Successfully Navigating the Due Diligence Phase
Buying or selling a business can be time-consuming and for a seller, the due diligence period can sometimes seem like a never-ending series of questions and information to compile. In the worst case, disorganization, misunderstandings, and inaccurate information provided during due diligence can delay or even crater a deal. However, with advance planning and a methodical, organized and efficient process, due diligence can be a straight-forward step that moves the buyer and seller to a successful closing.
The term “due diligence” was first coined in the Securities Act of 1933. So long as stock brokers exercised "due diligence" in their investigation into the company whose stock they were selling, and disclosed to the investor what they found, they would not be held liable for nondisclosure of information that was not discovered in the process of that investigation.
As applied to the process of selling or acquiring a business today, due diligence generally refers to the buyer’s process of verifying company information before closing.
Buyers want to know: Do you make what you say you make, do you own what you say you own, and are you in compliance with all laws and regulations?
Most transactions include a formal due diligence phase, which starts after the buyer and seller have signed a letter of intent. Information reviewed in due diligence can include financial information and bank records, corporate formation and legal documents, employee information, intellectual property, equipment and inventory, real estate and leases, marketing and client records, and more.
The amount of time required to conduct due diligence can vary depending on the size and complexity of the company to be acquired, the seller’s ability to produce and share documentation in a timely manner, and the experience of the buyer and his or her team. In most middle market transactions, due diligence takes a minimum of four to six weeks, but can drag out longer. In most cases, due diligence is handled simultaneously with the attorneys preparing purchase documents.
Whether you’re considering buying or selling a business, here are a few tips for handling due diligence:
Handling due diligence as a seller
Methodical preparation is the best way to ensure a smooth and successful sale and avoid last-minute surprises. Start preparing for the due diligence process as soon as you decide to put the company on the market. Your investment banker will help you prepare a due diligence package for prospective buyers. Your ability to quickly provide additional documentation that supports and verifies information on your business will go a long way in building trust with a buyer, and can help ensure the transaction closes successfully. Conversely, if you’re unable to locate documents, or if you provide conflicting or inaccurate information, seeds of doubt can grow in the buyer’s mind.
- Get everything up front. Every company has strengths, challenges, and weaknesses. Even successful, profitable companies have tried sales strategies that didn’t work, introduced new products that bombed, or hired employees who didn’t work out. The best way to handle potential concerns is to disclose everything early in the sales process, so that the buyer finds out information from you up front, not when they’re digging through detailed records just before a potential closing.
- Recognize that due diligence is part of the process. Much as you may dread the thought of the buyer and their lawyers and accountants rifling through your business records, remember that it’s a necessary hurdle which you must overcome to reach the closing table. If you have carefully prepared for a potential sale, have organized books and records, and have clearly and accurately described your business to a potential buyer, due diligence can be simply a time-consuming and administrative process to ensure your buyer feels comfortable enough to move ahead.
- Be tolerant of the buyer. The sophistication and level of expertise of your buyer can have a positive or negative impact on the due diligence process. A corporate buyer who has completed multiple acquisitions in your industry will likely know exactly what they want to verify, and will hopefully get straight to the point. However, even a sophisticated buyer needs to ensure they don’t miss anything - after all they are getting ready to pay you a significant amount of money. Working with a buyer to follow a due diligence checklist (described below) can help avoid requests for duplicate information, information that does not exist in your business, and more.
- Utilize technology. Your investment banker will manage the due diligence process by storing all records and documentation in an organized on-line data room, that requires password access and can limit who views which files. Some experienced buyers will also use software that can connect to your accounting system and quickly review all your financial records and identify areas for questions, while limiting time period viewed and automatically redacting customer and vendor names. While you'll need to feel comfortable with the buyer to provide this type of access, it can dramatically reduce the time and your work associated with due diligence.
- Quality of earnings reviews. If you are selling to a private equity buyer or a large corporate buyer, it's likely they will want to conduct a quality of earnings review, conducted by an independent accounting firm. You may see this referred to a "Q of E" report. Many banks providing financing for a transaction may also require the buyer to provide a quality of earnings report. In many cases, a professional accounting firm conducting this type of report can actually make your life easier, because they'll hopefully know exactly what to ask for. It also provides a buyer with peace of mind, which can help you as the seller when last minute negotiations crop up as you approach closing.
Handling due diligence as a buyer
Before starting the due diligence process, think through the information you need to verify. In addition to ensuring that all business records and the seller’s representations are accurate and honest, your acquisition criteria and goals will also drive your approach to due diligence.
- Prepare and prioritize a due diligence checklist. Before starting any due diligence, prepare a list of everything you want to see, then share the list with the seller and agree on a timeline. Ask the seller if they anticipate any problems providing the information you’re requesting. Update the list as you receive, see, or verify requested information. A list also helps save time and effort to prioritize. If you know that certain items could be deal breakers, request that information first.
- Use your team and technology. Be sure to work in conjunction with your lawyer and accountant, who will likely provide suggestions to add to the list, and help ensure that all documentation required in advance of closing is included. The seller's investment banker will likely set up an electronic data room so that everyone on your team can see documents in a password-protected website. Your accountant may also utilize software to quickly analyze the seller's financial records, saving you money and saving the seller time otherwise spent pulling records.
- Put yourself in the seller’s shoes. Hopefully your seller is organized, prepared, willing to provide you with all the information you want, and has every business detail at their fingertips. But bear in mind that the owner is still running the business on a day-to-day basis, and may be concerned about maintaining confidentiality associated with the sale. If the employees don’t know about a pending sale, a seller may not be able to delegate your requests for information to his or her employees. Delays can also occur when information needs to be gathered from the seller’s bankers, accountants, lawyers or other advisors.
While due diligence can be time-consuming and sometimes frustrating, an organized, methodical process can help both the buyer and seller, leading to a successful closing. To receive our latest due diligence checklist, email us at info@hughesklaiber.com.
Hughes Klaiber is an experienced investment banking firm. Want to learn more about selling a business? Schedule a confidential call here to discuss your business.
