How Financial Due Diligence and AI Are Transforming M&A Deals

0:00 [Music] Financial due diligence in particular is an exercise which involves comprehensive review of the financial health of a company. Quality of earnings is the crown jewel. True sustainable earnings power of a company. [Music] Today, we are diving into the critical world of mergers and acquisitions and due diligence. Focusing on how financial expertise drives deal value and mitigates risk.

0:32 The two critical areas where artificial intelligence really creates impact the interpretation. They can read through uh contract languages and identify uh a change in control clause. The second area is in their pattern recognition amongst large data sets. Invest in proper due diligence. It feels like an additional cost, but it's essentially a risk mitigating exercise.

1:02 [Music] [Applause] [Music] [Music] Welcome to the Canadian SME Small Business Podcast, where we explore the strategic financial insights and innovative solutions empowering entrepreneurs to build, buy, and optimize successful businesses. Today, we are diving into the critical world of mergers and acquisitions and due diligence. Focusing on how financial expertise drives deal value and mitigates risk.

1:57 In a competitive market, whether you are a buyer or a seller, securing investment and achieving financial clarity requires precision and a deep understanding of CFO metrics. Our guest is a highly experienced finance leader with over 19 years of global experience and a proven track record in M&A transaction services. Joining us today is Kapil Sukhija, founder at KSMC. Kapil is a Big Four alumni and an expert in M&A financial due diligence and quality of earnings reviews for deals ranging up to 30 million in enterprise value. He's also a skilled speaker and instructor for Venture for Canada's Entrepreneurship Through Acquisition programs.

2:39 Today, we will discuss the significance of financial due diligence, the key areas buyers must evaluate in an acquisition, the impact of AI on the due diligence process, and the value of turning unexpected challenges into strategic assets. Let's dive in. Kapil, welcome to the Canadian SME Small Business Podcast. How are you doing today? Very well. Thank you for having me on. It's always a pleasure to sit with business leaders and entrepreneurs. Kapil, your work is centered on M&A financial due diligence with a specialized focus on quality of earnings analysis. For many entrepreneurs, you know, like considering buying or selling, this term is critical but often misunderstood. Can you explain what a quality of earnings analysis involves and why it's a critical step in merger and acquisitions? Absolutely. Uh and I'll start with the basics. Um due diligence in particular, the literal meaning of the term is reasonable care or proper attention.

3:38 Um from legal terminology, what it essentially means is all the steps that a reasonable person will take uh before entering into an agreement or a transaction. In the M&A context, due diligence encompasses all the activities to validate and inspect uh the financials, um the operational capabilities, the uh the the environmental liabilities, the debt obligations, uh human resources, systems, uh and processes in place uh of a company.

4:12 Um financial due diligence in particular is an exercise which involves comprehensive review of the financial health of a company that is being acquired. Uh we are examining everything from revenue and cost structures to working capital needs uh and um uh historical performance trends. Um what it essentially does is it answers some fundamental questions. Are the financials accurate? What risks exist? Are the earnest earnings sustainable?

4:45 Um is the business poised for growth uh in the future? And more importantly, uh uh what is the business truly worth? Um within financial due diligence, quality of earnings is the crown jewel. It's the most critical component. Um a a the due diligence exercise primarily may encompass looking into tax obligations, debt obligations, um capital expenditure requirements. A QOE, on the other hand, basically reveals the and determines the true sustainable earnings power of a company by adjusting for one-time items, um non-recurring expenses, and accounting anomalies.

5:29 I'll give you an example. Uh imagine a company into manufacturing generating $2 million of EBITDA. Now, on the surface, it looks pretty solid. But a QOE analysis may reveal that um $200,000 came from a one-time insurance claim. Uh owner's spouse is drawing payroll but is not involved in the business. And there is critical uh equipment that that requires CAPEX but is being deferred by the seller.

6:00 Now, suddenly that $2 million looks or comes closer to 1 and 1/2 million dollars. This is important in M&A context because buyers generally pay a multiple of earnings to acquire a business. If you're paying three times of EBITDA and you've over estimated earnings by $500,000, you are you're you've overpaid $1 and 1/2 million dollars. Um that means the buyer basically is um not driving the right value or synergies from that particular acquisition.

