The ability to practice due diligence when evaluating a potential distressed business acquisition is paramount to the success of said acquisition. Thorough due diligence will allow your business to evaluate the true assets and liabilities that your target company has in tow.

A comprehensive appraisal of a target businesses’ situation means you’ll have a complete understanding of a distressed businesses’ commercial viability and thus its profit potential for you as a new owner.

Completing rigorous due diligence is often the difference between a successful purchase and a costly failure. In this article, we’re going back to basics to walk through some of the different approaches to due diligence.

The three types of due diligence

Due diligence is an all-encompassing evaluative process whereby a company examines commercial transactions that are critically linked to performance and success.

Due diligence processes have traditionally been categorised as either financial, legal or strategic, and considered very much separate approaches.

But businesses in today’s highly competitive landscape are realising the importance of a due diligence programme that combines elements of all three areas, to ensure a macro, rather than microanalysis.

1) Financial – assess earnings, assets, liabilities, cash flow, debt, tax returns
2) Legal – assess obligations and liabilities
3) Strategic – assess the market: customers, competition, business plans

Financial due diligence

After identifying a distressed buy-in opportunity, developing a winning turnaround strategy and approaching the target company to express interest, comes financial due diligence.

The financial due diligence process, sees you – the buyer – focus on analysing the financial information offered by a target company as a way of evaluating its underlying performance.

Financial due diligence fundamentals

• Earnings
• Assets
• Liabilities
• Balance sheet
• Debts
• Cash flow
• Tax returns

As well as understanding current performance and profitability and verifying that the information supplied to you in talks is accurate, you’ll start to identify opportunities to turnaround the business. You look at earnings, assets, liabilities, cash flow and debt, identifying the threats and opportunities represented by acquiring the target company.

When performing financial due diligence it’s important not to overly focus on one particular time period. To get a better picture of how the company fortunes could look after the deal is completed, you’ll need to look at the historic company performance.

That said, it’s important to complete financial due diligence itself within a tight timeframe to ensure the value of the company is not lost. Direct attention to the most significant value drivers only, in order to rectify the company’s lost position before it’s too late.

Legal due diligence

The goal of the legal due diligence process is to examine in great depth the legal foundation of a transaction. When buying a business out of administration, identifying legal issues at the due diligence stage, allows you to pull out of the deal if you see the legal challenges as too time-consuming, or have worries they’ll cause financial issues.

The costs involved in litigation for instance can cripple an acquisition before it even gets off the ground.

Legal due diligence fundamentals

• Supplier, customer and employee contracts
• Incorporation documents
• Deeds and ownership documents for asset
• Lease documents for land or premises
• Legal action, including litigation

Product liability claims could indicate there’s something seriously wrong with the intellectual property rights you are considering acquiring, so look out for these, to ensure you won’t have to face any protracted and expensive legal battles.

Any past legal judgements can damage the reputation of the target business, and have a knock-on effect on your ability to turnaround the business’ prospects.

All this goes to show that you cannot overlook the importance of legal due diligence when looking to acquire a distressed company. Any adverse legal judgements or pending cases can have far reaching ramifications which can impact both financials and strategy formulation.

Strategic due diligence

The strategic due diligence approach entails evaluation of the target company’s market. This could involve assessing their competitors, interviewing or otherwise acquiring feedback from their existing customer base and comprehensively analysing the assumptions underlying their current business plan.

You might discover a fundamental flaw in the businesses plan, if it can’t be rectified then you can always pull out of a deal at this stage.

On the other hand, after assessing the landscape the business operates in, it might emerge that the business is simply outmatched by their established competition, and your business might just not have the resources or expertise to compete on an even footing.

Identifying a business that fits your core capabilities is essential to ensuring a successful acquisition. With the correct initial targeting and strategic due diligence, your business will identify the risks that are most likely to be surmounted.

Strategic due diligence fundamentals

• Customer profiling and analysis
• Competitive landscape assessment
• Business plan comprehension

Don’t overlook the current employees. Getting buy-in from existing employees is essential to the success of any distressed acquisition. These are the people that gave the business value in the first place, and they understand the current business strategy, and the business processes and procedures better than you do at this stage.

Moreover, by tapping into the knowledge of the existing management you’ll have effectively have access to the history of the company, what went wrong, and the factors that brought the company to its current position. This knowhow will be a crucial element of turning around the distressed business.

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When looking to buy distressed businesses out of administration, you will be in a fiercely competitive field. First mover advantage is an important part of buying a business from administration and capitalising on the assets and complementary strategic abilities they present.

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