What You Need to Know to Pass Financial Due Diligence Easily

Hey there. I’m Pierre of Horizen Capital. I specialize in financial due diligence for buyers and sellers, helping them close with confidence and walk away from deals happy.

When selling a business, you need to prepare for financial due diligence to sell at your preferred price and terms. A little work now will save you headaches later. 

I often compare financial due diligence to buying a house. While visiting will give you a sense of whether you want to buy it, you’ll usually hire an expert to check everything from the pipes to the electrical wiring to ensure you’re getting a good deal.

You wouldn’t want to buy a house that later collapses around you. And buyers don’t want to acquire a company that loses money or can’t earn a return. 

If you want to sell your business, you need to prove to buyers your numbers are credible. I’ll explain how in this blog, but first…

What Is Financial Due Diligence?

Financial due diligence is where a buyer or their representative verifies and validates your company financials before acquisition. They’ll check the authenticity of your numbers, explain trends, and check for any red flags that suggest the business is not what it seems.

While that might sound like an audit, it’s a bit more than that. It’s not simply verifying and explaining every line item in your profit and loss (P&L) statement, for example. More, financial due diligence explains – in accounting terms – how your business went from A to B. 

Why Is Financial Due Diligence Important?

Financial due diligence is important because it helps justify your asking price. Many buyers calculate your valuation by running a multiple on your EBITDA, revenue, or some other metric. If they can verify the story told by your numbers, they’re more likely to apply a higher multiple. 

If they can’t verify your financials or the story doesn’t match the one you’ve told them, they’re likely to push for a lower valuation or might even walk away from the deal. Financial due diligence is, therefore, just as important to you as it is to the person acquiring your company. 

Financial due diligence verifies that your company and financial stories match. Not just in the accuracy of your numbers, but how they’ve changed over time and might change in the future. It helps buyers forecast performance to derisk the acquisition and ensure they’ll earn a return.

Are All Buyers Interested in Financial Due Diligence?

Yes, you’ll probably encounter some financial due diligence regardless of the buyer. 

Strategic buyers might be less worried about your financials and more interested in your people or technology, for example. Financial buyers, however, need reassurance that they’re feeding accurate numbers into their pricing models and your story is credible.  

What Is the Purpose of Financial Due Diligence in Acquisitions?

Checking for Red Flags

The first purpose of financial due diligence for buyers is to reveal any red flags to avoid nasty surprises later. They want to ensure nothing strange is going on, or if there is, to flag it early so they can decide whether it’s still worth pursuing the acquisition at the same price and terms. 

Example Red Flags During Financial Due Diligence

1. Loss of a Large Client 

One of a seller’s biggest clients leaves or a large, multi-year contract is due to end soon. Typically, this will negatively impact revenue and shouldn’t be included in the financials.

2. A Close Relationship Between the Seller and Clients 

If, for example, the seller and their clients were old school friends, those clients might not continue to use the services once the buyer acquires the company.

3. Data Manipulation or Accounting Tricks to Mask Problems 

While every seller will present their accounts in the best light possible, some are too aggressive, going beyond international standards, which suggests foul play. For example, a company can show faster YoY growth depending on the revenue cut-off.

Making Sense of Your Numbers

The second purpose is for buyers to understand your numbers. Numbers are easy to manipulate and are commonly drawn from multiple sources. As a result, you can present and interpret numbers in different ways. Buyer due diligence will dig deep to reveal the true story.

Preparing for Acquisition

The third purpose is to prepare sellers for acquisition. For example, you might hire an advisor to do financial due diligence on your business before listing it on Acquire.com. Why? It can help identify and remove any skeletons from the closet before they become a problem. Vendor due diligence, as it’s called, can also help you negotiate a better price for your startup. 

You usually engage in vendor due diligence when attracting multiple buyers to the negotiating table. In a competitive bid, you’ll usually get the same questions from multiple buyers, forcing you to repeat the same answers. Not so with vendor due diligence. 

Instead, the analyst with spend two to three months with you to learn your books, fix issues, and then produce a report you can share with all buyers. The analyst will have asked questions a buyer asks, saving you time. And if their reputation is solid, the buyer is likely to view your business favorably having seen an objective document. 

