Due Diligence is important for both parties in a business sale transaction, but for different reasons.
If you think about it, there’s a lot at stake for the potential buyer.
Yes, you’ve already provided information, some confidential and involving signature of a confidentiality agreement, which could be considered the start point of Due Diligence.
However the buyer is required to take a lot of information on trust when deciding, in principle, to go forward with the business purchase.
So enter Due Diligence.
A video by Tony Brown: Most business owners don’t know what due diligence is, or what to expect. Here is an explanation on the process.
This typically starts with the buyer signing a Letter of Intent. This is a conditional agreement to go ahead with the business purchase, subject to Due Diligence and any subsequent negotiation.
It’s a thorough audit. This is really about the buyer checking the facts to see if they're consistent with the information already presented by you.
It’s digging deeper to:
- validate that the valuation of the business is reasonable
- check that financial statements are a true and accurate portrayal of the company’s financial health
- that there are no existing hidden or unexpected risks, liabilities, future costs and any other surprises not already factored into the valuation
- assess the true long term business prospects, its potential, and the sustainability of its position in the market
Nobody wants to knowingly overpay for a business.
On the contrary, buyers will expect to gain from any upside potential that they've identified.
For their initial valuation the buyer will have made assumptions about the rewards they can expect to reap once they have control of the business. For example, by increasing margins, growing the customer base profitably, leveraging existing competitive advantage, and finding new sources of advantage by adapting the value proposition and tailoring activities in the value chain to match.
They won’t want to compromise their negotiating position by revealing their real thinking about the business’s potential during Due Diligence. So they're bound to understate this in their negotiations with you. Equally, they will not want to be left responsible for any undisclosed problems in the business, not of their making, unless the price has been adjusted accordingly.
Taking all this into account, it makes sense to assume that the buyer will make detailed and thorough business and legal Due Diligence checks using a specialist team of experts.
In general, the more money involved in the deal, the greater the risk, and the higher the potential return from resources deployed by the buyer in Due Diligence.
If you have been truthful with the potential buyer from the start, and your documentation and financial statements are in order, you should have little to fear from the Due Diligence process. The duration of this process is dependent on a number of factors, including:
- the size of the business
- its complexity
- the nature of the sale: whether it’s a simple asset sale, a stock purchase, or a merger with one of the buyer’s other businesses
Once the Letter of Intent has been signed Due Diligence can take up to 3 weeks to complete, sometimes longer.
However you can influence the Due Diligence timetable by:
- preparing certain information in advance
- agreeing early release of confidential documentation, perhaps using secure online file sharing
- and, by estimating the time it'll take you to provide missing information
You can’t possibly prepare for every question and eventuality, but there are some standard Due Diligence audit questions that you can cover off well in advance using a checklist.
An organised buyer will present you with their own information and question checklist before Due Diligence, so it’s a relatively straightforward task to compare these lists and identify gaps. There'll be subsequent questions from the buyer that may require more of your time, but it’s a good start.
Pre-empting buyer information requests will also give them confidence that you're organised and that you've got your finger on the pulse of the business.
Now to the detail of Due Diligence.
If it were your money, what information would you want to know?
It’s not the place here to list every document and piece of data. Besides, it could never be complete or relevant to every unique business sale situation. Here ExitAdviser looks at the categories of information most commonly expected to be on file.
It’s a good rule of thumb to assume 3 years of historical data and documentation, alongside current year-to-date financial data presented in the same format as previous years.
Some categories, or items within them, may not be applicable to your business.
Company reports and policies: articles of incorporation; equity structure; share distribution; organisation chart; tax records; board meeting minutes; company goals; etc.
Customers and Marketing: product or service lines; branding; value proposition(s); positioning against competition; sales and profitability of the top ten customers; customer information and databases; sales and marketing plans and promotional activities; distribution arrangements; public relations and articles released; customer service and satisfaction measures; etc.
Financial reports: audited accounts, profit & loss, cash flow, balance sheet; auditor reports and associated correspondence; real estate assets and leases; physical assets, owned or leased; schedule of debtors and creditors; schedule of inventory; bank balances; short and long term loans outstanding; detailed cost and revenue breakdowns; etc.
Operational systems: key activities and processes, and how they integrate together; work scheduling and lead times; current order book; production or delivery capacity; supplier relationships; logistics; after sales service; etc.
People resources and skills: staff numbers and payroll; employee benefits and claims; recruitment and training policies; management development initiatives; key worker resumes; any continuity plans; absenteeism; staff turnover; subcontractors; professional advisers used; etc.
Strategy and research: business model/plans; external assessments of the trading environment; internal audit reports; research undertaken; recorded business and competitor intelligence; etc.
Performance measurement: key performance indicators against targets; risk assessments; quality measures; reporting and review systems; corrective action plans; etc.
Material contractual relationships, obligations: any outstanding commitments that continue after the sale; supply or customer contracts, other contracts; etc.
Legal and regulatory compliance: any cases pending; litigation; previous convictions and rulings; licenses and permits required; data protection; environmental compliance; etc.
Technology and innovation: for example, ICT systems used; how these are integrated to maximise efficiency and effectiveness; new process and product innovation; etc.
Intellectual property: if applicable; brand trademarks as an example
Insurances and outstanding claims: full and up-to-date suite of insurance certificates relevant to the business; any pending or unresolved claims; etc.
This covers the documentary evidence.
However the buyer and their team will also want to see your business in action for themselves. This means a pre-arranged visit(s). If you employ staff the buyer will wish to meet them, particularly those identified as key workers, to get an indication of their continuing motivation and commitment under new ownership.
There are also subtle cultural considerations, such as the "way we do things around here”. Managing the crucial early transition period to a new owner will be highly dependent on the compatibility of cultures and approach.
In summary, the better the job you do in providing the required information, and the more cooperation you show, the more convincing you'll be to the buyer.
So what are the potential outcomes from Due Diligence?
From the buyer’s perspective there are broadly three scenarios. The first two lead to the next round of negotiations:
- the buyer is broadly satisfied that the facts are consistent with information presented before Due Diligence, and the two parties are in the right ball park on business valuation
- new liabilities/risks/costs or inconsistencies in information, or both, are uncovered that do not necessarily break the deal, but lead the buyer to request significant adjustments to the deal before agreeing to go ahead
- information is unearthed that breaks the deal completely, irrespective of the valuation (in other words the buyer decides to "walk away”)
In case one a final deal is likely to be close.
In case two there's still negotiation work to be done. The buyer may ask for a price reduction, or insist on personal guarantees from you against certain identified events occurring. Part of your final payment may be withheld for a period of time as security. You may be required to stay working in the business for an agreed period of time.
Any one, or combination of these conditions, could be requested. These may, or may not, be acceptable to you. You can see how under these circumstances negotiations can get quite complex.
In case three, the deal breaker could come at any time during Due Diligence causing the process to finish abruptly.
In the end you need to be comfortable with the deal on the table before going ahead.