What Is the Top-Down Approach to Due Diligence?

Due diligence, as applied to business acquisitions and mergers, follows a step-by-step process designed to help those involved make wise decisions. There are many ways to tackle the due diligence equation. One of them is a top-down approach that seeks to understand a target company beyond its financials.

At Mezy Inc., their due diligence services include comprehensive reports. From initial screenings to company valuation reports, they provide companies with the necessary information to move forward with their plans. They say that the top-down approach may or may not be utilized based on the particular deal being looked at.

Ownership and Management

The top-down approach begins with an analysis of company ownership and management. In the case of a small business operating as a partnership or LLC, ownership is especially important. Due diligence seeks to understand who business owners are, what their experience is, and their potential for growing and expanding the business beyond its current state.

Where corporations are concerned, the executive management team is more important. A proper due diligence analysis looks at each member of the management team in terms of past history and performance. That information is compared against what each member of the team is currently contributing to the target company.

Business Offerings

Next up are business offerings. Due diligence seeks to understand the goods and services a company offers. It seeks to analyze how those goods and services are provided, where they are provided, and the kind of value they represent to customers. Any other relevant information pertaining to business offerings is looked at as well.

Employees and HR Function

One company looking to acquire another will want to know about the target company’s workforce and HR functions. As such, due diligence involves looking at the total number of employees as compared to employee turnover. It involves an analysis of employee incentives, benefit programs, sick leave, etc. The idea is to understand the value of employee benefits in relation to their actual cost.

Cash Flow

As you might expect, cash flow is a big part of due diligence. A target company could have stellar financials in terms of its liabilities and assets. But if cash flow is limited, there may be too much risk involved. In some cases, companies like Mezy utilize something known as discounted cash flow to figure out where the target company stands.

Discounted cash flow is a complex formula involving past history, current conditions, and future estimates. It is designed to anticipate what a company’s cash position might look like down the road.

Debt Load and Taxes

From an accounting standpoint, debt load and taxes are more or less the opposite of cash flow. They suck cash out of a company’s coffers like nothing else. Therefore, it stands to reason that due diligence looks closely at both. In terms of debt load, we are talking all types of credit instruments from loans to equity financing. As for taxes, they speak for themselves.

Legal Matters

Last but not least are legal matters. It is important that due diligence uncover everything from judgments to liens and potential criminal investigations. No company looking to acquire another wants to get caught up in such things. When due diligence does turn up worrisome legal matters, the best bet is to turn and walk away.

Top-down due diligence is a method of evaluating a company starting with its ownership and working down to potential legal matters. It is not the only way to perform due diligence, but it does work well when employed properly. When inappropriate, there are other ways to perform due diligence.