You have found the target – now what?
The initial stages of the transaction have been completed and, following a preliminary evaluation of the target, a price has been agreed in principle with the founders. However, whether or not the deal actually goes ahead and what the final price will be is subject to due diligence. You know that due diligence is usually undertaken for traditional ‘bricks and mortar’ businesses but this is a start-up company and you are unsure what value a due diligence exercise will have. Equally, you have concerns that it could delay the process and may allow other investors in.
How long will it take?
Traditionally, due diligence has been carried out over a number of weeks or even months, but such timescales are not feasible in the internet age when everything must happen at speed. However, with the dotcom fallout being reported on every business page, the need for proper due diligence has never been greater and it is a foolhardy investor who proceeds without further investigation.
What is the point of due diligence?
In all cases, the primary objective of the work is to confirm the reliability of the information provided and on which the investment decision has been based. To put it simply, are you buying what you think you are buying? Any change in these preliminary assumptions may have a significant impact on the pricing, or may even question whether to proceed at all.
Who should do the work?
The due diligence exercise will usually be a combination of operational, financial, legal and commercial teams, sometimes involving the use of external resources. In selecting your external advisers you need to have identified your key requirements. For example, if the target is regionally based, then you need to be comfortable that they have sufficient local resources to cover the different locations.
Setting the scope
A key difference between a start-up and a more established business, when considering the scope of due diligence, is the lack of track-record. So whereas traditionally you may have been valuing businesses looking at cash flows and maintainable earnings, there may also be the need to evaluate non-financial information.
Traditionally a buyer may seek to protect himself by obtaining warranties or indemnities, but these will be difficult to enforce or of little value if the guarantor has no real assets. Again, in setting the scope for the due diligence work, it is important to isolate those areas which will have an impact either on the valuation or on the overall assessment of whether to proceed with the transaction and not to waste time considering information which is irrelevant.
So what information is important? To assist in your assessment of the business, consideration of the following key areas would be a good starting point:
- The people: For many start-ups this is the key to the business and you will need to ensure that the right staff are locked in for a period of time. Often in such ventures they will have outside interests which you need to understand and assess if these will cause difficulties in the longer term. There may be related parties which will also impact the underlying results if transactions have not been undertaken at arm’s length. For example, the business may be operating from rent-free accommodation or the equipment may be owned by the founders rather than the company itself.
- The financials: While financial information may be limited, it should not be overlooked as it will often throw up anomalies that need to be investigated. Questions that need to be asked include, who are the auditors and what is the finance team like in terms of experience? Have all transactions been recorded? Is there an over-reliance on suppliers or customers? Is there any committed expenditure which the new owners should be aware of? You may need to understand the impact of how the financials would look under US rather than HK GAAP (particularly important if you are thinking of a US listing).
- The market: The preliminary assessment of competitors and the size of the overall market need to be challenged. The particular technology and other operational factors should also be considered and benchmarked where possible.
- Taxation and regulatory: There may be structuring issues to consider, particularly if this is a cross-border transaction. Examination of compliance issues will also be a priority to ensure that no hidden contingencies are likely to arise post acquisition. Regulatory issues are likely to be significant if the target has a material PRC presence.
While the above list is by no means complete, it does highlight some of the key areas where issues arise, in particular when dealing with a start-up venture, but which are equally applicable to a more mature business. Time spent in performing such due diligence is rarely wasted and, at worst, will still provide useful additional information. Ultimately, it could prevent an incorrect investment decision.
Katy Briggs, partner, Transactions Services, PricewaterhouseCoopers. Email: [email protected]
