Typically, financial due diligence is focused on Quality of Earnings. Normalizing revenue and expenses and adjusting for any unusual items results in adjusted EBITDA. But what if the company is early stage and/or the company is unprofitable. What type of diligence can/should be performed to ensure you understand the historical performance and future prospects of the business? Below are a few suggestions on procedures with some additional discussion on each point.
Proof of revenue – you want to verify the traction the target is representing is real. One way to do this is to perform a proof of revenue which involves conducting a rollforward of accounts receivable and agreeing expected cash receipts to the bank activity.
Assuming the target is conducting its accounting on accrual basis, we would also recommend coupling this with a detailed analysis of the accounts receivable aging. The buyer (either itself or through its due diligence provider) should understand the collectability of significantly aged items and specifically request information regarding the existence of any current or anticipated customer issues.
Contract analysis – In conjunction with the proof of revenue analysis, if the target has a re-occurring revenue model (monthly, annual, etc.) or a contractual relationship with customers and is representing significant growth, we would suggest an assessment of significant contracts to ensure: i) they are executed, ii) the represented contractual amounts are accurate and iii) customers are in good payment standing. Contracts can also be analyzed to ensure proforma (i.e. run rate) and projected revenue amounts are reasonable and based in substance.
Run rate expenses – Often times, growing businesses (or those struggling) will have run rate operating expenses that are significantly different than historical amounts. This can be true across a number of categories including wages and committed marketing expend. Analysis should be conducted to compare historical cost to current committed cost to assess the impact on anticipated earnings.
An added benefit is both the revenue and expense analysis can be utilized to calculate expected cash burn rate. This is especially important if cash is being put to the balance sheet for future investment in growth. Combining this analysis with your own modeling can provide additional comfort that the anticipated uses of cash are appropriate; thus, helping protect your investment value.
Need clarification or want to further discuss any of the above points, please feel to reach out to Chris Fameree – firstname.lastname@example.org.
ABOUT THE AUTHOR – CHRIS FAMEREE, MANAGING PARTNER
Chris Fameree is the founding partner of Assure with nearly 15 years of combined public accounting and industry experience. He has led and participated in numerous engagements including SOC 1 & SOC 2 engagements, due diligence engagements, financial statement audits and other advisory projects.
Prior to founding Assure, Chris was a Senior Manager in the Transaction Advisory Services Group and Audit Group of a large regional CPA firm. During this time, Chris participated in numerous business combinations and due diligence assignments. These transactions ranged from $10 million to over $100 million in value. Chris also worked at a national CPA firm, where he served lead roles on engagements from international Fortune 500 companies to closely held private manufacturers.
Chris received his Bachelor of Business Administration in Accounting from the University of Wisconsin. He is licensed as a Certified Public Accountant in North Carolina and Wisconsin.