Key Takeaways
- Start Due Diligence Early: Buyers are shifting to perform high-level due diligence before submitting a Letter of Intent (LOI) to avoid costly surprises, better evaluate risks, and reduce post-LOI deal fallout.
- Understand the Business Beyond the Numbers: Early review of financials, operations, customer base, and company culture — plus site visits — helps buyers assess the business holistically and align expectations before entering exclusivity.
- Tax Structure and Deal Type Matter: Early analysis of deal structure (asset vs. stock) can influence purchase price and tax treatment. Engaging tax advisors upfront helps buyers model outcomes and negotiate smarter.
Until fairly recently, it was standard practice for private equity groups to begin due diligence processes after executing a Letter of Intent (LOI).
The LOI generally signals the beginning of a lockdown period during which the buyer is given exclusive rights to examine a potential purchase without any other possible buyers being involved.
But the exclusivity is for a limited period only (can be up to 30, 60, or 90 days, and usually subject to extension), and if issues or roadblocks arise during that time, there is a risk of losing a deal and incurring significant transaction costs that you cannot recoup.
New thinking, new methods
Consequently, a modern approach to the buying process is to begin with some serious preliminary due diligence before submitting an LOI.
Preliminary due diligence is an informal and relatively inexpensive process that establishes the basis for a potential purchase. The process will show if the seller is serious about the sale and allows the buyer to discover why the seller is selling, understand the financial health of the company, derive the worth and price (two very different things) of the company and whether the personalities involved are the kind of people you can do business with. High-level preliminary due diligence may also highlight any potential red flags that might surface and be problematic during the purchase or cause a buyer to decide not to submit an LOI at all.
A stigma that buyers want to avoid is that of re-trading every deal after an LOI. While diligence adjustments may arise that warrant an adjustment to the initial proposed price, applying some pre-LOI diligence may result in a bid that a buyer is more comfortable with, possibly avoiding contentious discussions that arise when proposing a purchase price adjustment.
Follow the money
Preliminary high-level due diligence is recommended at the outset and should commence with a more focused, but thorough accounting and financial analysis. Generally, this would include a review of key documents, notably a profit & loss statement, a cash flow statement, a balance sheet, and a statement of retained earnings. Those are the basics, but it’s also recommended to look at the overall performance of the business by studying historic trends and consistencies in the company’s recent performance. Depending on the nature of the company being investigated, it might be valuable to examine the accounts receivable, inventory and the value of land, buildings and equipment. This guide on inventory-related M&A due diligence outlines best practices that can help inform this evaluation. Also use this as an opportunity to understand significant undisclosed pro forma activity (possibly having positive or negative consequences).
In addition, it may also be beneficial to understand how the company has marketed and differentiated itself by reviewing marketing tactics and strategies and analyzing how that affects potential viability and profitability. It might also be valuable to include some broad customer analysis looking at profile, demographics and local competition.
It is highly recommended to perform a site visit with the company. If a key central location exists, consider bringing an expert to ensure the basic systems—electrical, water, plumbing, heating and air conditioning—are in good working order and will not need to be replaced soon. Ideally a seller already has available a list of significant capital improvements that a buyer will likely need to make to continue operating the business.
Personality matters
If all those areas of research look positive, then a management interview is a fitting end to the preliminary process. Ahead of any in-person sessions, consider taking some time to assess the workforce and related costs. How many employees are there? What is the management structure? What benefits are offered? How qualified and experienced are the employees?
Finally, the preliminary interviews and meetings allow the buyer to witness the culture of the company, to evaluate the reasons for the sale and get an overall sense of whether this company fits with the buyer’s vision and long-term goals. If a seller indicates they plan to exit the business right after a transaction, the buyer should assess whether the seller is integral to the continued performance of the business, and if the buyer has a capable individual to backfill the seller’s role. These factors could have a significant impact on prospective earnings and, ultimately, purchase price.
More time and effort devoted to preliminary due diligence will generally result in a more streamlined process post-LOI. It will help build a solid working relationship with the seller early in the transaction process, possibly provide an advantage over other bidders in the sale process, and lead to fewer failed transactions and purchase price adjustments.
The Importance of pre-LOI Due Diligence
I always recommend that, as a buyer that you really understand the type of entity you’re acquiring before you even go into signing an LOI and getting involved in that process because what that does is it allows you to include any necessary language in the LOI as to whether you’re going to do an asset or a stock deal.
It also allows you to potentially adjust purchase price. If you’re going to see that you’re not going to get any benefit of a step-up for tax purposes, then maybe you want to come in at a lower purchase price, so it allows you to do that on the front end. And it also just helps to reduce the amount of surprises for both buyer and seller throughout the process.
For a buyer, an asset acquisition is generally the best answer from a tax perspective because that’s typically going to give you a step-up for tax purposes. Sometimes a stock acquisition is required, especially in the healthcare sector, when you have to maintain that provider number. It is difficult to receive a step-up for tax purposes if you’re buying the stock of a C corporation. I would encourage you to get your tax accountants and tax attorneys involved very early in the process to help potentially structure around that. I would also encourage you, if you are planning on paying an additional purchase price, to get a step-up to model that out, see what it looks like. Because depending on how long you’re planning on holding that investment, it may or may not be worthwhile to try to pay extra for the step-up.
To learn more about how to approach transactions with clarity and confidence, review LBMC’s Private Equity Roadmap — your guide to navigating the deal process from initial interest to successful close.
Content provided by Jessica Toney and Brian Davis.