It's astonishing to see how some buyers dismiss due diligence as a mere inconvenience and expense in the process of purchasing a business, without fully considering the risks involved. Unlike buying a house, acquiring a pharmacy entails numerous potential pitfalls, each with the potential for significant consequences. Moreover, the emotional aspect of the buyer adds another layer of complexity, as it may lead them to overlook crucial risk factors. This oversight leaves the buyer exceptionally vulnerable to unforeseen challenges.
If we revert to investment fundamentals, you are investing a certain sum of money in an asset, expecting a certain return on your investment. In the case of a pharmacy, you are investing $x million to purchase a pharmacy business based on the earnings reported to you by the seller. If those earnings materialise, all is well. But what if they are not as they appear? That's why you need to undertake pre-purchase investigations as part of the conditions of sale, to reasonably ensure you are aware of potential risk areas. The due diligence process is a key part of these pre-purchase investigations. Ultimately, though, it is up to you whether you want to proceed, but it's best to be fully informed.
It is also important you understand the motivations of the various parties involved in the process.
A due diligence simply focuses on the risk of the reported profits being overstated. Simply put, for profits to be overstated, income needs to be overstated and/or expenses understated. This brings the focus of the due diligence process mostly to these two areas. The party undertaking a due diligence then investigates the areas where errors, omissions, mistakes are likely to be made.
For example:
Income – banking deposits, customer debtors, PBS debtors, GST, timing and recognition, cash, dissecting what is sales income (Sales, professional health service income, rebates, incentives etc.)
Gross Profit – supplier invoices, GST, Trade Creditors, stock on hand valuations, timing and recognition.
Expenses – Bank payments, expense allocations, trade creditors, GST, recognition and classification, timing.
So where do we often see errors and mistakes?
1. The records are so poor that undertaking any due diligence is simply impossible.
2. Sales materially in excess of POS Sales totals with no explanation or reconciliation.
3. Gross Profit materially in excess of POS totals with no explanation or reconciliation.
4. No stock take records and unable to verify stock values.
5. Closing stock significantly higher than opening stock yet no material change in sales of stock purchase levels.
6. Unexplained significant variations in sales, gross profit and expenses compared to prior years.
7. Omission of expenses.
8. Supplier invoices not correctly recognised in the relevant period.
9. Employees paid cash and not recognised in the accounts of the business.
10. The seller has other pharmacy businesses and income and expenses incorrectly allocated between different stores.
11. The trading performance is worse than what the buyer initially realised.
We note that on some isolated occasions, we have seen some sellers and brokers put pressure on the buyer by imposing limits and restrictions on the due diligence process, particularly by limiting the reporting timeframe. So be careful here and make sure you seek advice from your accountant about the time frames. Firstly, you want the due diligence clock to start ticking only from when the seller has supplied everything the buyer and the buyer's accountants (or the person undertaking the due diligence) have requested. Some sale agreements try to commence the due diligence process from when the agreement has been signed, then take their sweet time to collate the information, giving the buyer and the buyer's accountant little time to undertake a proper due diligence investigation. Secondly, ideally, the due diligence reporting timeframe should be 28 days. Some sellers and buyers try to reduce this timeframe. Thirdly, we have seen instances where some brokers place a lot of pressure on the buyer and the buyer's accountant during this phase.
Our key advice advice:
1. Be careful. Listen to your advisors and try to maintain a level head during this phase and not be too emotional. Too excited to not see the risks, or too negative to not see the opportunities.
2. Make sure the person undertaking the due diligence investigation understands community pharmacy. This aspect is very important.
3. Make sure the timing of the due diligence clause in the sale contract only commences once the seller has supplied all information requested. And the term for the due diligence is a minimum 21 days, ideally 28 days.
4. The due diligence investigation will only highlight risk areas. It is only up to you, the buyer to decide whether you want to go ahead.
5. Do you want to the due diligence process to be a general, all-encompassing investigation, or only focus on specific aspects. It is your choice.
We have undertaken many due diligence investigations over the years, and 99% happen smoothly with no issues at all. But things do happen, and it is best that you are careful.