Business Acquisitions: A Deep Dive into Due Diligence

2^nd installment of Navigating M&A from Pre-LOI to Close.

1. What to Expect Leading up to an LOI
2. Business Acquisitions: A Deep Dive into Due Diligence
3. Nearing Close, Now What? Strategies As You Approach the End of Diligence and Negotiations

Blog by Ben Greenberg, VP of Corporate Development at IT Solutions

If you’re considering M&A initiatives or navigating the challenges of growing your MSP, we invite you to connect with Ben and explore our M&A resources.

Congratulations! If you’ve signed a letter of intent (LOI), it’s a significant accomplishment any businessperson should be proud of. However, it also means you’ve kicked off an intense phase of detailed diligence. Although seller preparedness matters, the efficiency of this process is typically reliant on the buyer’s sophistication; therefore, it’s important that a seller understands the buyer’s detailed diligence plan prior to signing an LOI.

Key Diligence Workstreams:

• Quality of earnings evaluation
• Operations and technical reviews
• Tax diligence
• Legal due diligence
• Cultural fit
• Insurance and employee benefits review
• Functional specific discussions

Let’s dive into a few.

Quality of Earnings

You will want to closely examine revenue generation to assess the quality of earnings (QofE). This is a process to remove any distortion in financial figures due to various accounting methods or one-time events to more accurately reflect run rate operations. A QofE should be completed by a reputable third-party accounting firm.

Various factors can impact the quality of earnings, such as:

• Revenue recognition policies: Are revenues being properly deferred for multi-year contracts or recognized upfront?
• One-time or owner expenses: Are there any clear one-time expenses or owner-related expenses that would not be part of a future business?
• Operating margins: Are margins increasing through legitimate operational improvements or short-term cost-cutting?
• Organic growth: Is growth coming from new customers or services or mainly acquisitions?
• Capex spending: Is technology and infrastructure spending sufficient to support growth?

This is just a short list of many, but each factor will impact whether earnings are sustainable. These facets may also provide insight into potential opportunities for future expansion.

Legal Due Diligence

Legal due diligence considers any legal obligations or requirements. Areas to review include:

• Client agreements: Understanding terms, obligations, consent requirements, length, auto-renewal, and termination. This should include top clients and any large recent or upcoming renewals.
• Vendor agreements: Reviewing vendor contracts to assess costs, relationship terms, exclusivity clauses, minimum purchase requirements, or other commitments.
• Intellectual property: Assessing IP registry and documentation to ensure ownership and transferability of any internally developed software, trademarks, or patents that would be considered key assets.
• Compliance: Assessing compliance of internal processes and controls with any relevant regulations for data protection, privacy, cybersecurity, or other areas that could impact MSP performance or reputation.
• Employment matters: Examining any employment contracts, bonus plans, restrictive covenants, or equity compensation commitments to understand future liabilities and compliance with local laws.

You will also want to pay particular attention to potential litigation, especially if it involves clients, partners, or employees. You need clarity on potential risks and should take them into consideration when negotiating final terms. For example, if there is pending litigation, you may want to pursue indemnification from the sellers.

Functional Specific Discussions

In-depth discussions with functional leaders from the business will help you assess capabilities and risks while simultaneously helping build your integration plan. Examples of areas to probe include:

• Technology: Infrastructure and roadmaps to ensure sufficient capabilities and alignment with growth plans.
• Operations: Processes, tools, and staffing models tied to service delivery.
• Sales & Marketing: Sales pipelines, cross-sell ability, sales processes, and marketing team structure and role in broader organization.
• HR: Talent and organizational structure, compensation strategy, employee handbook and benefit alignment, key influencers, as well as potential attrition concerns.
• Finance: Who’s responsible for day-to-day bookkeeping, tax strategy, and budgeting process? It is best to bring your CFO or controller in on the QofE process to get ahead of any unique accounting methods and understand adjustments.
• Customer Success: Customer onboarding and support model, expansion and retention capabilities.

The goal is to probe the capabilities needed to execute future plans across these functions. This builds confidence in the growth strategy and helps develop an integration plan to leverage strengths or address gaps. Nobody likes a surprise on day one.

Cultural Fit

Employee dynamics will play a crucial role in acquisitions. There must be a cultural fit among employees who share similar core values. When operating systems and core values align, it creates fertile ground for continued growth.

Employee engagement surveys are a good way to get a handle on culture. If there are concerns, you need to know about them sooner rather than later.

Confirmatory Diligence

As negotiations on the definitive agreements wrap up, confirmatory due diligence is done to validate no major changes have occurred since the initial review that could impact deal assumptions. This provides assurance before officially closing the deal.

Key areas to probe include leadership changes, new legal or compliance issues, customer churn, employee attrition, or changes in revenue projections. For instance, loss of major customers since the initial due diligence could substantially impact revenue forecasts moving forward.

Finalizing the Acquisition

No matter how much due diligence you do, there will still likely be things you uncover once the acquisition is complete. However, walking through the key phases and being detail-oriented in your approach will not only help mitigate risks and surprises but also allow you to develop a detailed integration plan prior to the transaction closing.

Once the deal is done, it’s time to get to work and grow the company together.

The IT Solutions Advantage

At IT Solutions, we pride ourselves on our thorough and meticulous due diligence process. Our experienced team ensures a collaborative approach between buyers and sellers to ensure a comprehensive understanding of all operational and cultural aspects, fostering smoother transactions and higher deal certainty. Trust IT Solutions to guide you through every phase of the acquisition process with precision and expertise.

Whether you’re looking to confidentially discuss exiting your business or strategies to foster growth through acquisitions, we invite you to connect with Ben Greenberg, VP of Corporate Development at IT Solutions.