value and necessity of exit readiness in M&A preparation. It explained why clean books, current tax filings, and accurate financial statements are the foundation of a successful transaction. That's all true, but preparation doesn't close the deal. It's just the first phase in an extended process. So, what is due diligence in M&A transactions?
Due diligence decides whether deals live or die. If you're a small business owner, this is important information to get familiar with. Let's get to it.
Let's start with a clear definition of due diligence.
Due diligence is the investigative phase of a merger or acquisition. If you're a buyer, it's a time to verify what you're getting is worth what you're paying for it. Sellers use it to confirm that the buyer has the resources and credibility to make the deal. This phase can make or break a transaction.
How do deals collapse or alter in the M&A stage?
- Undisclosed liabilities surface during review.
- Inconsistent records erode trust between parties.
- The data do not support unrealistic valuations.
The Novyx Group invests heavily in due diligence to ensure thorough analysis of financials and tax records. The outcome of that analysis is that we are able to determine how to advocate for your financial interests in the most effective way possible.
Due diligence is a rigorous process that takes time.
Due diligence typically takes anywhere from thirty to ninety days, depending on the complexity of the deal and how many players are involved. Buyers and sellers need to examine financial records, tax history, legal obligations, and operational data to assess risk and validate the terms of the deal.
- Buyer Goals: Verify the seller's claims, identify hidden risks, and determine whether the asking price reflects the true value of the business.
- Seller Goals: Demonstrate that the business is everything it's represented to be and that the financials amply support valuation claims.
So, when we think about what due diligence is in M&A, we have to understand that the objectives differ depending on which side of the table you're sitting on, but both parties are going to be looking at the same numbers.
Financial due diligence and tax due diligence are connected but not the same. Financial statements may provide insight into company performance—an assessment of utility. Tax data is examined to reveal current and future tax liability—an assessment of risk. Both are forensic activities; a near-obsessive attention to detail is critical to success.
Financial due diligence is concerned with business performance and the overall viability of the transaction at hand.
To discover potential discrepancies, financial statements and revenue reports are weighed against tax filings all the way back to the inception of a business. Here's what a thorough financial due diligence review looks like.
- Matching reported financials to tax returns aims to expose inconsistencies in revenue, expenses, or reported income.
- Profit and loss account analysis addresses the ability of a business to sustain its current performance, which ultimately leads to a Quality of Earnings (QoE) report that determines if revenue performance is consistent over defined periods.
- Return on investment and valuation assessments determine whether the company's financial performance justifies the asking price.
- Funding source reviews examine buyers' access to capital or financing so that sellers can determine if buyers can complete the transaction.
Buyers don't want to pay for an underperforming asset. Sellers want to know exactly what to expect. Both parties need to root out any potential issues before coming to the table. That leads us to the final step.
Purchase determination synthesizes the information from prior analysis and assessments, and Novyx brings a formal recommendation to sellers or buyers to either proceed with, renegotiate, or walk away from the deal.
The Novyx Group's expertise lies in bringing together all these elements into a comprehensive picture of the deal's viability.
Tax due diligence is a historical and forensic investigation of risk.
As stated above, tax due diligence runs parallel to the financial review, but it focuses specifically on the target company's tax history and compliance posture. Unresolved tax liabilities kill deals. Accordingly, our tax due diligence process is exhaustive.
- Review at least five years of federal and state tax returns for accuracy, completeness, and consistency with the company's financial records.
- Perform a compliance and liability identification assessment to expose outstanding obligations, pending audits, or areas of potential exposure.
- Analyze asset schedules to verify that depreciation methods are sound and reported asset values align with the books.
- Examine the K-1 schedule and operating agreement of clients or opposing parties to clearly document ownership structures, profit-sharing arrangements, and partner obligations, and assess whether they are consistent with the terms of the proposed deal.
No buyer wants to inherit outstanding tax obligations and a business with a history of non-compliance. No seller wants to walk into a deal unaware of their business's current and potential tax obligations and actively engaged in non-compliance.
What if your business has had a spotty past? The Novyx Group addresses issues through deal structuring, price adjustments, or the addition of indemnification clauses.
The most significant obstacles to an M&A deal are often found during tax due diligence, particularly when the buyer or seller has inadequate accounting representation. What is due diligence in M&A? It's how we keep your business clear of obstacles and positioned for success.
Smart sellers see due diligence as an opportunity to close deals quickly.
Due diligence will go smoothly if your books are clean, your tax filings are current, and your financial statements accurately reflect the health of your business. If you're a seller, you should also conduct your own due diligence. Some key questions to ask include the following:
- Is the acquiring party financially capable of completing the transaction?
- Do they have a track record of closing deals or a history of renegotiating terms at the last minute?
- Are their funding sources verified and committed?
What does my business’s financial, tax, and compliance record look like, and what can I do to correct the record?
Sellers aren't the biggest fans of due diligence. We want to change that mindset. Due diligence is not a hoop to jump through to get paid. Doing it right can reinforce the valuation and ensure a profitable outcome for all parties involved.
Small businesses need a strategic and operational partner at the center of due diligence efforts.
Consultants provide strategic guidance. Lawyers handle contracts and regulatory compliance. Lenders structure the financing. Each of these advisors plays a critical role, but the CPA-led M&A firm is the financial foundation upon which everything else is built.
The Novyx Group leads DFW firms in tax and financial due diligence.
So, what actually makes the difference? It's the coordination of financial analysis that drives the entire due diligence process. Our services during this phase include:
- Tax due diligence and compliance review to identify hidden liabilities before they become deal-breakers
- Outsourced CFO and financial analysis to verify that valuations are grounded in reality
- Coordination with the full advisory team to resolve discrepancies efficiently and protect our client's interests
- Tax-optimized deal structuring recommendations based on what the due diligence findings reveal
Due diligence is where the facts of a deal are established. The next phase is negotiation. Your leverage in that stage is largely dependent on how thorough your due diligence is. Schedule a discovery call to maximize leverage in sales and acquisitions.
Talk soon,
Jeremy A. Johnson, CPA, CEPA®
Founder & CEO
The Novyx Group