6:31 A QOE exercise protects buyers from overpayment and helps sellers present businesses accurately leading to smoother transactions and enable fewer post-close disputes. That's a very clear explanation of how quality of earnings moves beyond, you know, like reported net income to establish a reliable baseline of sustainable profitability. Now, let's clarify how this specific analysis, you know, differs from the traditional financial review most businesses are familiar with. Many business owners, Kapil, think a clean financial audit is enough to satisfy a buyer. However, due diligence serves a fundamentally different purpose. In what ways does a financial due diligence engagement differ from a traditional audit in uncovering a company's real financial performance?

7:21 Absolutely, and that's a very good question and often misinterpreted uh by um you know, clients. Um and the context and purpose of an audit uh and a due diligence are fundamentally different. Uh an audit is generally driven by external requirements or investor needs. Uh for publicly traded companies, an audit is mandated by securities regulations. For private companies, while not mandated, audit is required in certain circumstances. Uh for example, a bank may require audited financials uh for or as a lending condition.

7:59 Um investors may need audit for assurance or governance. Due diligence, on the other hand, has a very specific context. We have a buyer and a seller and both have agreed to move forward on a potential transaction. They've agreed on preliminary terms, signed a letter of intent, and now the buyer wants to evaluate the business that is being bought before they sign the deal. Um so so due diligence is transaction focused and not compliance driven.

8:30 I'll give you an example of uh you know, what else happens in an audit which is different from a due diligence. An audit uh looks into the target's financial uh the client's financial statements and confirms or comments on whether they are conforming with accounting standards like IFRS or ASPE, which is accounting standards for private enterprises, and provides assurance on the numbers uh that are being presented, whether they are being presented fairly. Uh the due diligence, on the other hand, is addressing very key questions uh whether the business that is being bought is viable for the future uh for this buyer.

9:10 Uh whether there are you know, key risks that exist in a particular business that needs to be looked into specifically from a buyer's perspective. Um I'll give you an example. We did uh recently review uh a technology-based software as a service company with clean audited financials. Uh the audit report stated that the revenue is recorded in compliance with the accounting standards. But the due diligence exercise revealed that um 40% of the annual recurring revenue of the company basically generated from three top customers um and two of which were due for a renewal within 6 months of the proposed closing date. 40%.

9:53 Absolutely. Uh so um an audit didn't flag that as an issue. Um, but, uh, for a buyer, uh, the due diligence was important because it represented a customer concentration risk, which directly impacted the business valuation and the deal structure. So, while both audit and due diligence involves financial analysis, the purpose and context of the two are very different. So, that really highlights a critical distinction, Kapil. You know, due diligence is proactive and focused on the future value of the deal, uh, while an audit confirm past compliance.

10:32 Beyond the numbers, Kapil, let's explore the broader strategic factors that buyers must evaluate to ensure a successful acquisition. Acquisitions are about more than just the financial figures. The non-financial elements often determine the long-term success of merger entity. From your experience, uh, what are the most critical factors buyers should evaluate before an acquisition, like strategic fit, culture, and the target's customer base, and, uh, market position? Sure, and that's a very good question, and, uh, often asked to me.

11:05 Uh, I'll split the answer in three key components, which are also the critical factors in my view. Uh, one is the strategic fit. Um, before undertaking under undertaking a due diligence, um, I generally, uh, try to understand the deal rationale from my clients. I ask them, uh, why this deal? Has the target company that you are looking to acquire, um, got certain features that enhances your competitive, uh, positioning in the market, uh, through new product offerings or services, or access to a new geography?

11:42 For an example, if you are an auto part reseller, uh, operating in Mississauga, uh, looking to expand geographically, acquiring a similar business in Milton makes sense. But, if you're acquiring a similar business, uh, in the same region or next block, uh, that might not create the same synergy because ultimately both businesses will be targeting the same customer base rather than getting a new one. Um, next, financial and operational health.

12:15 This is where I see buyers becoming smarter. Uh, they really unders- try to understand the quality of earnings. Uh, they want to know, uh, what are the sustainable earnings of the business? What are the drivers of margins, uh, in this business, and how they can enhance it post acquisition? What are the risks that exist? Uh, what are the working capital requirements, and so on and so forth. They also look look into the operational capabilities that form the backbone of the company. For example, its systems, uh, its processes, and how scalable they are.

