Buy Side Due Diligence
Introduction
This article looks at buy side due diligence. This is the process undertaken by investors and business owners looking to acquire some or all of the equity in a company.
There are two ‘sides’ to diligence – the ‘buy side’ and the ‘sell side’.
Buy side vs sell side
The sell side of any deal is the one looking to raise money – giving up equity in exchange for investment, or selling their company outright for a new owner to come in and run it. Sell side due diligence is often comparatively straight forward, particularly where there is a full sale of the company.
So long as the buyer is reputable, has the necessary funds, provides references that are satisfactory, and is unencumbered by any legal restriction preventing them from making the acquisition, then a seller’s diligence is quite simple. They want to raise money, and in most cases will not make it too difficult for people to give it to them.
The buy side – for diligence purposes – is more complicated. Here an investor or buyer is looking to enter a business based on some assumptions about the business itself, knowledge of the market and opportunity, and/or representations from the owner. These must be rigorously examined to ensure the investment is likely to be sufficiently profitable as to justify the risk inherent in any investment or acquisition.
For the rest of this article, we’ll look at what’s involved in buy side due diligence, who does it, and how buyers and investors get comfortable proceeding with a deal.
Types of buy side due diligence:
As part of any investment or acquisition, there are three main types of due diligence an investor or buyer will generally do:
- Commercial due diligence
- Financial due diligence
- Legal due diligence
Then depending on the type of business, its stage, industry sector, and the buyer or investor’s intentions for the company there are many other supplemental forms of diligence that may be sought. Commonly this could be technical, regulatory, IP, HR, tax or even environmental.
Whether these are stand alone diligences or simply touched on under the three main types of diligence can also be a semantic difference. In our experience running commercial diligences for many leading private equity funds, as well as buyers from our core service sectors, we have found that there is no standard, ‘one size fits all’ diligence. What one client views as standard, another will view as unnecessary. Sometimes this even varies between deal teams within large investment funds.
Who does it and why?
Potential investors and buyers set out on the path to acquire a target company based on a set of assumptions about the future of a market. This may be a market they are already in, a market they are adjacent to and looking to expand into, or indeed a market they are looking to enter for the first time.
Though we call these assumptions, they are really a set of carefully researched and thought out hypotheses. Invariably, The overarching assumption is that the investor or buyer will be able to create additional growth in the target acquisition either through operational efficiencies, sales and marketing improvements, or ‘inorganic growth’ – further mergers and acquisitions.
The due diligence audit is therefore an essential part of establishing that an investment case is sound, and an investor or company should risk their capital on the target company.
What are buyers and investors looking for?
As mentioned in the introduction, there are three primary types of buy side due diligence an investor will look to perform as a standard part of any deal: legal, financial, and commercial.
Legal Diligence
Legal diligence is primarily aimed at ensuring the target company does not have any undisclosed legal issues that could impact its ability to operate in a given market. These might relate to intellectual property, SEC or IRS filings, ongoing litigation with customers or competitors, issues around where the company is registered, patent applications or the personal legal status of the founder(s).
In my first set of terms with investors, I was surprised at pages of provisions regarding my own liability and terms of forfeiture of equity. It was made quite clear that any legal issues, regardless of whether they were relevant to my ability (or freedom) to run a company, were grounds for forfeiting my shareholding.
This was perhaps naive, but it goes to show that where significant sums are at stake, the owner of the target company may face significant legal due diligence to ensure that there are no nasty surprises for investors and buyers, as their reputations may be linked if something unsavoury comes to light following a deal.
Financial Diligence
Financial diligence is usually undertaken by an accountant. While forward projections are likely to fall under a commercial due diligence, the financial due diligence will look at historical records to try to ascertain the true financial position of the company.
This can be as much art as science. Though GAAP (Generally Accepted Accounting Principles) exist, and companies are bound to comply with them, there is still a great deal of variation in how accounts are put together.
Often accounts are deliberately massaged (as much as is allowed within the law) to present the most favourable financial appearance to prospective buyers and investors. Companies have significant flexibility in how and when they record a transaction, or write off equipment, or make investments of their own.
Getting an accurate perception of a company’s real financial status is therefore essential for any buyer or investor, as many demons can lurk behind the facade of a well massaged set of accounts.
