The due diligence process enables investors to do a better job of determining the appropriate price
to pay for a privately held firm. This article delineates some factors that a prospective buyer should
investigate thoroughly to determine the value of a small, privately held business under consideration
for purchase
Components Of The Asking Price
Usually, the buyer and seller will not agree initially on a selling price for the business, nor will they use the
same methods for valuing the worth of the firm. The seller is often inclined to overvalue the business, giving undue weight to personal or emotional needs. The buyer, on the other hand, is likely to undervalue the business, influenced primarily by the amount of cash and financing available for the purchase. A more objective approach to valuation would examine both past and pro forma cash flows to determine the worth of the business. Factors such as real estate, patents and trade secrets owned by the business may increase the selling price, while other factors such as outstanding lawsuits, changes in the regulatory environment and impending managerial changes may decrease it.
To consummate a sale, the buyer and seller may need to adjust their initial estimates of the worth of the
business. The process of due diligence helps the buyer and seller arrive at a mutually acceptable price for the
business. While the due diligence process is usually approached as a way to test the veracity of the seller’s
representations, it can also serve to educate the buyer and the seller about the true worth of the business.
The Importance Of The Due Diligence Process
The prudent investor understands the advantages of buying an established business, but also recognizes the
pitfalls awaiting the unwary purchaser. The cautious buyer reduces acquisition risks by engaging in thorough due diligence before finalizing the purchase. While some buyers skip due diligence, considering it an unnecessary expense, such a decision is usually unwise. A systematic due diligence can prevent a financial calamity or allow the purchase of the target firm for a better price or on more advantageous terms.
The responsibilities of a due diligence analyst include verifying the accuracy of the seller’s representations,
discovering undisclosed problems, and uncovering hidden assets and opportunities. If due diligence verifies the accuracy of the seller’s representations, the buyer’s confidence in the original valuation increases. Similarly, the discovery of hidden or neglected assets automatically increases the value of the deal for the purchaser. On the other hand, when due diligence reveals undisclosed problems, the buyer has an opportunity to walk away from the deal or negotiate a more favorable purchase price. In each of these cases, due diligence significantly enhances the buyer’s position in the potential transaction
CONDUCTING DUE DILIGENCE
The buyer conducts due diligence to make certain that he or she understands fully all aspects of the business
that is for sale. A serious due diligence process requires careful planning, the retention of various experts and skillful execution. At a minimum, due diligence needs to be carried out in the following areas: financial statement analysis, inventory, payroll, pension funding, market position, customer and vendor relationships, human resources, legal liabilities, creditor relationships, and intangible assets.
Financial Statements
The firm’s financial statements typically provide critical information about the financial health of the
business; however, the accuracy of the picture provided depends on whether or not the accounting records were maintained in accordance with Generally Accepted Accounting Principles (GAAP). If a certified public accountant audited and certified the financial statements, the picture painted by them is probably accurate. Moreover, it is even better if one of the national accounting firms conducted the audit (Dahl, 2004). However, the financial statements of most privately held firms do not meet these criteria. Small, private firms are frequently somewhat casual in their accounting practices. In such cases, due diligence is crucial to determine the value of a business.
The first step in examining the financial statements is to determine how carefully and how long the firm has
maintained its accounting records and observed GAAP. The less rigorously GAAP have been applied, the greater effort will be required to verify the accuracy of the financial statements. The precision of the numbers associated with sales, inventory, payroll, travel and business entertainment deserve particular scrutiny
Payroll
The payroll costs of many small, private businesses require close inspection. The salary and perquisites of
the seller may be considerably higher than they would be for a comparable professional manager. If the current owner is overcompensated, the business may be worth significantly more on a discounted cash flow basis than current financial statements suggest.When examining payroll issues, the due diligence analyst needs to determine the expectations concerning any future employment at the firm by the seller and his or her family members.Since family members may be overcompensated, there could be an opportunity to increase cash flow upon sale of the business. Conversely, the wages of non-family members currently employed by the firm may be artificially low, causing dissatisfaction and increasing turnover costs.