12:49 The third and, uh, most important factor is culture, and something which is often underestimated by a lot of parties. Uh, M&A, um, isn't just about numbers, assets, or EBITDA. Uh, it's about people. Uh, it's critical that, um, uh, you know, both the parties are aligned. Uh, if there are differences or fundamental differences between leadership styles, decision-making approaches, or, uh, core values, then integration becomes a real challenge.

13:26 So, in nutshell, uh, the the critical factor or the most critical factor is not to identify a good company, but to identify the right company for the right reason at the right price. Yeah, as you rightly said, Kapil. You know, like effective M&A evaluation clearly requires a holistic approach, you know, weighing financial health alongside strategic fit and the organizational culture. We will take a quick break. Hey. You think you know UPS?

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15:03 Welcome back, everyone, to the Canadian SME Small Business Podcast. Let's continue our conversation with Kapil. Let's shift our gears and look at how technology is impacting the M&A process itself. The pace of M&A is increasing, and technology, particularly artificial intelligence, is starting to play significant role in handling massive data sets quickly. What impact do you see AI having on how due diligence is performed today, and how you are embedding AI in the work you do at KSMC?

15:36 Perfect. Uh, so, this is a question that I really enjoy answering. Um, the technology landscape in the field of due diligence, um, is, uh, evolving, um, as we speak. Uh, and, uh, we are at a very interesting inflection point. Um, for the most part, in the last decade or so, we've relied heavily on automation. Rules-based processes and systems that that organize that process data faster, uh, organize financial information, uh, and present it systematically.

16:11 Uh, this is really helpful, and, uh, really speeds up our work. What we are seeing now is a genuine shift to artificial intelligence. That is, machines learning and reasoning. Uh, this is where, uh, a lot of investment is going, and this is work in progress as we speak. Um, the two critical areas where artificial intelligence really creates impact, uh, is, um, the interpretation, uh, the data interpretation skills.

16:45 Uh, AI tools today generally get the context without being programmed as such. For example, they can read through, uh, contract languages and identify, um, a change in control clause. For example, they can read and identify from, uh, language in a contract which says, "More than 50% ownership interest is being transferred." as a change in control control provision without the contract actually, uh, having that, uh, term being used in the language. Uh, it can read through, uh, minimum purchase obligations of 200,000, uh, and identify them as a potential red flag for a buyer.

17:27 The second area where AI tools are critical, uh, is in their, uh, in their pattern recognition amongst large data sets. Um, if you're analyzing last 3 years of gross profits of a company, the AI tool can not only comment on the trends, but it can correlate declining gross margins with customer contract provision, which basically states the pricing has been increasing every year or has been aggressively set.

17:59 Uh, now, where I would say these AI tools, uh, have limitations, uh, and where human involvement is paramount, uh, are a few areas like, um, clearly, uh, some of these AI tools are still learning, um, and humans need to validate the outputs, uh, that are generated because it can misinterpret data. Uh, the other area is handling of confidential information.

18:30 And the third and the most critical impact AI cannot, uh, get into in due diligence. Um, the questions, um, I would I would basically say that, uh, AI today cannot es- essentially help with, uh, looking into a business model and comment whether it is, uh, good or implementable for a particular buyer strategy. Uh, AI cannot assist in, uh, negotiating on deal terms, uh, earn-out structures, purchase price adjustments based on the totality of findings in the due diligence process, or help negotiate those, uh, with the with the seller.

19:13 Um, so, how we at KSMC really, uh, assess and use AI tools is essentially viewing them as powerful assistants, which help us, uh, analyze data quickly, uh, and enhances our efficiency, but complement them with our professional skills and experience, something which the clients essentially want, uh, and pay us for. Right. Uh, so, AI critically, uh, helps uh, to the moot point, basically, the AI, uh, helps in two keyfold areas. Uh, one is, um, processing data faster, uh, and analyzing data, uh, from large data extracts, but the strategic implementation, the professional judgment, and the business acumen that the clients basically look for are coming from expert professionals like us. And it cannot be replaced by AI, I believe. Absolutely, yeah. AI is clearly, you know, like transforming the due diligence by enhancing the speed, as you rightly said, accuracy, and the ability to uncover hidden insights from vast amounts of data. Finally, Kapil, let's discuss your passion for supporting the next generation of entrepreneurs through acquisition.