Having a professional do financial due diligence on your business before a buyer also means you’re prepared to answer difficult questions. Rather than tell a buyer you need a week or so to investigate an issue, your advisor can answer it instantly. 

How to Prepare for Financial Due Diligence

You can prepare for financial due diligence alone or with professional help. I’m biased, but I think there’s no better way to prepare for financial due diligence than with an expert. They have the knowledge and experience to ensure you pass this acquisition stage easily. 

Ask an Advisor to Help You Prepare for Financial Due Diligence

Expert assistance comes in two flavors, described below.

1. Vendor due diligence. A financial due diligence advisor will spend one to three months with your company to conduct financial due diligence, ask questions a buyer would ask, and produce an exhaustive financial report you can later share with interested buyers. 

Since the advisor’s name or company brand is attached to the report, they need to be thorough. Expect them to pore over your financials and ask challenging questions. While demanding, remember they’re also there to help you and answer buyer questions.

2. Vendor assistance. A financial due diligence advisor will spend time with your company, commonly a few weeks to a month, and help you prepare for financial due diligence. Rather than produce a report, they’ll help you answer buyer questions, help manage your M&A process and tidy up your financials, or prepare a robust business plan ahead of your conversations with prospective investors.

Since this is a lighter form of vendor due diligence, the advisor doesn’t do everything on your behalf. Instead, they help audit and prepare your accounts, guiding you through common buyer questions and how to answer them with evidence that verifies your story.

Of course, you don’t need to hire a financial due diligence advisor. But going it alone is riskier.  Buyers (and their due diligence advisors) are usually less forgiving of mistakes. That said, as long as you’ve been organized and honest in your accounting, you can do it alone.

How to Prepare for Financial Due Diligence Without Help

Passing financial due diligence is possibly one of the hardest parts of the due diligence process (except, perhaps, legal due diligence). If you decide to prepare alone rather than with an advisor, follow these guidelines. 

Ensure Your Financial Reporting Is Accurate

Whether selling a $50 million or $5 million business, your financial reporting must be sound. Your monthly management reports and annual statements must balance with no missing line items or discrepancies. Otherwise, you’ll erode buyer trust in your numbers.

Track and Understand Your Key Metrics

For example, if you own a SaaS business, your key metrics include lifetime value of customer (LTV), churn rate, growth rate, and customer acquisition cost (CAC). Track and understand these metrics so when buyers ask about them, you’re ready to answer. 

If you say you don’t have them or you need time to prepare a report, this will reflect poorly on you and could jeopardize your acquisition. Ensure you tidy up your reporting and prepare to share these metrics instantly.

Learn What Questions Buyers Ask

Your preparedness during due diligence can send a positive message to buyers. Imagine confidently answering every question with verified data to back up your claims. What buyer would turn you down? Few, so prepare your answers in advance.

Questions will vary from buyer to buyer, but some are common to all acquisitions and you can make an educated guess for the others. The classic questions include: Who are your top ten customers? What’s your revenue per customer? Can you give me your current churn analysis?

You should be able to produce this data easily, so rather than ask buyers to wait while you gather answers, create your analyses now and update them as you go. In other words, wow buyers with your preparedness and they’ll be happy to close the deal with you. 

What Does the Financial Due Diligence Process Look Like?

You know what’s expected of you during due diligence. You’ve hopefully prepared for it, either by hiring an advisor or doing it yourself. Now you’re probably wondering how financial due diligence feels, and what the process looks like. Here’s a general overview. 

Step 1. Meet Your Auditor

On smaller acquisitions, the buyer might do financial due diligence themselves – especially if it’s a private equity group, for example, that has the right people for the job. Other buyers will hire experts and advisors to do financial due diligence for them. Step one is meeting that person.

Avoid being combative. While financial due diligence can feel like an audit, the buyer wants the deal to close. They’re simply verifying that what they’re buying is what it appears to be. Rather than be prickly or defensive, try to establish rapport with them.

Your buyer’s due diligence advisor wants the process to go smoothly too. It makes life easier for them as well as you. Your cooperation is essential. You’ll work together for a few weeks at least, and they’ll explain everything they’ll need from you during that period.

