Simplified due diligence for lower-risk deals: Benefits, risks, and best practices
Conducting due diligence before acquiring or investing in a business is always considered best practice. A thorough investigation of the target company’s financial, legal, and operational health can provide investors with clarity and comfort around their potential investment.
But what about in smaller, or more seemingly straightforward deals? Many buyers may contemplate conducting a simpler due diligence process to save time and cost, and they are right to consider this. However, this only serves as a viable option when investors carefully define what qualifies as a lower risk transaction, and tailor the scope accordingly.
It’s also important to know that this strategy would be particularly relevant for corporate acquirers with deep industry knowledge and benchmarks.
Are deals for smaller companies always lower risk?
From the outset, a £2m acquisition might seem less risky than a £200m deal; smaller businesses typically have simpler operations and fewer elements to diligence. However, smaller does not automatically mean safer, and size alone is not a reliable risk indicator, here’s why:
Firstly, smaller companies may lack the financial controls and reporting structures present in larger firms. For instance, a larger business is more likely to have organised monthly management accounts and audited financials, which enhance confidence in the reported figures. They also often have dedicated finance teams to answer questions, as well as strongly established processes.
By contrast, a very small owner-managed company might never have been audited, nor may it have professional finance staff, meaning its financial information could be less reliable or complete. In some cases, a larger target can be easier to diligence because data is well-prepared, organised and maintained internally, whereas a small company might rely on an external accountant.
When evaluating transaction risk, deal size remains important, but acquirers should also consider the quality of the company’s information and infrastructure, which tends to correlate with size. A low-risk small deal would be one where, despite its size, the business has clean financials and straightforward operations.
How does deal structure influence risk?
When considering the risk of a purchase or investment, it’s always vital to look at the deal structure to gain understanding of how the target’s valuation was estimated, and how sensitive that figure is to changes in financial metrics.
For example, if the valuation was estimated via a multiple of the company’s current earnings, then any inaccuracies in those earnings (e.g. unrecorded expenses or optimistic revenue recognition) could have produced an overvaluation, and the deal structure thereby carries a higher risk. On the other hand, a valuation that is more conservative or structured to account for uncertainties carries a lower risk.
How could a reasonable adjustment to profits, assets or debt affect the price?
If part of the purchase price is an earn-out (future payments contingent on the business hitting performance targets), it is imperative to evaluate its proportion within the total deal. This area adds an extra layer of complexity to deals and requires thorough diligence scrutiny, such as determining how the earn-out is measured and if the financials might be adjusted or manipulated to meet targets.
Sometimes the target business is being restructured prior to sale e.g. the business is being carved out of a larger company, or the owner is transferring certain assets out before the deal. These types of situations can create gaps or anomalies in the financials, and often prompt the following questions:
- Are all revenues and costs fully reflected in the carved-out financial statements?
- If the business was part of a bigger entity, have they allocated shared costs like rent, group insurance and admin staff properly?
- If a new company was incorporated recently to house the business, does it have all the historical data?
Carve-outs often require extra diligence on financial statements to ensure nothing was left behind or double-counted, and that the financial information reflects the business on a “stand-alone” basis.
What business characteristics should a simplified due diligence focus on?
In any acquisition, understanding how the business operates day to day is essential, even when you’re taking a simplified due diligence approach. The aim isn’t to audit every figure, but to identify features that could materially affect value or future performance.
By focusing on a few core checks, you can surface these potential issues early and make a better-informed judgment about whether simplified diligence is sufficient. The following areas deserve particular attention:
Customer and supplier dependence
Does the business rely heavily on a handful of customers or suppliers? High concentration is a red flag indicating vulnerability, as the loss of a major relationship could significantly impact the business overnight.
For example, if one client contributes 50% of sales and isn’t on a long-term contract, this isn’t a low-risk scenario. The acquirer would need to investigate the stability of that relationship by reviewing customer satisfaction, contract length, and renewal likelihood.
