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Selling a Business Part 4: Due Diligence
29 May 2023: Selling a Business Part 4: Due Diligence
Due diligence: when selling a business, it’s important that the business owner be prepared for what will likely be seen as an extremely intrusive process.
This is the fourth in our 6-part series on selling a business and this one is about the part of the process that is most likely to cause friction with the seller. Why? Because most sophisticated buyers will appear to place no trust whatsoever in the information provided by the seller even though it might be delivered by a broker.
Generally speaking, in the best of circumstances buyers are skeptical. After all, even in the smallest deals, a “mom and pop” buyer is about to put the family fisc on the line. In larger deals – in which the buyers might be small private equity groups or family offices – the management of such buyers have a fiduciary responsibility to their investors. The dive they do to confirm the information they’re getting and know as much as humanly possible about the business they’re targeting is deep, indeed.
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Once the parties have agreed to the outline of the transaction – that is, a letter of intent, which should include the time parameters of due diligence, has been signed (the subject of last week’s Part 3 post) – the buyer will submit a request for the initial round of documentation he or she will want to examine. This list will be broad and deep – and in all likelihood, only the first of several.
Why several? Because most of the initial tranche of documents provided will raise additional questions and need clarification.
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Our course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, teaches you how to accurately value and successfully sell businesses.
From the seller’s standpoint, the interesting thing about the due diligence process is that, being represented by a professional business broker or M&A specialist is likely to make the entire procedure much easier, less time consuming and much less invasive.
Why?
Because the broker will already have much of what the buyer will want to see. And the broker will have prepared the seller for what the process would likely entail thus giving the seller plenty of time to start gathering some of the more arcane documentation – stuff a seller might never think of without the advice of the broker.
Maintaining Confidentiality
When selling a business, most sellers are, not surprisingly, concerned that the data and proprietary information that gives them a competitive edge – as well as the financial performance of their business – does not become public knowledge. They are especially uneasy about the possibility that this information could get into the hands of a competitor.
So, instead of sending all this highly personal and discrete information via email and having no idea who at the receiving end might see it, a good broker will usually suggest setting up a virtual data room (VDR) allowing the seller to control access to the data. In fact, utilizing a VDR generally makes the process so efficient, it’s not unusual to discover that the buyer has set one up already. But while that’s an encouraging sign suggesting that the buyer understands the importance of confidentiality and the effectiveness of using a VDR, we suggest to our brokers that when they discuss using a VDR with their selling clients, they counsel setting one up that the seller controls.
(The Brokers Roundtable℠, an online community created and hosted by Worldwide Business Brokers, has a live interview with Greg Brinson, of CapLinked Partners, California-based provider of Virtual Data Rooms (VDRs), scheduled for Thursday, 22 June. VDRs are essential in controlling the flow of information when confidentiality is important. At the conclusion of that discussion there will be a Q&A during which attendees can get their questions answered by a pro. But you’ve got to be a member to attend. You can sign up for The Brokers Roundtable℠ here.)
Having the seller set up a VDR will, if nothing else, illustrate to the buyer the seriousness with which the seller takes the need for confidentiality.
What to Expect
There are any number of things that need to be addressed during the due diligence period. Here are a few of them.
- Financials. Needless to say, a buyer wants to confirm the revenue and expense numbers, the expense categories, the business’ hard assets, the cash flow and the “true” net earnings (discretionary [or adjusted net] earnings). This requires a close examination of the profit and loss statements, tax returns, the business’ balance sheet, leases (especially real estate leases for ongoing rent increases), etc.
- Inventory. Does the actual inventory match the inventory claimed by the sellers? What amount of the claimed inventory is obsolete? Does any need to be written down?
- Corporate Status. Is the company current and compliant with all governmental requirements? Is it “in good standing” with its state’s or provinces’ corporation commission?
- Corporate Structure. Who has the authority to sign transaction documents? If there are multiple owners, has there been a corporate resolution to sell the company?
- Management. Who makes up the management team? What is the management structure? This is particularly important if retention of some or all of the management team is part of the deal.
- Employees. A roster of employees, their titles or positions, their salaries or wage rates, their tenure and, if applicable, their certifications and qualifications.
- Tax Payments. Is the company current on its tax payments, particularly withholding tax? Payroll and wage taxes that are not current at the time the business is transferred will often come back to bite the buyer and most buyers are aware of this potential liability.
- Contracts and Leases. Supply contracts, sales contracts, equipment leases, real estate leases; each must be examined, particularly for any changes in terms or financial impacts that may be triggered by a sale of the business, known as “change of control” clauses.
- Work in Progress. A buyer will want to verify the status of all work in progress. Such work would include the percentage of a service contract that has been completed. For example, if the target company is providing HR services under contract, how much of that contract has been completed and how much paid for? In another example, if the target company is providing laser sights for the military as part of a three-year, one million unit contract, how much of that product has been delivered, how much accepted and how much paid for? In still another example, if the company manufactures widgets from components bought from various outside suppliers and keeps a widget inventory ready to fill orders, how much of its production is complete (see Inventory, above) and how much is only partially complete?
- Debt. An astute buyer will confirm what is claimed by calling the lenders and creditors. But they will also have a UCC search done to make sure nothing is filed that even the sellers don’t know about.
The Bottom Line
If a professional business broker or M&A advisor, has been engaged to find a buyer, that professional knows what’s needed and in all likelihood the information a buyer will need to conduct the due diligence of the business has already been gathered and put into a clear, understandable format meant for buyers. In our network, we call this the Offering Memorandum though others sometimes refer to similar documents as a Confidential Information Memorandum (CIM) or “book on the business”. As a rule, it includes the pertinent data described above as well as photos, location maps and pretty much any information a serious buyer would need in order to make a decision. Our goal with the Offering Memorandum is to provide the potential buyer with all the information it needs to make a decision pending only a site visit to inspect the facilities and hard assets, and to confirm the data we and the seller provided.
Professional business brokers, especially those who have earned the Certified Business Intermediary (“CBI”) designation, understand what a buyer needs in order to perform proper due diligence in anticipation of acquiring a business.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at jo*@Wo*******************.com.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
Joe
Searching For…
A small U.S.-based private equity fund is looking for opportunities in small, niche vertical market software companies such as automotive, education, agriculture and real estate with between US$500,000 and $5 million in revenue. This is a an unusual small-company quest.
If any of you know of something that might fit, please let me know.
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 500 in the world. He can be reached at jo*@Wo*******************.com