Business Buying Masterclass: Financial Due Diligence

Welcome back to the Business Buying Masterclass!

In today’s session, we dive into the critical topic of financial due diligence, a cornerstone in the acquisition process.

To enrich our discussion, we’ll integrate insights from industry experts Chris Williamson of Cayne Crossing and Elliott Holland of Guardian Due Diligence.

Thank you for tuning in to the 11th session of this Business Buying Masterclass.

Let’s get started!

Introduction

Congratulations on making it through the toughest part: getting the seller and broker on board and finalizing your Letter of Intent (LOI).

Now that you're under LOI, the seller is willing to lift the proverbial ‘hood’ of the business and provide access to detailed financial information.

This is your first look at the data underlying the information provided in the Confidential Information Memorandum (CIM).

It’s a crucial phase where the rubber meets the road, offering a real glimpse into the business’s actual performance and financial health.

In this session, our goal is to help you navigate the post-LOI deal roadmap, focusing on the essential steps and best practices for conducting financial due diligence.

We will explore the nuances of Quality of Earnings (QofE) reports, share expert advice on identifying red flags, and provide actionable tips to ensure you’re making a well-informed decision.

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Guest Contributors

Elliott Holland is the founder and managing director of Guardian Due Diligence, a firm specializing in Quality of Earnings (QofE) for small and medium-sized business (SMB) transactions. With a rich background in private equity and a Harvard MBA, Elliott brings over 20 years of experience in evaluating and managing acquisitions. Guardian Due Diligence has supported numerous entrepreneurs and investors in making informed decisions by providing comprehensive financial due diligence and QofE reports. Elliott is known for his deep understanding of SMB dynamics and his commitment to ensuring clients avoid costly mistakes and uncover potential fraud in their transactions.

Chris Williamson is a founding partner of Cayne Crossing, a boutique consulting firm focused exclusively on financial due diligence and Quality of Earnings (QofE) for small and medium-sized businesses (SMBs). With over 20 years of experience and a background in Big Four accounting, Chris has led over 1,000 transactions, providing clients with the insights needed to make informed decisions. Cayne Crossing is renowned for its hands-on approach and deep understanding of the unique challenges in the SMB market. Chris is passionate about entrepreneurship and leverages his extensive experience to help clients navigate the complexities of financial due diligence, ensuring they uncover the true financial health of potential acquisitions.

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Financial Due Diligence: The First Look Under the Hood

Financial due diligence is the process of verifying the financial information provided by the seller.

It aims to confirm that the business's reported earnings, expenses, and assets are accurate and provide a true reflection of its financial health.

This process typically includes a thorough review of financial statements, tax returns, customer contracts, and other relevant documents.

Chris Williamson of Cayne Crossing emphasizes the importance of this step:

"Financial statement quality across SMBs is the wild wild west. There is no concept of Generally Accepted Accounting Principles (GAAP) in this end of the world. This means the baseline of your valuation, EBITDA/SDE, may be totally incorrect and at the mercy of the seller’s (often) biased interpretation of their financial picture.”

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The Role of a Quality of Earnings (QofE) Report

A Quality of Earnings (QofE) report is a comprehensive financial assessment designed to bridge the gap between the business's financial statements and reality.

Here is a clip from Mundane Millionaires of Elliott explaining what a QofE is:

Chris further explains that: "A QofE focuses on illustrating the true or 'normalized' state of historical EBITDA and how it bridges to free cash flow. In short, what you receive from a seller or their broker is often an (unintentionally) misconstrued view of the reality of the business you will be taking over."

Elliott Holland from Guardian Due Diligence adds, "The financial part of a quality of earnings is somewhat similar deal to deal. The data inputs vary. The work you have to do to get them into a standard format varies. But the output is pretty consistent. If you look at a hundred reputable firms' quality of earnings, we'll structure stuff differently, different levels of depth in the analysis, but they look similar."

