Summary:
Funding failure of GoMechanic ! Not all deals agreed on Shark Tank happened ! Primary reason?- Financial Due Diligence ! This part of the Diligence process has been gaining importance for Investors and consequently for Businesses as well.In this write up we go through the brief aspects as to why Financial Due Diligence is required and its impact on the business.
You might have seen or heard of ‘Shark Tank’. It started in the West and very well adopted by Sony Networks in India. The first season of that was amazing and we witnessed quite a lot of deals happening over our Television Screen or OTT platform. We saw Startup founders pitching their business for a few matter of minutes and Investors (Sharks) agreeing to invest in the Startup business. But do you think it was so simple that the Sharks invested in just a few minutes of pitch?In reality, it cannot be that simple. What we could see was just approximately 1/16th of the time they spent pitching for the investment. Moreover, investments agreed by the sharks were subject to their review. This review is what Due Diligence is and the most critical side of which is Financial Due Diligence.
You won’t be surprised if it turns out that fewer than 20% of the investment pitches agreed upon on the TV network were really made. A lot of them did not qualify through the Financial Due Diligence that the Investors (Sharks) conducted.
So what exactly is Financial Due Diligence?
Financial due diligence is a set of actions that needs to be undertaken in order to ensure that a target company or a proposed project is financially sound and the risk levels are acceptable. Financial due diligence entails assessing the financial status and condition of the entity under review to confirm its accuracy and assess its overall financial health. It’s imperative to go through this process before investing your money in any company or project, as the saying goes, “One should not enter into any transaction without knowing what they’re getting into.”
The purpose of financial due diligence is to give the buyer or investor a clear understanding of the company’s financial condition and performance,competitive landscape, growth prospects as well as any potential risks associated with the transaction. Additionally, if necessary, it enables the buyer or investor to negotiate a better price or deal structure.
But why is it necessary for an Investor to perform financial due diligence?
Financial due diligence is important because it can help the investor avoid making investments in companies/ deals that are not as financially healthy as they appear on the face of it. In fact, Mr. Anupam Mittal, one of the sharks on Shark Tank India, stated in an interview that he made a few deals out of FOMO (Fear Of Missing Out) and by the looks of deals while he shouldn’t have invested into them.
While due diligence is not foolproof, it can help to prevent costly mistakes. For example, if a company’s financial statements are found to be misleading, an investor may decide not to go ahead with the deal. Or, if a lender uncovers serious financial problems, they may refuse to provide the loan. In short, financial due diligence is a critical part of any major decision-making process. It helps protect organizations from making bad investments or taking on too much risk.
Now that you know whats’ and whys’ of financial due diligence, you should be aware of the stuff that are subject to review in it.
The Sharks that we see agreeing to invest in a business on the show typically conduct a review of the company and their paperwork at the back end before actually funding.These paperwork usually includes Financial statements, Tax returns (Income Tax and GST), accounts receivable and accounts payable aging schedules, Bank statements, Credit reports, Insurance policies, Leases and contracts, Loan agreements, Minutes of board meetings and shareholder’s meetings (if applicable) and any other document as they professionally deem necessary.
Is financial due diligence required to be carried out only by the party who proposesto invest their money?
No, because each deal entered into involves two parties, and hence financial due diligence is possible from both sides.One being Buy-side due diligence and other Sell-side due diligence
1. Buy-side financial due diligence is the process of investigating a potential target that you are considering acquiring. Here, you decide whether the target business is worth more than the price you are paying. The best case scenario is that the target company’s financial position is established as sound and stable, with a positive outlook moving forward, in the acquirer’s best interests. Prior to investing in a company, it is typically carried out by an institutional investor, like a pension fund.
2. Sell-side financial due diligence, on the other hand isthe process of investigating a company that you are thinking of selling. The seller’s goal is to increase the company’s value and make it more attractive to prospective buyers. An investment banker will typically be hired by the seller to assist in this process. Here, you must decide whether the company is actually worthmore than the price you are asking for it.
Who performs financial due diligence and what are the different stages of it? Is it the business owner, or one of his staff members’? Or perhaps a third party?
Financial due diligence is naturally conducted by investment bankers and private equity firms hired by the company.The teams responsible for conducting the due diligence typically include seasoned accountants and financial analysts. They frequently employ specialized tools and methods to assist them in conducting their analysis.
Various stages involved in a financial due diligence are Pre-Screeningof Company’s Financial Statements and other publically available information, Financial Analysis that identifies potential concerns in the financial information obtained over a period of time, Operational Review that identifies efficiency and effectiveness of business operations, Analysing of Business and Financial Risks involved through Risk Assessment and at last the exit strategyplan for the investor to realize the desired gains or shield from losses in the event of business failure.
What might be the potential issues that one might run into while performing financial due diligence?
- Identifying material misrepresentations in the financial statements as financial due diligence is not an audit.
- Inadequate disclosure of informationi.e. inability to obtain accurate and up-to-date financial information.
- Requires a large amount of data analysis and can be time-consuming.
- Poor accounting practices and weak internal controls
- Lack of transparency around related party transactions
- Can be an expensive process. Because it often requires the use of outside experts.
These challenges, if improperly handled, can cause major issues in the future. For instance, if material misrepresentations are discovered in the financial statements, it may affect the target company’s valuation and jeopardize the deal. Buyers must therefore exercise caution when approaching a qualified financial due diligence expert and make sure they have a reliable process in place to identify and manage any risks.
We think we have been able to provide a crisp overview of what financial due diligence is and how it operates. We are ready to help you with our due diligence professionals and are only a few clicks away if you require any assistance with the actual implementation of due diligence for your business.
“Partnering with Execor team was exactly what we were looking for. They are much more than accountants; they provide guidance and are available to talk through decisions that impact our business.”
Results
- Execor’s solutions helped the executive team understand the financial impacts of their operational and sales decisions.
- Salient gained a holistic view of their cash flows and timing of their Series A raise.
- Our capable outsourced accounting and finance team provided confidence and stability to the executive team of a growing company.
Looking forward to how these updates will modernize processes and strengthen industry reputation!