Step 2. Review Information Requests

Next is to review the buyer’s financial due diligence information requests. You might receive an Excel or other spreadsheet or link with a list of around 100 questions. The list might feel exhaustive, but if you’ve prepared well, just copy your answers and evidence to the file. 

The exact amount of questions will vary depending on the size and complexity of your business. If your company has completed an M&A transaction before, for example, your buyer will probably ask questions about that. They might want to look at subsidiaries and so on.

Most buyers and due diligence experts will assign each line item a priority indicator so you know which to focus on first. Most buyers learn a lot from initial due diligence and might not need immediate answers to questions they’re more comfortable with. Treat every line item with equal gravity, however. Mistakes, even on regular priority items, risk your acquisition.

Step 3. Management Call

Once you’ve replied to the first set of questions, you’ll normally get on a call with your buyer’s due diligence expert. The goal is for the buyer to understand what they couldn’t from your answers and evidence alone. They must know how your business arrived at these numbers. That will involve a Q&A with you and your management team to clear up any issues.

This is also the time for discussing high-level trends. For example, if the buyer’s advisor saw a drop in revenue over a couple of months, they’ll want to know why. Maybe you involve your CFO to provide additional context, and then the buyer’s advisor will analyze your numbers again to find evidence of your claims. 

Step 4. Final Analysis

This step doesn’t involve you as much as the buyer’s due diligence advisor. Now they’ve reviewed your answers, got additional context over meetings, and finished their analyses, they’re ready to produce a report for the buyer. 

Generally, this will include basic financials such as profit, revenue, and segmentation by geography, customer, and so on. They’ll also go through a P&L that explains every line item and how you got from the past to the present day.

It’s then up to the buyer to decide whether the price and terms you’ve negotiated support the financial picture their advisor has built of your business.

Common Mistakes Sellers Make During Financial Due Diligence

To make a good impression on your buyer, avoid the common mistakes sellers make during financial due diligence. Few buyers will take ignorance as an acceptable excuse.

1. Not Reconciling Your Financial Data Sources

Your audited accounts should reconcile with the management reports you receive. While that’s a simple enough goal in theory, in practice, you deal with multiple data sources – from marketing, sales, accounts, and more – that can and often do differ. 

If your accountant can’t reconcile your sales and accounting reports, for example, identify and resolve the discrepancy. Otherwise, buyers will ask why you didn’t resolve the discrepancy and improve reporting. At least mention known discrepancies to them otherwise it could harm your relationship to the point of derailing your acquisition.

2. Not Calculating Your Financial Data Correctly

Mistakes in your formulae or calculations are common. Small mistakes are easy to spot and resolve, but larger ones might need an advisor’s forensic accounting. Buyers might forgive small errors but will treat anything larger as a red flag, putting your acquisition at risk.

3. Aggressively Presenting the Data

Many sellers try to present a restated EBITDA or some other important metric to justify a higher valuation. Only do this if it’s justified. A buyer might send you an LOI on your restated EBITDA, but if you haven’t substantiated your claims, they’ll likely reduce their offer after financial due diligence, which is not a fun conversation to have. While buyers might tolerate a small amount of wishful thinking, aggressive manipulation will reveal cracks in your story, claims, and valuation. 

4. Making Claims You Can’t Substantiate

Forecast too aggressively or make wild claims you can’t provide evidence for, and you’ll fail financial due diligence. Your buyer agrees to your asking price assuming everything you’ve told them is true. If you can’t verify your claims, you jeopardize your valuation. For example, presenting a faster growth rate due to one-off purchases (not recurring revenue) is inaccurate and likely to result in a difficult conversation.

In all four examples above, buyers might revise their offer. Not only does this potentially mean less cash and harsher terms, but it creates tension in your acquisition. Psychologically, the buyer feels that you were trying to get away with something, intentionally or not, and you might not be able to rid the deal of that bad smell. Think about this when you’re tempted to cut corners or massage your numbers for a better deal. 

Need expert help to sell your business? Want to list in front of 120,000+ vetted buyers? Then create your seller account now and get end-to-end acquisition support until closing. 

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