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Key Components of a QofE Report

1. Proof of Cash

One of the foundational elements of a QofE report is the proof of cash.

This step ensures that the financial statements align with actual cash flow.

Chris notes, "Proof of cash is step one. Do the financial statements actually agree with the cash that came in and out of the bank accounts? The answer almost always is yes, but we’ve seen times when it doesn’t. This important check helps gauge the operating cash flow of the business."

2. EBITDA Adjustments (Add Backs)

Understanding and validating EBITDA adjustments is crucial. "What is the normalized revenue and EBITDA of the business? After taking into account everything you’ve learned about the seller’s financial statements, this is where it all comes together in a summary format to tell you what it means," says Chris.

3. Working Capital Analysis

Another critical aspect is the working capital analysis.

Chris explains, "Determine the working capital needs of the business and the resulting impacts in relation to how you have structured working capital in your LOI. If you are receiving a normalized level of working capital at closing, this will help you define the peg."

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Common Pitfalls and How to Avoid Them

Elliott shares some of the common pitfalls he has encountered in his practice: "I've seen deals where the seller deposited a million dollars into the bank account and tried to call it revenue with no invoices. Another time, they added every darn thing as an EBITDA adjustment. These fraudulent activities can severely impact the valuation and viability of the business."

Here is a Mundane Millionaires clip where Elliott expands on the risks involved:

To avoid such pitfalls, it’s essential to:

• Hire a reputable QofE provider: Choose a provider with experience in SMB transactions and a strong track record.
• Stay objective: Remember that you are no longer an objective party once you are emotionally invested in the deal.

• Thoroughly vet the financials: Ensure all financial statements, bank statements, and tax returns are scrutinized for inconsistencies.

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Expert Advice: Red Flags to Watch For

According to Elliott, some red flags to watch for during financial due diligence include:

• Significant discrepancies between bank statements and financial statements
• Unusually high or low working capital requirements
• Inconsistent revenue recognition practices
• Large, unexplained adjustments to EBITDA

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Conclusion

Financial due diligence is a critical step in the acquisition process.

By thoroughly vetting the business’s financials and leveraging the expertise of seasoned QofE providers, you can uncover potential issues, renegotiate terms, and ensure you are making a sound investment.

Thank you for joining us for this session of the Business Buying Masterclass.

We hope these insights and expert advice help you navigate your next acquisition with confidence.

Now, let’s dive into a recent episode of the Mundane Millionaires podcast featuring Elliott Holland, where he shares more about his experiences and expertise in financial due diligence.

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Mundane Millionaires: Full Episode with Elliott Holland

Listen to or watch the full episode today and please leave us a five-star review on your favorite podcasting platform!

Listen to Mundane Millionaires Now!

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Disclaimers

Now for a few required disclaimers. Sorry in advance!

1. This course is being presented strictly for educational and informational purposes and not for the purpose of marketing any legal services or seeking legal employment and is not motivated by pecuniary gain.
2. The opinions stated in this course from the authors represent the opinions of such individual authors and not the opinions of any other person or organization.
3. Nothing contained in this course or otherwise from the authors hereof is to be interpreted as legal, financial, tax, investment, and/or any other form of advice. Please consult your own legal, financial, tax, investment, and/or other advisors.
4. The authors are not your lawyers, and no information provided in the course of this class or otherwise has the effect of forming an attorney-client relationship between you and the authors. In short, get your own lawyer!
5. This course is being presented by The SMB Center LLC and has no affiliation or relationship with SMB Law Group LLP.

About the Authors

Eric & Kevin, the authors of this masterclass, have worked for some of the most elite law firms in the world.

During their time in BigLaw, they regularly worked on transactions in the hundreds of millions to billion-dollar-plus range for some of the most recognizable companies in the world and have extensive experience with M&A.

The authors have since begun investing in select SMB acquisitions and have co-founded an SMB-focused law firm where they’ve collectively worked on billions of dollars in SMB-focused M&A.

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