Financial Due Diligence for family-owned businesses: What financial investors look at closely

last updated on 22 February 2022 | reading time approx. 2 minutes

The segment of small and medium-sized enterprises, most of which are family-owned businesses, increasingly attracts financial investors. For the family-owned businesses that have become the object of sale, the sales process poses new challenges that not only open up opportunities but also entail risks. The most important prerequisite to seize those opportunities or to avoid the risks is to know which aspects are most carefully examined by the (financial) investors during due diligence.

In most family-owned businesses, the company's management consists of a few family members. Thus, the focus is on the alignment of performance-related and managerial duties of such persons. A “four-eyes principle” and key controlling mechanisms are not in place or are applied only in a basic form. This can adversely impact the validity of financial information presented in the annual financial statements. Thus, the focal point of due diligence is to verify whether such information may be regarded as reliable.

In most cases, the connections within the company may have a considerable impact on the company's success factors. Here, the personal relationships between the company owners (and especially customer relationships) and their impact on the company's success are of particular interest to investors. Investors try to estimate to what extent the company's profitability can be maintained in the absence of family engagement.

Because of close interconnections between family and business, the relations with related parties are of crucial importance. For example, it is often the case that essential components of fixed assets constitute the private assets of a family, and thus the borderline between family and business matters is not always clear-cut. This can directly affect the net assets and results of operations and may create the necessity of fixed assets adjustments. The factors that are of particular importance to potential buyers include observing the arm's length principle, business-related needs, remuneration of the family members and regulations referring to appropriation of profits. To prevent sustaining losses on the purchase price that might result from unexpected outcomes of due diligence, the seller should analyse the results of operations for such normalisation issues in advance and adjust them accordingly or prepare sound arguments for their adjustment.

Family-owned businesses occasionally have a substantial share of loan capital that takes the form of shareholder loans. What is more, shareholders often stand surety for the company and give other personal securities. Alternatively, securities are issued also for other business activities of a shareholder. When analysing financial debt, the said issues need to be addressed and solved during the transaction structuring process. Since family-owned businesses rarely have a (comprehensive) planning system in place, the plausibility and reconcilability of future net assets, financial position and results of operations are analysed with special care and are critically reviewed. Therefore, it is recommended to develop such an integrated planning system which would serve as a basis for negotiations before the transaction takes place.

Financial investors carry out very detailed and in-depth analyses in the process of due diligence. A good preparation helps the seller to maintain control over the transaction process and thus to enforce their own interests.