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What Are Due Diligence Tests?

By Generational Equity

due diligence test

Over the years we have talked a great deal about due diligence and its importance and impact on deals actually closing. As one of our clients described to me, “The easy part of the M&A process is getting to the letter of intent (LOI). The hard part is once you have the LOI, getting through due diligence…and due diligence was incredibly time consuming.”

His perspective is not unique. Based on post-deal close interviews I have conducted, the sentiments are the same: Be prepared to work really hard for 3-4 months after the LOI.

Today I’m drilling into the due diligence process and looking at one of the many “tests” that buyers are now requiring before a deal actually closes. As you can imagine, as a deal gets closer to completion, buyers need to be assured that the assumptions they have made about the post-close financial picture of the company will be accurate.

To ensure this, since they are usually using your latest quarterly financials as their guide, they often ask for last-minute updates of key financial items to run these tests. One test that is becoming more frequent is called a “net working capital test.”

Here are some actual instructions from a buyer we are dealing with regarding what they will require us to deliver on behalf of our client prior to close:

The Purchase Price contemplates that the Company will deliver working capital at closing to adequately support its operations. Accordingly, the final documentation will include a net working capital test (“NWC Test”) structured with the intent of delivering, at closing, net working capital levels required to support the business in its current form. We contemplate that net working capital will be defined as current assets minus current liabilities of the Company as described in the Company’s financial statements, calculated in accordance with GAAP.

Current assets will include Accounts Receivable, and Other Current Assets. Current liabilities will include Accounts Payable, Accrued Liabilities and Other Current Liabilities. For purposes of the NWC Test, any asset or liability excluded from the Transaction (i.e. cash & equivalents, current maturities of debt, shareholder/related party loans etc.) would, likewise, be excluded from both the NWC Test and the targeted net working capital. The NWC Test would also exclude any accounts related to income taxation or shareholder loans, if any. The NWC Test will be structured as NWC relative to a band of values, with the Purchase Price being reduced on a dollar for dollar basis if NWC is below the targeted band and the Purchase Price being increased on a dollar for dollar basis if NWC is in excess of the targeted band.

Key Takeaways

OK, two items stand out to me from these specific instructions. First, you can see how important it is to get the data for this test correct because it will have a direct impact on the value paid for your company. If any of the items outlined above are not accurate, and you overstate or understate your NWC, you could be facing a difficult situation post-close.

Secondly, and most importantly (especially if any of these items listed are unclear to you), you really need the guidance of an M&A professional to escort you through due diligence because this is ONLY ONE of many financial tests buyers may perform before closing.

If you are negotiating a deal on your own and you are learning how to do so on the fly, be ready for some hiccups as you work through due diligence and face tests like this one. Although the concept of a NWC test is not hard to fathom, the details of getting it right can be a challenge for many non-CPA business owners.

That is why we encourage business owners who are contemplating an exit event to create a team of M&A professionals to navigate the M&A waters. This not only should include an M&A advisory firm, but we also believe a CPA, an M&A attorney, and a wealth manager are key parts to this crew. This is how Brad Whitlock, an experienced M&A attorney described it to me a few months ago:

Of course M&A transactions close every day having no professional representation on either side of the deal. However, if you want to close a deal with an optimal buyer and have a deal structured that to your advantage, honestly, you will need guidance. Don’t be cheap; hire a team, get help, and allow them to work for you. You have invested too much sweat equity into your business not to do so.

If you are interested in learning more about due diligence and financial tests, please give us a call at 877-213-1792 or provide us with your contact information on our website. We hold complimentary, educational, exit planning seminars throughout North America that are full of great information to help you be prepared for issues like NWC tests.

Carl Doerksen is the Director of Corporate Development at Generational Equity, part of the Generational Group.

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