Commercial diligence
We wrote a long post on the details of commercial due diligence. So we’ll be brief here. Commercial diligence is part of what we support with here at Unequal Outcome. It looks at the operating, sales and marketing model in the business plan, sales forecasts, market opportunity, competitive landscape and customer sentiment surrounding a target company.
Often much of the desktop research work – looking at total addressable markets, obtainable market share, competitive landscapes, and forecasts is preliminary to voice of the customer work, where customer or consumer interviews are carried out to understand how the target company is perceived by its primary audience.
These interviews look to unearth information such as weaknesses in the buying or post sales process or the effectiveness of the target company’s marketing based on how it is perceived by consumers vs the competition in is marketplace.
Just as with legal and financial due diligence, investors and buyers will generally engage a due diligence expert to conduct this king of commercial due diligence investigation.
Buy Side Due Diligence Outcomes
The reality of investing in and acquiring companies is that you will look at many more deals than you actually do. In an environment where good deals are scarce, it is essential to understand whether what you are paying for the future opportunity that comes with investment or acquisition is a fair price.
One of the most critical outcomes of a due diligence screening for any investor or buyer is confidence that the opportunity for improving the underlying asset is there post deal.
Traditionally due diligence may have been seen as a negative exercise, in the sense that it is typically concerned with risk management around a potential acquisition or investment – validating existing concerns and identifying previously unearthed ones.
However, here at Unequal Outcome, our experience has been that the private equity investors we work with tend to approach it as a positive exercise. While clients are conducting internal research, diligence provides an opportunity alongside that work to validate the excitement underpinning their investment hypothesis. They view diligence as much as an opportunity to identify greater opportunity to add value post deal. Of course, any seasoned investor will be alive to the downside risks, and will assiduously hunt them out.
Investment banks
The role of investment banks is outside the scope of our competence, as we tend not to work directly with them. However, they often play an important part in deal origination for institutional investors, so it is worth covering what they do briefly before we wrap things up.
Investment bankers work both on the sell side and the buy side of transactions – either identifying investors for a client on the sell side, and helping raise capital to invest for clients on the buy side.
For our private equity clients, particularly where a deal is an M&A deal, one of the first steps in the transaction process if often receiving a teaser from an investment bank. This could be done by a major investment bank or even a specialist advisory firm. These teasers anonymize the client company, but provide details on the industry, the company’s products and services, and the core financial details.
If this fits with the investment thesis of the private equity fund, and the opportunity is a fit based on the teaser, the private equity firm will sign an NDA with the investment bank, and receive a ‘confidential information memorandum’. This contains far more detailed information, the investment bankers’ investment thesis, and a detailed company profile.
The image below from CFI shows an example of the timeline between first contact from an investment banker and a deal closing for a private equity firm. The link also provides a much more detailed description of the role investment banking and investment bankers play in the investment eco system – and how investment banks work with their colleagues in private equity.
Conclusion
Buy side due diligence is a critical part of the deal process. Any investor or buyer will want to be sure that their investment thesis is well validated, the downside risks are well understood, and the potential to add value post deal is well quantified.
A typical diligence will encompass commercial, legal and financial research. The larger the deal, generally, the more extensive this process is likely to be. Investors and buyers will typically engage an external due diligence consultant to undertake all or some portion of the work.
This is important, as it allows for a more impartial appraisal once an investor has satisfied themselves on the case for investment. It also frees up valuable internal resources to manage deal flow across multiple projects that are often ongoing simultaneously.
FAQ
What is buy side due diligence?
This is due diligence undertaken by the investor or company acquiring equity in a target company. It usually encompasses financial, legal and commercial aspects of a company, at a minimum. When discussing the due diligence process it is the buy side diligence process that is generally being discussed.
What is sell side due diligence?
Sell side due diligence is undertaken by the owner of the target company. Generally it is focused on ensuring the potential buyer is a serious, fit and proper acquirer for the company – and that they have the means to make the possibility of a successful deal high.
Who performs commercial due diligence?
This is typically undertaken by a third party due diligence consultant, such as Unequal Outcome.
Who performs legal due diligence?
This is typically done by a law firm engaged by the buyer.
Who performs financial due diligence?
Typically this is done by an accountant engaged by the buyer.