Opening the Books – Preparing for Due Diligence

Any business owner seeking to raise capital must inevitably ask a simple question. Will my funding proposal represent an attractive proposition to lenders or equity investors?

It’s a question that is often the precursor to a series of steps that will ultimately create a better business. A requirement for additional finance forces a change of perspective. When running a business day-to-day, the attention of the owner tends to be focused on immediate priorities, such as winning new customers and managing cash flow. But once you need to think in terms of borrowing or selling shares, you begin to see the company as investors see it – and in terms of what they are looking for.

The due diligence process plays a major role in ensuring that investors have the information they need to weigh risk and opportunity. The helicopter view is that lenders – whether banks or individuals working through P2P and private debt platforms – require assurance that a business will be able to meet its repayment requirements. On the other hand, equity investors are looking for growth. As such, any business seeking funding must be prepared to undergo extensive and comprehensive due diligence.

So what should businesses expect and how can they prepare?

Preparing For Due Diligence

In preparing for due diligence, company owners (or managers) must ensure that they have all the information that potential investors require.

This not only includes accurate figures on turnover, profitability and cashflow, but also some (perhaps) less obvious information. For instance, it is necessary to confirm the ownership not only of the company itself, but also the key aspects of the business, such as vital intellectual property or the right to sell or market products supplied by third parties.

Those carrying out the due diligence process will also scrutinise past debt obligations, legal documents for the company, and valuations of relevant assets. It is helpful to get key business information like this prepared in advance of seeking funding as most investors will need to comb through it carefully before making a decision. 

Questioning Assumptions

As such, the prospect of the due diligence process should prompt owners and managers to take a cold hard look at the assumptions on which their current business plan is based. From the inside looking out, it can be tempting to take an overly optimistic view of things, such as the size of the market, sales projections, expected profits, and growth opportunities.From a lender’s perspective, an overly-optimistic sales projection that proves to be unfounded is likely to impact the borrower’s ability to honour a repayment schedule. Thus, even before approaching an investor– of any kind – it is important for companies to carry out “whatif” analyses, based on best-case and worst-case scenarios.

Clarity of Purpose

Accurate and up-to-date figures combined with realistic assumptions will help build the credibility of a borrowing company in the eyes of investors.

But is also vital that the business plan – as it relates to the capital required – is clear in terms of how the money will be spent and why it is needed. This will often relate back to projections. For instance, if the money is to be used to bring a new product to market or provide equipment that will increase production capacity, then the business must be able to make a strong case that a market exists and that the return will justify the investment.

A business should also be prepared to answer questions about the past. For instance, there are very few businesses that have not had to cope with bad years, perhaps resulting in redundancies or temporary struggles to pay suppliers. Historic problems are not necessarily deal breakers, and (for some lenders) evidence that management has successfully overcome difficulties by making hard but necessary decisions can be a plus. With this said, businesses must be prepared to be honest and open because it is likely that any past issues will come out of the woodwork through the due diligence process.

Due diligence professionals may also want to know about the businesses vulnerabilities – for example, a high level of customer turnover or over-dependence on a key member of staff. Again, these issues should be thought about in advance and addressed honestly.

Security

Finally, it is important to audit the assets that may be required as security by lenders. A professional valuation is necessary to determine the genuine market value of the asset.

Any comprehensive due diligence process will involve database checks as well as personal interviews. It is, by necessity, a thorough process.

Put simply, the preparation processes requires rigorous focus on the quality of the business plan, and a willingness to address potential vulnerabilities or assumptions according to market realities. The good news is that, in preparing to face scrutiny, owners often take some important steps towards creating businesses that will be not only investor-friendly, but also more generally stable and successful.

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