Due diligence, explained simply
Due diligence tests the seller’s information against source evidence across finance, tax, legal, commercial, operational, IT and HR. It normally begins once a letter of intent is signed and ends when the purchase agreement is executed.
Findings feed directly into the price, the working capital target, the protections in the purchase agreement and the conditions to closing.
Where due diligence sits in a transaction
IllustrativeTypical sequence of a private company acquisition
Diligence runs between the letter of intent and signing, typically 30 to 90 days for a mid-sized private company.
Principal workstreams
| Workstream | Question it answers |
|---|---|
| Financial | Are reported earnings sustainable, and what is the net debt and working capital position? |
| Tax | Are there unpaid or contingent tax liabilities? |
| Legal | Are contracts, licenses and ownership in order, and what rights transfer on a change of control? |
| Commercial | Is the market healthy, and will customers remain? |
| Operational | Can the business operate as presented after the sale? |
| IT and cyber | Are systems and data adequately controlled? |
| HR | Will key people stay, and are employees correctly classified and paid? |
Worked example
A private equity sponsor agrees to acquire Alder Creek Manufacturing for $40.0 million, being 8.0x reported EBITDA of $5.0 million. Diligence finds that only $4.6 million of EBITDA is recurring, and that the largest customer may terminate its contract on a change of ownership.
At 8.0x, $4.6 million of EBITDA supports a price of $36.8 million. The sponsor reduces its offer by $3.2 million and makes renewal of the customer contract a condition to closing.
Alder Creek Manufacturing, Inc. is a fictional company. All figures are illustrative.
Why it matters in a deal
Buyers price on a multiple of earnings, so any error in earnings is multiplied in price. Diligence findings also drive the purchase agreement: the price, the indemnities and the conditions to closing.
Red flags
- Slow or incomplete responses to information requests
- Figures that do not reconcile between documents
- Dependence on a single customer, supplier or individual
- Unexplained changes in results in the months before the sale