By Lewis Allen and Jeff Mathew, Business Analyst at Acumen Corporate Development Inc.
Prior to the acquisition of a business, the purchaser will usually have an opportunity to carry out financial and legal due diligence on the business. This period of time is commonly known as the due diligence period and normally lasts from a few weeks to several months. During this period, the purchaser has an opportunity to “look under the hood” of the business being purchased, referred to here as the target, to review its legal and financial condition and determine whether there are any existing or pending issues.
Financial or legal problems uncovered during the due diligence period can result in the purchaser’s initial valuation of the target being incorrect. Therefore, it is critical for the purchaser to use this time to confirm that its understanding of the target’s legal and financial position is consistent with its expectations. Once proper due diligence has been completed, a purchaser will be more comfortable closing the transaction at the agreed upon, or an adjusted, purchase price.
At Thompson Dorfman Sweatman LLP and Acumen Corporate Development we provide and coordinate legal and financial due diligence for your transaction so you can avoid costly problems and be more comfortable with your purchase decision. Below is a summary of the legal and financial due diligence we can provide and coordinate.
FINANCIAL DUE DILIGENCE
REVIEW OF THE FINANCIAL STATEMENTS: The financial due diligence process begins with an understanding of the target’s financial statements. They tell the numeric story of how the target has performed during the reporting periods, and how it is trending. Proper financial due diligence will help the purchaser: (i) value the business and negotiate the purchase price; (ii) assess the target’s growth opportunities; (iii) identify integration strategies and synergies; (iv) identify issues; and (v) avoid costly mistakes.
With that in mind, not all financial statements are created and reviewed equally. The first step in reviewing a target’s financial statements involves assessing their reliability. Financial statements audited by an external professional accountant will be the most reliable and provide the most assurance to the purchaser that the financial information is free of errors or material misstatements.
Alternatively, “reviewed statements” depend more on broad trends of the business, such as year-to-year fluctuations in account balances, and less on specific business records like invoices. Reviewed statements provide a moderate level of reliability and assurance.
Finally, “notice to reader” statements are prepared by an external accountant using the corporation’s own financial records. These statements are the least reliable and provide no assurance because they are unaudited and may not have been prepared in compliance with any form of regulated accounting standards.
Once the level of assurance for the target’s financial statements is determined, it will serve as a general guide for how much reliance can be placed on them throughout the financial due diligence process. Where there is inadequate professional assurance, requesting and analyzing substantiating documents from the target can help flesh out the integrity of the financial statements.
NORMALIZED EBITDA: Keeping the level of assurance in mind, we can then use the financial statements to undertake a thorough examination of the target’s earnings before interest, taxes, depreciation and amortization (EBITDA). This step is crucial for confirming or determining the appropriate valuation for the target.
Valuation often involves applying an industry-appropriate range of multiples to the target’s normalized EBITDA. The target’s EBITDA can be normalized by accounting for non-routine transactions and other outliers that may occur in a given year, but do not occur regularly. A one-time expense related to a particular customer or the payment of a shareholder bonus may be normalized to better reflect the true earnings of the business. Ensuring the correct adjustments have been made to normalize EBITDA is an important part of the financial due diligence process and helps the purchaser confirm its understanding of the profitability of the target and ensure that the appropriate purchase price is set.
INTERNAL ANALYSIS: We can also help the purchaser further understand the target by examining other significant financial information not directly available on the financial statements. By analyzing the right information, the purchaser can gain valuable insights into aspects of the target which would not appear on the financial statements. For example, margin analysis can determine which product lines have the most value and customer analysis can help determine the concentration of sales by each customer.
Sensitivity analysis can also be performed to determine the effect on the business of losing a key customer and on the ultimate valuation of the target. By properly reviewing and understanding the target’s internal financial dynamics, the purchaser can better understand the operations of the business and ultimately better assess its actual value.
SYNERGIES AND INTEGRATION: Once the purchaser understands the value of the target, it can take the next step in assessing what synergies may be created as a result of the transaction which will further increase the value of the target to the purchaser. Synergies are opportunities for cost efficiencies and additional profits created through complements between the purchaser and the target. For example, overhead costs for administration and accounting staff and IT may be reduced by efficiencies created by the acquisition. Such a positive synergy would reduce costs and lead to an increase in EBITDA beyond normalized numbers.
Further, the purchaser and target may collectively enjoy increased purchasing power resulting in economies of scale, or increased market penetration for complementary products or services. Also, in addition to the synergies that enhance the bottom line, the financial due diligence analysis should identify the costs of integration or additional expenses that would be incurred post-closing, including severance, termination fees and other similar penalties.
In every situation, the synergies available are different and vary heavily depending on the business being purchased and the entity acquiring it. With proper financial due diligence, the purchaser can assess which synergies are likely to create additional value upon integration with the target.
