The letter of intent is the easy part of your acquisition. But watch it all slip through your fingers when due diligence reveals a customer concentration problem, and your buyer walks away. The deal that looked set on day one didn’t have a chance once the liabilities accruing in the background came to light.
This guide walks through due diligence the way our clients are walked through it: financial first, then tax, with the red flags that end deals flagged along the way.
Why is Due Diligence an Accounting Problem?
Due diligence starts with a spreadsheet. First-time buyers assume it’s a lawyer’s problem, but it stems from the production floor.
Financial due diligence is a comprehensive review of the target company’s financial records, statements, and projections. With this, you’ll have a clear picture of your business potential and the stability that everything else gets built on.
For a manufacturer, that potential is measured in more than revenue. It includes the condition of the equipment on the floor, the age of all fixed assets, and whether the accounting system’s numbers match what a buyer’s team observes during a plant walkthrough
Due diligence takes different forms, and each answers a different question:
- Commercial: Does the business’s equipment, supply chain, and customer base support the growth story?
- Legal: Are contracts, permits, and records in order?
- Financial: Are the numbers on the statements real, and do they hold up under independent review?
- Tax: What exposure may exist, and could it remain or transfer to the buyer?
Acquiring a manufacturing business is a capital-asset deal as much as an earnings deal. The machines, facilities, inventory, workforce, and operating processes are central to the business’s value. Each carries risks that don’t show up in a clean P&L.
You don’t want to get the numbers wrong in your financial due diligence, or all downstream decisions like price, structure, and risk will be impacted. Buyers generally won’t want to inherit losses they didn’t price into the deal.
Why Due Diligence Matters for Mergers and Acquisitions
Every company considering a sale should expect the buyer to run a financial analysis before officially committing. They will want to understand future growth potential, how the business is structured, and what current practices look like on the floor.
During mergers and acquisitions, the type of due diligence performed gets more specific.
- Hard Due Diligence: Focuses on EBITDA, aging of receivables and payables, cash flow, and intellectual property. These are the traditional due diligence activities.
- Soft Due Diligence: Studying a company’s culture, management, and workforce, essentially the behind-the-scenes factors that impact customers and operations.
All of these will raise questions, and a seller should be able to answer them. Your role is to be transparent and validate your company’s value with documentation.
A review should not become a source of renegotiation. Sellers who do this work in advance tend to see the benefit reflected directly in the outcome.
Read more about how to prepare your manufacturing business for a sale.
What a Financial Review Should Cover
The review should cover the target company’s financial records, statements, and projections in full, but the specific mechanics matter the most.
Buyers should verify every claim the seller makes by reviewing three to five years of financial records, tax returns, and legal documents. Confirming the business’s true value and uncovering hidden liabilities is largely the buyer’s responsibility, not the seller’s.
Specific checks may matter more than the rest:
- Reconcile or sample deposits to reported revenue for the trailing year
- Review the capitalization policy for fixed assets, asset capitalization can play a big part in EBITDA calculations.
- Scrutinize every EBITDA add-back, including owner compensation, related-party rent, and expenses labeled “one-time” that repeatedly occur.
- Stress-test the business to understand how far revenue and margin could fall before the business could no longer cover its obligations.
- Check working capital needs against seasonality. Manufacturing businesses often carry uneven cash conversion cycles tied to production runs.
- Verify equipment condition and inventory valuation. A plant running near full capacity needs capex to grow. Tie the fixed-asset register to a physical floor walk and budget for the next one to three years.
A financial review determines whether the earnings are real. But it does not, on its own, answer whether the tax position behind those earnings is clean. Sellers can take steps in advance to prepare for the buyer’s valuation to help the deal move one step closer to being signed.
What Does Due Diligence Preparation Look Like?
Preparing for due diligence should take the same amount of care as preparing for your business sale in the first place. This is your chance to show your company’s true value and support a successful close.
Make sure every aspect of your business is clean and prepared, starting with this list.
- Organizing three to five years of federal, state, and local returns, including any elections filed for.
- EBITDA, Valuation report, or Quality of Earnings review.
- Evaluating and reducing customer-concentration risk.
- Key employee analysis
- Audit history, including findings of prior examinations.
- Escrow protection where risk exists.
- Net operating losses and credits.
- Correspondence with taxing authorities, along with payroll, sales, and excise tax compliance documentation.
More than protecting against penalties, a clean tax file can remove the most common reasons a deal gets re-traded in the final weeks before closing.
The Business Acquisition Risks of Not Conducting Due Diligence
The underlying problems don’t disappear when diligence is skipped or rushed through to meet the deadline. Instead, these problems may become the buyer’s responsibility or reduce the value of the transactions.
The scale of the risk is larger than most business owners expect. Shortcutting the process shows in a few recurring forms:
- Valuation distortion. A buyer who accepts the seller’s numbers without independent verification is pricing the deal without facts.
- Inherited liabilities. Environmental exposure is a clear example in manufacturing. A Phase I ESA site inspection identifies potential. A Phase II should be completed before any binding commitment to avoid inheriting undisclosed liabilities. The advisor risks assuming past liabilities, open work orders, and compliance flags.
- Post-closing litigation. When problems surface only after the deal closes, the dispute usually lands in court instead, running for years and costing more than the transaction itself was worth.
- Culture integration failure. Whether existing labor agreement terms carry forward depends on deal structure, which can be especially tricky if there is a union involved.
- Key personnel turnover. The workforce being intact can add real intangible value to a deal, losing a key player can be a domino or an exponential value driver for the organization or operation.
- Tax exposure. Worker misclassification and uncorrected retirement plan issues rarely show up in a quick review and can produce liabilities later.
Taking measures to mitigate issues before the due diligence process occurs is only a modest expense compared to what the above risks can cost later.
How an Ongoing Partnership can Help
The purpose of due diligence is to identify risks and determine how they should be addressed in the transaction. Every item uncovered should translate into a concrete term in the purchase agreement: a price adjustment, an indemnification clause, an escrow holdback, or, where the finding is serious enough, a walk-away right.
Buyers walking away from risky deals avoid inheriting liabilities that show up years after the deal closes. When you work with the right team throughout the process, you can better prepare your business for an acquisition and avoid unintentionally hiding red flags.
At MBE CPAs, we’ve walked manufacturing business owners through both sides of this process. If you’re preparing to buy, sell, or simply want to understand where your business stands, we’re glad to talk through what a clean diligence process looks like for you.