Balance sheet judgements
Potential acquirers or investors should review the balance sheet for items that depend on significant estimates or management judgment. Common examples include:
- Stock valuations
- Work-in-progress (WIP) on projects
- Accrued income or long-term contracts
- Bad debt provisions
In smaller businesses, these may be less rigorously calculated, for construction or contracting businesses, WIP and revenue recognition can materially affect the stated profits, so even with a simplified approach, targeted testing in these areas is crucial to prevent a write-off after acquisition.
Exceptional or one-off items
It is also crucial to inspect the company’s recent financial performance for any exceptional items or one-time events. Sometimes sellers present an adjusted profit figure excluding certain costs they deem one-off (e.g. a legal settlement or a one-time consultancy project) or non-recurring revenues. Are those costs truly one-off, or do similar expenses recur often? Identifying revenue that won’t repeat, or costs that are likely to recur is essential to understanding true earnings. A genuinely low-risk deal would have a clean earnings history without heavy normalisation adjustments.
For businesses where sales and cash flow are seasonal or cyclical, a full due diligence would include a detailed working capital analysis to see how cash needs fluctuate throughout the year. If you choose to undertake a simplified diligence, you should still perform at least a basic review of working capital trends. A company might look strong at year-end but could require a lot of cash at another point, and if the business is highly seasonal, then this is a risk point. It’s best to avoid finding out after finishing that you’ll need to inject more cash to handle a seasonal swing.
Tax
Tax is also crucial area of review in a simplified review. A comprehensive scope may include extensive review of tax documentation and correspondence, whereas a simplified “red flag” approach would consider the target’s corporation tax computations, VAT returns and PAYE / P11D records, with accompanying questions aimed to unearth any specific tax issues. Some common issues discovered in a “red flag” due diligence approach include:
- Section 455 tax on cash withdrawals.
- Incorrect claims for capital allowance super deductions.
- Failure to align with the Quarterly Instalments Payments regime.
- Incorrect treatment of the Domestic Reverse Charge.
If you decide that a limited due diligence is appropriate, here are some best practices to ensure it is effective and doesn’t leave you exposed:
Consider a Two-Phase Approach
One way to balance speed against thoroughness is a staged due diligence.
- Phase one can be a focused “red flag” review of key risk areas, allowing a quick scan for any major deal-breakers.
- Phase two would be the full due diligence, only if phase one didn’t raise any “show-stoppers” or if the deal progresses to final negotiations.
Outline a clear scope
Outline exactly which areas are in-scope for your simplified diligence and which are out-of-scope, based on your risk assessment. By being specific, you and your advisors know where to concentrate. It’s also important to identify thresholds or triggers that would expand the scope. For instance, you might state “if any evidence of regulatory non-compliance is found, we will then include a compliance review.” This way, you have a controlled method to handle surprises, rather than letting the process drift aimlessly.
Use an expert provider
When time and scope are limited, it’s vital that the people doing the diligence are experienced and efficient. An expert due diligence provider can often spot issues quickly and know where to probe with minimal information. They can also rely on their experience to judge what is “normal” for a business of this size and industry, as well as what looks odd. Encourage them to speak up if they think you’re not looking at something important. You want advisors who will say, “We’ve done the limited work you asked, but we really think you should also check X,” so you can then decide knowingly.
Closing thoughts
No matter how streamlined your process, never lose sight of the fundamental goal of due diligence, which is to understand what you’re buying. That means at minimum, you should come away knowing the business’s true financial performance, the key risks it faces, and any deal-breakers. Keep circling back to that question: “Do we thoroughly understand this business and where the risks lie?”. If after a simplified diligence you can confidently say yes, you likely struck the right balance.
At Price Bailey, our approach to each FDD is rooted in ensuring the fundamentals are covered and the scope is tailored to address your concerns. We aim to understand the business in depth, pinpoint where the risks lie, and never leave major questions unanswered. To speak to one of our SCF advisers today, get in touch using the form below.
We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.