All transactions carry risk, but on small deals the impact of that risk can be disproportionately high relative to the deal value. Ask yourself: would one undiscovered issue cost more than the financial due diligence fee?
That is why financial due diligence is so valuable.
What is financial due diligence?
Financial due diligence identifies and quantifies risks, enabling buyers to mitigate or reduce these, either by renegotiating the purchase price, adjusting the deal structure, or securing appropriate indemnities or warranties. However, issues identified in due diligence can be significant enough to cause the buyer to pull out of the transaction, demonstrating the importance of due diligence.
The challenges of financial reporting in owner‑managed businesses
Small, owner-managed businesses typically prepare unaudited financial statements and often lack regular, reliable management accounts. Financial systems, processes, and controls might be unsophisticated, and finance teams can be disorganised.
How weak controls and poor reporting inflate valuation risk
Weak financial reporting increases the risk that EBITDA is misstated. Personal expenses, misclassification of costs, one off income, related party transactions, and customer concentration can materially impact business valuation. The true extent of these may be hidden during initial negotiations, but due diligence brings them to light and quantifies their impact.
Quality of earnings: validating true business value
Financial due diligence validates the value of the business by providing an accurate quality of earnings assessment and identifying adjustments to be made in the enterprise value to equity bridge.
How due diligence findings strengthen negotiation power and structure business acquisitions
Issues identified in due diligence can help:
- Reduce purchase price
- Adjust normalised working capital or completion mechanism adjustments
- Strengthen warranties and indemnities
- Negotiate favourable deal structure terms (deferred consideration or earnouts)
At Mercer & Hole, we take the time to understand the requirements of each individual client, make recommendations of what we think is an appropriate level of due diligence considering risk, valuation, deal structure and sector, and provide a tailored, deal specific scope of work for business acquisitions.
Ensuring risks are reflected in the final deal
After due diligence is complete, we work closely with clients through to deal completion to ensure that issues are appropriately reflected in warranties, indemnities, or the deal structure.
We try to find commercial solutions to the issues uncovered, but some issues cannot be mitigated through negotiation. As a result, we are seeing an increasing number of transactions fall through because the risks identified during due diligence are too significant for buyers to overcome.
Common issues uncovered in small business due diligence
Recent due diligence findings uncovered by Mercer & Hole that have materially impacted transactions include issue in relation to:
- The lack of robust stock system
- Unrealistic cashflow modelling
- Insufficient tax compliance
How financial due diligence reduces acquisition risk and improves deal value
On most transactions, investment in focused financial due diligence pays for itself by preventing overpayment, uncovering risks and strengthening a buyers’ negotiation position. Mercer & Hole’s Corporate Finance team tailors the scope of work to the client’s risk profile, timescales, and budget, delivering clear findings and recommendations that can be used to make informed decisions.
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