The Purpose of Financial Due Diligence: Understanding the Value of a Target Company

Financial due diligence (usually referred to as “FDD”) is a vital component of any business investment process. As a rule of thumb: the bigger the investment, so should be its FDD. But why do sophisticated investors insist on it being inherent to almost any deal? What purpose does the FDD achieve, and what is recommended to look for with regard to each purpose?

The primary purpose of FDD is to evaluate a target company’s financial health and performance, identify potential risks or liabilities, and provide buyers with information to make informed decisions in connection with a specific financial model.

During FDD, the DD team will typically review the financial statements, tax records, contracts, legal documents, and other relevant information of the target company to gain a clear understanding of the target company’s financial position. This process enables the DD team to highlight any potential issues that may impact the target company’s value and negotiate the transaction terms accordingly.

A good DD team is connected to the legal angle of the transaction. It provides an additional value to highlights and risks – and an X factor concerning the negotiation stand.

The secondary purpose of the FDD is to determine the transaction price based on target earnings before interest, tax, depreciation, and amortization — EBITDA (or adjusted EBITDA). This is often called the “Locked Box” mechanism. This method ensures that the purchase price is based on the target company’s actual performance, reducing the risk of overpayment or underpayment and providing a clear incentive for the seller to maintain performance after the sign-off and before the transaction date.

To this purpose, it is essential to make sure that the DD team is composed of people that can swiftly learn the financial results of a target company and also make a compelling case on the economic aspect of it.

The third purpose of FDD is to prepare for post-merger integration (PMI). FDD can provide valuable insights into the target company’s financial systems and operations, helping the buyer identify any potential challenges or issues that may arise during the integration process. These insights include identifying potential issues related to the target company’s financial reporting and control systems, assessing the target company’s financial operations, and identifying any potential accounting or tax issues that may arise during the integration process.

By conducting thorough FDD and identifying potential challenges or issues related to post-merger integration, the buyer can develop a more effective integration strategy and plan. This inquiry aftermath can help ensure a smooth and successful integration process, reducing the risk of financial or operational disruptions and maximizing the value of the acquisition.

The PMI purpose is usually achieved by insisting on a well-drafted and illustrated FDD report. An easy-to-read report serves as a compass for the PMI team instead of just a starting point.

To conclude, these are the main goals for FDD:

  • Assist in the valuation of a target company;
  • Determine the transaction price based on the target’s adjusted EBITDA; and lastly
  • Preparing for PMI.

It is fair to say that we are biased. We have started our firm believing that we have an added value for each of the goals mentioned above: through our legal angle; through our innovation and learning skills; and finally, through our modern way of presenting the reports, we can better help companies purchase companies.