The purchaser’s financial due diligence process should go beyond a review of the financial statements and include investigating the key metrics of a target for integration issues, synergies and, ultimately, to determine the basis for valuation and set the appropriate purchase price. Thorough financial due diligence will help the purchaser develop an in-depth understanding of the target’s operations and help the purchaser feel comfortable that the potential acquisition will provide the expected return on investment.
LEGAL DUE DILIGENCE
Proper legal due diligence is also necessary to help the purchaser make a better informed decision, set the appropriate price and avoid a myriad of unwelcome surprises after the purchaser takes ownership of the target.
Problems which can be avoided through effective legal due diligence include the purchaser being burdened with outstanding tax debts, liens on its assets, unresolved litigation matters, environmental violations, work orders and employment law violations. When these issues are uncovered before a transaction closes, appropriate adjustments can be made to the purchase price, or sometimes, the transaction can be called off before the purchaser finds itself with a significant and costly headache on its hands.
The structure of the particular transaction and the nature of the target’s business or assets will dictate the specific due diligence searches that should be performed. For example, some searches carried out for the purchase of a restaurant will differ from those carried out for the purchase of an online business. Further, the due diligence searches described in this article are appropriate for a transaction for the purchase of the shares of a corporation, and will differ from the searches completed on the purchase of a corporation’s assets.
When purchasing the shares of a corporation, the purchaser is buying the corporation along with any “skeletons in the closet”. Therefore, a purchaser must ensure that it has thoroughly investigated the business and its assets to determine if there are any significant problems it will inherit when the purchase closes.
Below is a summary of the most common legal due diligence investigations we complete for our clients.
CORPORATE REVIEW OF THE TARGET: This step involves reviewing the target’s incorporating, organizational and corporate documents (including the Articles of Incorporation, By-Laws, corporate resolutions and any Unanimous Shareholder Agreements) to determine, among other things, that the target is subsisting, validly organized and capable of doing business in its jurisdiction, and that any shares being purchased were validly issued. In this step, we can also confirm there are no special restrictions preventing the seller from entering into the purchase and sale transaction, whether there are any shareholder or other corporate consents required for the purchase and that the target is properly registered and current with its governmental filings.
REAL PROPERTY SEARCHES AND REVIEW: If the target owns land and buildings, a search of the title to the land will confirm ownership and uncover whether there are, among other things, any encumbrances, zoning restrictions or easements registered against the property. In addition to searching the title, real property due diligence also involves confirming that all realty taxes have been paid, whether there are any local improvements assessed against the property and that the property is zoned appropriately for the purchaser’s intended use. Searches will also reveal if there are outstanding by-law infractions, work orders or penalties assessed against the property for building or fire code violations or for other regulatory non-compliance.
Depending on the real property being purchased, it may also be appropriate to obtain a surveyor’s certificate and zoning memorandum to confirm that there are no encroachments on the property or on neighbouring lands, and that the property complies with municipal zoning by-laws. Also, sometimes it will be wise to obtain an environmental site assessment or a property condition report.
If the target is leasing the property it occupies, the lease agreement should be reviewed to determine if the landlord’s consent is required for the sale of the target and to confirm that the terms of the lease are acceptable to the purchaser.
PERSONAL PROPERTY SEARCHES: It is not possible to search a public database to confirm that the target owns its personal property (i.e. assets other than land and buildings). However, a prudent purchaser should make inquiries under The Personal Property Security Act (Manitoba) and other acts to determine whether any parties have a registered lien against the personal property of the target or against the shareholders of the target. A purchaser of personal property that is subject to a lien will take a subordinated interest in the goods, which means that the purchaser will not acquire full rights over the assets until the lienholder has been paid what they are owed.
OTHER PUBLIC RECORDS SEARCHES: In addition to the real and personal property searches described above, the target should also be searched to determine if there are any past or present bankruptcy filings, if it has provided any security under the Bank Act of Canada, if the target or its shareholders are involved in any past or present litigation and if there are any violations or unpaid remittances with the Canada Revenue Agency, Employment Standards Branch, Workplace Safety and Health, Workers Compensation Board or other governmental agencies. Unpaid amounts to these governmental agencies for business tax, payroll tax, pension and employment insurance withholdings and other remittances can result in liens being imposed on a target’s assets. Due diligence searches must be completed to ensure that no such liens exist.
Financial due diligence and legal due diligence lay the groundwork for a successful purchase transaction and information learned during the due diligence period will help guide the preparation of the purchase agreement. This way, problems uncovered can be appropriately dealt with between the parties first and not in a courtroom after the purchase closes.
If you are considering purchasing a business and would like assistance with the legal or financial due diligence, please contact us for more information.
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