20:25 Kapil, apart from advising strategic and financial investors clients on buy and sell decisions, you are actively involved with Venture for Canada's entrepreneurship through acquisition initiatives. Tell us more about what the entrepreneurship through acquisition model is and how you are helping new leaders and searchers succeed in this space. Absolutely. So, again, let's start with you know, what the entrepreneurship through acquisition model is, or ETA model as it is called.

20:55 It essentially originated from fund approach, originated back in the '80s from Stanford's Graduate School of Business. The objective of the model is simple. Rather than acquiring rather than running or starting a new business and operating it from scratch, which comes with its own risks, a searcher or an aspiring entrepreneur looks for sustainable cash-flowing business and acquires it from retiring baby boomer owners and operate it as an owner-operator.

21:39 The model works something like this. Aspiring searcher would identify a cash-flowing business and finance it through a combination of bank loans, seller finance, and potentially investor equity, and operate that business as the owner-operator. The evolution of ETA is having significant context in Canada as we speak today, also because of the fact that we are witnessing a significant surge in the intergenerational transfer of wealth that is happening or going to happen in the next decade. We are looking essentially at $2 trillion of wealth to be transferred in Canada alone.

22:26 Without buyers, and and these are these are essentially long-term businesses which with proven business models, trained employees, and established customer relationships. Without buyers, these businesses risks potential closure, eliminating jobs, and impacting economic value from the communities. Venture for Canada, or VFC, is a national not-for-profit which is at the forefront of promoting and supporting the ETA model in Canada through its various programs that are aimed at providing education, research, and community to aspiring entrepreneurs.

23:12 Through by being associated with VFC as a instructor and a panelist, I'm giving back to the community through my professional experience and skills. My role is to work with aspiring entrepreneurs to help them understand financials, how to read and implement financial analysis, how to structure deal terms balancing risks, and essentially helping them and advising them through the life cycle of an M&A. Okay.

23:46 The ETA model is clearly a vital, often overlooked venue for young leaders to become entrepreneurs by leveraging existing business structures as well as people like you as good experience for helping them out. Kapil, your insights today on quality of earnings, M&A strategy, AI, and ETA model have incredibly valuable. If there is one key message you want our listeners to remember about making confident financial decisions, what it would be? Sure. So, in the M&A context, the old adage buyer beware holds true, but that doesn't mean that you should be afraid.

24:26 If you are a corporate acquirer, a searcher on the ETA route route, a lower middle market focused private equity firm, or a family office, it means to be informed. Essentially, what we are talking about is good deals are generally not always picture perfect. Every business has its imperfections. The key is whether you understand them, can you quantify them, and can you address them post-acquisition?

24:58 The real value that certain deals and which have successful or higher rate of successful successfully closing are the ones where buyer and seller have established a strong relationship. They have established a certain level of trust and clarity in the process. They come with realistic expectations, and they have a sound understanding of the business's financial position. Invest in proper due diligence.

25:29 I think goes without saying that it feels like an additional cost, but it's essentially a risk-mitigating exercise where buyers can prevent themselves and save multiples of their investment by potentially preventing themselves from overpaying or identifying deal breakers which become the base for them to avoid potentially getting into a bad deal. Right. That was really an inspiring, you know, actionable advice. Thank you so much for sharing with our audience. What if any of our audience is interested to learn more about you or they wanted to get connected with? What is the easiest way?

26:09 Well, I'm freely approachable on my email or phone. We also have our website by the name www.ksmc.ca, and I'm happy to, you know, interact through the social media like the LinkedIn. Kapil, it has been a real pleasure, you know, having you on the Small Business Podcast. Thank you so much for sharing your insights and vision with our listeners. Thank you, SK. It's been a pleasure for me to be a part of the podcast as well. That was an insightful conversation with Kapil Sukhija, founder at KSMC, on the significance of financial due diligence, key areas of consideration while evaluating a business acquisition for buyers, and the impact of AI on the way due diligence are conducted.

26:54 Thank you for tuning in to the Canadian SME Small Business Podcast. We appreciate your continued support. Be sure to subscribe to our podcast for more expert insights and resources that can help your business thrive. You can also visit our website, canadiansme.ca, for more valuable information and resources. A special thank you to our podcast partners, RBC, UPS, A1 Global College, ADP, and Google for their ongoing commitment to empowering small businesses across Canada. Until next time, keep innovating and striving for success. We will see you in the next episode.

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