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Manufacturing is a massive part of our economy. From cars to clothes, electronics to food, it’s hard to imagine life without it. Unfortunately, like everything else in our lives, the manufacturing industry has been impacted by the COVID-19 pandemic and the resulting shift in the labor market and supply chain disruptions. These challenges have yet to be overcome entirely by the manufacturing industry, but there has been industry growth and profit over the last year. Because of this, buyers are eager to acquire businesses in the manufacturing sector but are more thorough in their due diligence when considering a company.
Whether you’re preparing to conduct due diligence or be the subject of a due diligence review, here are three things you need to know about how the process has changed and how that may impact the value of a business.
1. What is due diligence for business transactions?
Due diligence investigations are performed before purchasing a company to ensure no hidden liabilities or problems associated with the company. This includes checking the financial statements, legal documents, and any other information that may be relevant to the purchase. Essentially, it’s a process that allows the buyer to thoroughly assess risk before making a business purchase.
“You’ll often hear a deal or an offer being presented with certain contingencies in place for that deal to get to closing,” explains Nick Fares of NEO Business Advisors. “The due diligence process is where each of those contingencies is reviewed in more detail, and then contingencies are removed as those due diligence items are addressed.”
Due diligence is a crucial part of the sales process, regardless of whether you’re the buyer or the seller. The care with which the documents and information are provided should be the same as the care with which a buyer reviews the information. Each party must be thorough and transparent in presenting or examining information as part of the process.
“Where you see more variances is in the type of industry the business is in,” says Nick. “Manufacturing firms or other organizations that only serve other businesses (known as a business-to-business or B2B organization) are going to have a different set of due diligence parameters than something that is a B2C or business-to-consumer (like a retail business, for example). There can be different permits or licenses (like a liquor license) that need to be reviewed as part of the due diligence for one business that wouldn’t be reviewed in other types of businesses.”
2. What is the due diligence process?
How do I know what I need to review?
“There’s going to be a checklist. Typically, a buyer will provide a due diligence request list when due diligence starts. The purchase agreement will set the general framework of that due diligence checklist. Often a buyer will start with an initial list and, as they start reviewing the items from that initial list, they add more items. For example, they may ask to look at three years of financial records, and in reviewing that, an item may come to their attention that makes them want to see an additional two years. So, an initial three-year history becomes a five-year. Still, they will follow a checklist.”
Who is responsible for initiating the process? The buyer or the target company?
In addition to clearly identifying the requested information, the checklist will help determine who is responsible for providing what information. In that checklist, certain items will be the buyer’s responsibility to provide or the buyer’s accountant or attorney; others will be the seller’s responsibility, the seller’s attorney, or the seller’s accountant. If there’s real estate involved, you may even have some items that rely on outside vendors (like an environmental site assessment). External service providers that are relied on for those items.
“As a broker, we facilitate the due diligence process. We act as an intermediary between all parties, the buyer and seller, buyer’s counsel, seller’s counsel, third-party vendors, etc., and help with that flow of information,” Nick continues. “We help gather the information, disseminate it to the right people, help with analysis, etc.”
“When conducting due diligence, you’ll review all financial and legal aspects of the business as well as operational pieces, searching for issues and challenges. Are there employee issues? Customer issues? Problems with the supply chain or vendors the company uses? You’ll search for and, once identified, address those concerns with the seller.”
“When looking at the last couple of years of financial history, look at things like revenue by the customer to see if there’s a big change in who the top customer is year-to-year. Maybe the top customer changes every year, rather than being consistent year after year. Identify any worker’s comp claims, whether any key personnel have left the business or have been added to the business in recent years, too. Those types of changes are going to impact the business.”
3. How does due diligence look in 2021?
“Big changes came in 2020 with COVID. A lot of things became top priorities that weren’t before. Employee change is a top concern for buyers right now. A lot of due diligence focus is being placed on employee retention. Were employees retained and working through COVID? Did employees who were laid off come back? We look at key management personnel, too. If you have a sales manager with key contacts or a production manager with 20 years of experience, those are harder positions to replace. Buyers want to make sure that long-tenured personnel are staying in those roles. They want to see that the key employees stayed in those roles through COVID and also plan to stay in those roles after the sale of the business is completed.”
“Another issue we see is financials. Again, financial due diligence is challenging because, even if they stayed open as essential businesses during COVID, many businesses still saw a dip in revenue ranging from 10% to as much as 50%. So when you are reviewing financials and seeing that drop in revenue, you have to ask many questions and truly understand what caused it. What caused the dip in revenue? Which customers was it associated with? Has that recovered in 2021? Is it going to recover going forward? If so, how and how fast?”
“The other component that’s a wildcard in financials right now is the government funding that came out of the CARES Act,” details Nick. “We saw the paycheck protection program, both first round and second round. We also saw the economic injury disaster loan or EIDL loan. They weren’t always categorized correctly on financial statements when those were first issued. Some businesses put those funds into income. Those have to be taken back out because they are nonrecurring and unrelated to the business’s actual performance. Many employers who retained employees are now getting a rebate on BWC payments, too. Basically, there are now some variables to financials in our post-COVID world that we didn’t see pre-COVID.”
These variables have changed the due diligence process, making it more difficult than in years past. This is also why Nick believes it’s increasingly important to have a professional business broker involved in the process alongside you. “We’re used to seeing it. We’ve gone through several transactions now that have involved PPP loans, EIDL grants, bureau of workman’s comp rebates, changes in personnel, etc., and have brought them to successful closings, making us more prepared to help the next business owner navigate those challenges.”
“When we represent the seller, we’re always going to do our work upfront to make sure that buyers are educated on these topics, that they know how to account for these changes when reviewing financials and the business’s valuation. That way, when we bring the business to the market, we’re accurately presenting it to a buyer.”
The same care is taken when representing a buyer. “When we represent buyers, we want to make sure they’re aware of these changes because a $300,000 paycheck protection program categorized as income could skew revenue and the valuation of a business significantly high. We’ve had cases like that. We’ve had cases come up where we’re looking at an income statement, and they’re showing a PPP loan categorized as income, and we have to educate the buyer to back those numbers out.”
“We had a company just recently where the business was brought to market at a $1.2 million valuation. The broker they were working with originally had the income miscategorized, so a business doing $100,000 in cash flow looked like it was doing $400,000 in cash flow. Fortunately, we were able to educate the seller on why that was inaccurately high and ended up closing that transaction for $375,000. Both buyer and seller were happy with the terms of the deal.”
NEO Business Advisors
At NEO Business Advisors, we have our pulse on the market. Because of our relationships with accountants, attorneys, and lenders, we can see the broader picture of what’s happening in the market across industries, competitors, customers, and the supply chain. Now, more than ever, we’re here to use that knowledge and experience to help our clients navigate the unique challenges and obstacles of valuation and due diligence in a post-Covid world smoothly and successfully. Contact us today so we can put our expertise to work for you.