DUE DILIGENCE:
Once of agreement has been reached in-principle between the various parties, the financing institutions will wish to carry out “due diligence” enquiries. Up/until this point, the decision to finance has been based largely on information supplied by, and representations made by, the management team. It is likely that the financial institutions will not have conducted an independent review, but will also have relied on the management’s representations. However, any indicative offers of finance will be subject to detailed due diligence, which will seek to verify the information provided.
Due diligence is a term used that includes all the activities that are associated with investigating an investment proposal to assess feasibility. It includes carrying out in-depth reference checks on the proposal related aspects such as management team, products, technology and market. Additional studies and collection of project based are done during this stage.
Due diligence enquiries may include an independent market survey carried out by experienced marketing consultants or industry experts, particularly if the financiers are unfamiliar with the industry or if the management’s revenue projections seem too optimistic.
The most detailed due diligence carried out by the financiers will be commissioned on a wide-ranging report from a firm of accountants. The scope of report is usually determined by the lead investor in consultation with other investors, lenders and the management team; it is unlikely to include a form of an audit. The report should be focused on areas might include the gross margins earned of different products, the evaluation of stock and work-in-progress, capital expenditure programmes, or the sensitivity of cash flow projections, the fluctuations in the level of revenues. Detailed planning at the outset of the investigation should ensure that there is no duplication of the work to be carried out by legal advisors, or of due diligence already conducted, or to be conducted by the financiers.
The scope of the report should be agreed in advance by all parties financing the firm, so that separate or additional reports are not required by mezzanine financiers or providers of bank finance, who may have different areas of concern or different requirements for the verification of information to those of the equity provider. For example, a provider of bank finance will be particularly interested in interest cover, gearing levels, asset backing and the effect of a detailed sensitivity analysis on these ratios.
The report should give the reader a thorough understanding of the business, including any potential problem areas, so that a balanced decision may be taken regarding the proposed investment. Often the reporting accountants will seek to identify the strengths, weaknesses, opportunities and threats relating to the business and to identify and evaluate the critical success factors of the business.
In the past, financiers have often complained that due diligence reports have included too much factual information, with too little comment or analysis of key issues. An accountant preparing a due diligence report, must be prepared to make commercial judgments. It is ironic that, whilst the accountant with a wide range of professional experience involving a number of different business and transactions is best-placed to provide such advice and commentary, the most common complaint leveled at such reports is that they tend to be bland and lacking an informed and incisive commentary.
Areas of due diligence would include:
1) General assessment
a) Business plan analysis
b) Contract details
c) Corporate objectives
2) People
a) Managerial abilities, past performance and credibility of promoters.
b) Financial background and feedback about promoters from bankers and previous lenders.
Availability of skilled labour.
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