Inventory
For many businesses, especially retailers, inventory represents a significant asset. The person responsible for
due diligence needs to verify the existence of the inventory and evaluate its salability. Since inventory frequently changes, due diligence in this area presents a challenge. The initial step is to determine if the amount of inventory is comparable to the amount shown on the books. If not, the analyst needs to establish if the difference is due to ordinary fluctuations or if there is a systematic misrepresentation. The second step consists of determining if the inventory is salable, which can be particularly difficult for fashion-oriented businesses such as apparel or in technology, where obsolescence is an issue.
Pension Funding
The due diligence effort should include an assessment of the company employee pension fund to determine
whether it is over funded or under funded. Under funding could result in a significant unrecorded liability, while conversely an over-funded pension plan could result in significant added value to the acquiring firm .A
plan is fully funded when, according to the actuarial standards prescribed, the cumulative contributions to the pension fund are equal to the cumulative payments expected to employees Publicly traded companies are required to disclose under-funding in the main body of the financial statements, however privately-held companies do not have to meet the same standards. The key assumptions about future implicit growth rates in the investment portfolio may be ripe for exploration. If the company uses a defined contribution plan, however, a different set of analyses would be in order.
Travel and Entertainment Expenses
Many travel and entertainment expenses may not be strictly necessary for the success of the business. Small,
private firms frequently provide luxury cars to the owner(s) and family members. Some owners regularly charge travel, meals and entertainment that may have both business and personal objectives. A thorough investigation should show whether the owner(s) and family members might have misused the travel and entertainment account. If so, the analyst has discovered additional cash flow that increases the value of the business.
Intangible Assets
Patents, trademarks, service marks, brand names, copyrights, trade secrets, other intellectual property and the reputation of the firm represent intangible assets that may not be readily apparent to the current owner. Some assets, such as the brand name of the company’s major product and patents on manufacturing processes, are currently creating economic value for the firm. However, some intangible assets,
such as a brand name of a discontinued product or the backlist of a publisher, may not be a source of current value to the firm, but have the potential to generate significant economic value in the future. In such cases, the business may be worth considerably more than a discounted cash flow analysis would suggest.Journal of Business & Economics Research – May 2007 Volume 5, Number 5 66
In some cases, a rigorous analysis of the intangible assets of a firm can yield a great opportunity to discover
hidden shareholder value. However, naïve optimism in estimating the potential cash flow could result in an erosion of shareholder value. In conducting due diligence, intangible assets should be separated into two general asset categories. The due diligence effort should attempt to recognize and quantify intangible assets that arise from both a contractual or other legal right(s) and non-contractual but separable basis. Contractual or separable intangible operating assets would generally include the following: (1) key customer contracts; (2) existing order backlog; (3) operating and financial leases; (4) licensing and royalty agreements; (5) key employee employment contracts; (6) trademarks; (7) web site co-branding agreements; and (8) pollution abatement credits. Intangible assets that are capable of being split off from the acquired firm and later sold, transferred, rented or exchanged should also be recognized . These non-contractual but separable intangible assets include such diverse items as “grandfathered” exemptions from current regulations, any proprietary, unpatented technologies, registered domain names, trade secrets or prestigious quality awards and certifications. However, any costs associated with the exploitation of these intangible assets should also be included as a reduction in the pro forma cash flow
Concluding Part
Purchasing a small, privately held business can be more risky than buying a large, publicly traded firm. In
particular, it may be more difficult to establish the appropriate offer price for a small firm, for a variety of reasons. The buyer can overcome the uncertainties associated with the valuation of a small firm by conducting a systematic due diligence process. This article delineates some factors that a prospective buyer should investigate thoroughly to determine the value of a small, privately held business under consideration for purchase.
