Until fairly recently it was standard practice for private equity groups to begin due diligence processes after executing a Letter of Intent (“LOI”).

The LOI generally signals the beginning of a lockdown period during which time the buyer is given exclusive rights to examine a potential purchase without any other possible buyers being involved.

But the exclusivity is only for a limited period only (often only 90 days, subject to extension), and if issues or roadblocks arise during that time, there is a risk of losing a deal and incurring significant transaction costs that you cannot recoup.

New thinking, new methods

Consequently, a modern approach to the buying process is to begin with some serious preliminary due diligence before submitting an LOI.

Preliminary due diligence is an informal and relatively inexpensive process that establishes the basis for a potential purchase. The process will show if the seller is serious about the sale and allows the buyer to discover why the seller is selling, understand the financial health of the company, derive the worth and price (two very different things) of the company and whether the personalities involved are the kind of people you can do business with. High-level preliminary due diligence will also highlight any potential red flags that might surface and be problematic during the purchase or cause a buyer to decide not to submit an LOI at all.

A stigma that buyers want to avoid is that of retrading every deal after an LOI. While diligence adjustments may arise that warrant an adjustment to the initial proposed price, applying some pre-LOI diligence may result in a bid that a buyer is more comfortable with, possibly avoiding contentious discussions that arise when proposing a purchase price adjustment.

Follow the money

Preliminary high-level due diligence needs to be done up front and should commence with a limited, but thorough accounting and financial analysis. There should be a review of key documents, notably a profit & loss statement, a cash flow statement, a balance sheet, and a statement of retained earnings. Those are the basics, but it’s also vital to look at the overall performance of the business by studying historic trends and consistencies in the company’s recent performance. Depending on the nature of the company being investigated, it might be valuable to examine the accounts receivable, inventory and the value of land, buildings and equipment. Also use this as an opportunity to understand significant undisclosed pro forma activity (possibly having positive or negative consequence).

Also understand how the company has marketed and differentiated itself. Check out previous marketing tactics and strategies and analyze how that affects potential viability and profitability. There should also be some broad customer analysis looking at profile, demographics and local competition.

It is highly recommended to perform a site visit with the company. If a key central location exists, bring an expert, to ensure the basic systems—electrical, water, plumbing, heating and air conditioning—are in good working order and will not need to be replaced soon.  Hopefully a seller already has available a list of significant capital improvements that a buyer will likely need to make to continue operating the business.

Personality matters

If all those areas of research look positive, then a management interview is a fitting end to the preliminary process. Ahead of any in-person sessions, take some time to assess the workforce and related costs. How many employees are there? What is the management structure? What benefits are offered? How qualified and experienced are the employees?

Finally, the interviews and meetings allow the buyer to witness the culture of the company, to evaluate the reasons for the sale and get an overall sense of whether this company fits with the buyer’s vision and long-term goals. If a seller indicates they plan to exit the business right after a transaction, the buyer should assess whether the seller is integral to the continued performance of the business, and if the buyer has a capable individual to backfill the seller’s role. These factors could have a significant impact on prospective earnings, and ultimately purchase price.

More time and effort devoted to preliminary due diligence will generally result in a more streamlined process post-LOI. It will help build a solid working relationship with the seller early in the transaction process, possibly provide an advantage over other bidders in the sale process, and lead to fewer failed transactions and purchase price adjustments.

Video: The Importance of pre-LOI Due Diligence

I always recommend that as a buyer that you really understand the type of entity you’re acquiring before you even go into signing an LOI and getting involved in that process because what that does is it allows you to include any necessary language in the LOI as to whether you’re going to do an asset or a stock deal.

It also allows you to potentially adjust purchase price. If you’re going to see that you’re not going to get any benefit of a step-up for tax purposes, then maybe you want to come in at a lower purchase price, so it allows you to do that on the front end. And it also just helps kind of reduce the amount of surprises for both buyer and seller throughout the process.

For a buyer, an asset acquisition is generally the best answer from a tax perspective because that’s typically going to give you a step-up for tax purposes. Sometimes a stock acquisition is required, especially in the healthcare sector when you have to maintain that provider number. It is difficult to receive a step-up for tax purposes if you’re buying the stock of a C corporation. I would encourage you to get your tax accountants and tax attorneys involved very early in the process to help potentially structure around that. I would also encourage you, if you are planning on paying additional purchase price, to get a step-up to model that out, see what it looks like. Because depending on how long you’re planning on holding that investment, it may or may not be worthwhile to try to pay extra for the step-up.

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