Many people today use their smartphones or laptops to ask Google to help answer questions. In this case, I searched for “define due diligence,” and here is the first response:
noun: due diligence
reasonable steps taken by a person in order to satisfy a legal requirement, especially in buying or selling something.
- a comprehensive appraisal of a business undertaken by a prospective buyer, especially to establish its assets and liabilities and evaluate its commercial potential.
Many people believe the due diligence process of purchasing a pharmacy is only a set period of time; however, it is really a fluid practice throughout the entire process of acquiring the business. Think of due diligence in two phases with the first phase being your initial review of the business and the second phase the deeper dive into the business to validate (or reject) what you thought from your initial review. In a way, due diligence is like a funnel where you, as the buyer, are taking a calculated approach to reviewing the business in its entirety. You start with basic information to do your initial analysis which may highlight certain aspects of the business you would like to better understand. It may be items you would like to further question or have the seller clarify. The end goal of this due diligence is to educate yourself as much as possible about the business you are acquiring with the intent of a successful transition in the long term.
Due Diligence: Phase One
As mentioned earlier, I break down the due diligence process into two phases. The first phase is the initial review of the business you are looking to acquire. In this stage of the process, you gather the necessary information to formulate your desire to pursue this business further. The typical information you may request from the seller at this stage would be their financials and script information. You will want to see their last three years of business tax returns for the pharmacy and the most current year-to-date Income Statement and Balance Sheet. In addition, you will most likely want to see their script counts for this same time period.
Once you have this preliminary information, you should review and determine the feasibility of the project as it relates to your objectives.
- Is it the type of pharmacy you would like to purchase?
- business model, revenue size, etc.
- What is the gross profit?
- How is the current owner managing expenses?
- Does the store have proper cash flow?
With this information, the next step is to determine the potential sale price you may be willing to pay for the pharmacy. In some cases, the seller has an asking price and this initial review would allow you the chance to determine the feasibility of the asking price. In other circumstances, the seller asks you to make an offer which you may be able to do with the information provided. In either case, you should have enough information to determine if you would like to pursue the pharmacy further and may present a term sheet or letter of intent (LOI) at this point in the process.
Assume you would like to move forward with the acquisition and you present an offer in writing to the seller. Your written offer may include a “due diligence period,” which would be an agreed upon period of time between both the buyer and the seller to perform a further review of the business. This would lead you into Phase Two of the due diligence process.
Due Diligence: Phase Two
Now the fun begins! The buyer has submitted a written offer to the seller, and the seller has agreed to the terms outlined in the term sheet. Now what?
During this phase of the process, the buyer starts to work with a lender, such as Live Oak Bank, to start securing the necessary financing to purchase the pharmacy. During this process, the bank should work with you to prepare a cash flow analysis to review the feasibility of the overall project based on the agreed upon terms and conditions (T&Cs) between buyer and seller. This process will usually lead to further questions as trends in the business and other documents may be analyzed.
For example, when reviewing the pharmacy revenues year-over-year (YOY), you may notice the revenues have increased slightly YOY. You may then cross reference that with their script counts and notice the pharmacy script counts have also increased YOY. While this may be a good trend, you would like to know what has been driving the growth. This would be a good conversation to have with the seller who may then inform you the growth is coming from increased advertising efforts or something unique like a competitor pharmacy closing their doors. In either case, what you are trying to understand is if the growth will continue at the same pace or level out.
Looking at revenues and trends in the financials are the “common” metrics to review and analyze, but there may be other items you want to consider like labor costs and staffing, ability to grow the business, or simply understanding the current business model. In today’s pharmacy market, a lot more independent pharmacy owners are diversifying and adding compounding, long-term care, specialty, and telepharmacy to name a few. In all these cases, you want to understand the impact each market driver may have on the business you are acquiring. For example, if the pharmacy is compounding, are they dispensing through both third parties and cash? If they are involved with long-term care dispensing, do they have contracts with group homes, etc? There is no right or wrong answer with these examples since every store presents its own benefits and challenges; however, you are educating yourself to fully understand the business you are acquiring and can manage this information to ensure the business is sustainable post-acquisition.
Hidden and Outside Due Diligence:
At this point, you have completed two phases of due diligence which have primarily focused on the specific metrics of the pharmacy you are acquiring. Many buyers may think this is where the due diligence process ends, but it’s not. You should take one more approach to cover all angles of the purchase.
As a lender who specializes in lending money to independent pharmacy owners, we often look at the key performance indicators (KPIs) to model future financial performance of the pharmacy. However, another item of due diligence should be focused on positive and negative external drivers that may impact the future state of the business. These include knowing the specific market where the pharmacy is located (i.e. city and state, rural vs. metropolitan, etc.) along with possible foreseen or unforeseen changes influencing the specific pharmacy. This could be anything from the population of the town growing/declining to new pharmacy regulations. These may be harder to identify. There may be a good chance these impacts are minimal, if any, but your goal is to educate yourself before the sale to ensure you are prepared to handle any potential impacts.
A Meaningful Exercise:
Whether you are purchasing your first pharmacy or own several stores and are acquiring more, the due diligence process should be an important element for any buyer to explore. The ultimate goal of purchasing a pharmacy is to be able to generate revenue and profit. Performing the proper due diligence will provide the necessary information to educate yourself. A football team does not go into a game without performing due diligence of their opponent. A good student would not go into a test without proper study and class attendance. A pharmacy buyer should not purchase a pharmacy without the proper due diligence to ensure the highest probability of a successful outcome. Every question you ask and everything you learn will ultimately assist you with making the best decisions.