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Financial Due Diligence

You have selected a target business, which is a privately held business, to look at more closely for a potential acquisition. This article aims to give a brief overview of what type of data you can expect review to enable a determination of the financial condition of the business, and what figures you will use to conduct your business valuation.

In contrast to German rules, a privately held business does not need to conduct any financial (or statutory) accounting according to US GAAP for reporting purposes. The business will, of course, be practicing some form of basic bookkeeping. Most small businesses will be using a bookkeeping software (e.g. Intuit QuickBooks), which can also generate basic financial reports. Additionally, there will be tax accounts. In contrast to Germany, the tax accounts are not based off of the statutory accounts (with adjustments for tax). Tax accounting for purposes of preparing the corporate income tax return is based off of accounting rules set out in the Internal Revenue Code. The Seller may also have taken steps to prepare “normalized” accounts, based either off of the management accounts or the tax accounts.

Let us assume you have three sets of data: the bookkeeping records (with financial reports), the tax accounts (in the form of tax returns) and the normalized accounts. Depending on how orderly the finances have been kept, you should be able to make an attempt to tie back each of these three sets of data into one another. You want to tie back the revenue figures to customer invoices and you want to verify expenses against expense receipts. To make sure all the expenses have been captured in your review, you want to tie down balances to the cash balances in the operating bank account as well as check the inflows and outflows from the operating bank account. You then want to check the tax returns to make sure the information from the bookkeeping records has been accurately carried over (with adjustments) to the tax returns.

Typically, the seller gives a representation and warranty in the Sale and Purchase Agreement (“SPA”) with respect to the financial reports delivered to the buyer. The financial reports are stated to be true and correct in all material respects and that they give a fair and accurate view of the financial condition of the target. If the SPA has only documentational closing conditions, then you can define a breach of the rep and warrant as an event of default, allowing you to walk away from the deal in the event of a misrepresentation. But it is not likely that a misrepresentation in this area will be uncovered until after closing and transfer of ownership. In this case the buyer’s remedy should be explicitly covered contractually, which is ordinarily either a claim for damages or, if the damage is material enough, a rescission and unwinding of the SAP, which involves a transfer back of the business to the seller. The 2nd remedy is of course very messy and difficult to carry out in practice, since the time between the first transfer and the transfer back is significant and difficult to capture commercially and legally. Accordingly, your remedy will be a claim for damages, which is also not a great situation to be in. This is why the due diligence is your preferred method of protecting yourself. Thereafter, in practice, it is caveat emptor, despite the remedy of damages in the case of a misrepresentation.

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