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Reading Between the Lines During Financial Due Diligence

The standard financial due diligence process focuses on providing potential investors with an understanding of a company’s sustainable EBITDA, historical operating trends, working capital needs, and accounting policies and procedures.

However, access to the C-suite during fieldwork allows a financial diligence provider to gain valuable insight into other aspects of a company’s operations that may be just as important when evaluating a deal. In particular, financial diligence teams may uncover significant issues affecting post-acquisition integration and the investor’s ability to effectively monitor and effect change post-transaction.

Management team observations

Perhaps the most important qualitative observation a financial diligence provider can offer an investor is his/her assessment of the management team’s capabilities and internal dynamics. Management’s ability to effectively work together as a team is paramount to the future success of the sponsor’s investment. A domineering CEO or passive controller can have far-reaching impacts on an investor’s ability to work with the management team and trust the financial results post-transaction.

Financial due diligence engagements may also uncover key employees not previously considered by the investor, and conversely may also reveal talent voids. To ensure a seamless transition, an investor should be armed with knowledge of all key employees so that employment agreements and/or retention bonuses can be negotiated alongside the purchase agreement.

System limitations

ERP and accounting information system limitations are frequently encountered by financial due diligence teams. Aside from affecting the flow of information during the deal process, financial diligence providers should consider the effect of poor systems on post-transaction monitoring and reporting. Investors should be able to assess whether key operational data is readily available and whether company personnel are adequately trained on internal systems, as investor reporting requirements are typically more robust than founder-led businesses.

Post-acquisition accounting issues

Analysis of a company’s revenue recognition policies and procedures should be a standard procedure of every financial due diligence engagement. However, a financial diligence provider should also be cognizant of an investor’s post-acquisition plans to change the business and the resulting effect those changes may have on revenue recognition.

For example, an investor may plan to transition a software company from a license-based business model to a SaaS-based service offering. Revenue recognition would look much different under a SaaS-based model, and it is the financial diligence provider’s task to help illustrate the effect on future GAAP earnings.

Purchase accounting rules may also affect post-acquisition revenue recognition. Under U.S. GAAP, deferred revenue on the opening balance sheet is reduced to the cost to provide the service, plus a reasonable margin. The financial diligence provider should ensure the investor is aware of any potential deferred revenue “haircut” and its effect on future revenue and loan covenants.

Summary

A financial diligence provider’s job should extend beyond quality of earnings and financial trend analyses traditionally observed in financial due diligence reports. The financial diligence provider should work to uncover all matters affecting the investor’s ability to integrate the potential acquisition and achieve revenue and growth targets in the investor’s model. Probing questions and “reading between the lines” can help expose issues that are best addressed prior to writing the check.

About the Authors:

Brandon Lamb and Lathrop Smith of Maxwell Locke & Ritter LLP in Austin, Texas contributed to this article.  They can be reached at 512-370-3200 or blamb@mlrpc.com and lsmith@mlrpc.com

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