About Due Diligence

Why Due Diligence Matters

Pummeled by the recession, many small business owners should be permitted an enormous sigh of relief as they watch the value of their small businesses growing. According to the National Federation of Independent Business, America’s small businesses are more confident than they have been in more than three years, and are projecting both sales growth and job creation. The reviving health of small companies across the country will no doubt have more owner-managers considering a sale in the near future. 

The improved outlook for small companies has not escaped the notice of private equity firms and large companies looking to invest during this period, each with record amounts of available capital to deploy at a time when there is a limited supply of deal opportunities. Consequently, you may find suitors interested in your business are not in short supply. 

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How To Hurry Along The Due Diligence Process

Documenting a small business's assets and operations is a time-consuming task.

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Business buyers and sellers should surround themselves with professionals. Attorneys, accountants, loan officers, appraisers and real estate brokers all play a role. The seller's team prepares the financial reports, determines a reasonable list price for the business, finds a buyer and documents the vital components of the daily operations. Much of this can be completed before the business is advertised for sale, and that can shorten the due diligence period. The buyer's team verifies the documentation, determines an offer price and arranges financing. The attorneys for both parties negotiate the deal.

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When Selling A Business, Do Your Due Diligence

That includes checking on prospective buyers and self-examination

When contemplating the sale of your business, make sure you have handled your side of the due diligence correctly to avoid costly disputes and litigation. Due diligence from a seller’s perspective needs to be broken into two components, starting with the identification of a good prospect and followed by performing due diligence on yourself in order to identify risks and exposures that may ultimately impact the transaction both from a closing and a deal adjustment standpoint.

First, let’s start with the process of identifying a prospect. In order to identify a qualified prospect, it is very important that you set up a team of experts who can simplify the process. A prospective seller needs to pull together an experienced team in order to make the appropriate decisions in the business disposition process. The team should be comprised of your trusted financial adviser who will assist you in selecting a capable investment banker/business broker (depending on the size of the transaction) and a business transaction attorney. Working from the presumption that your financial adviser and investment banker/business broker have done all the ground work for setting up a good prospectus and financial package, you are now in a position to pre-qualify prospective buyers for your business.

The pre-qualification process starts with gathering financial and personal information on prospective purchasers of your business. The number one rule is that the prospective buyer provides you with personal financial statements and references before you, the seller, release any pertinent financial information. At the point of receipt of the requested information, you then need to be given permission to talk to the prospective buyer’s financial advisers including, but not limited to, the accountant, banker and business attorney. The purpose of this process is obvious — you are verifying that the prospect is not a "tire kicker” and is worthy of having the opportunity to look at your financial records and determine if he or she is truly interested in your business.

This process will also eliminate competitors who are just shopping for free information on your company with no intentions of having an interest in buying the company. Presuming that the pre-qualification process has been successful, the next step is to perform due diligence on your own company. By exposing what your potential "warts” and problems are in advance, you can help avoid common issues that often lead to purchase price disputes and possibly costly litigation going forward. Once the prospective purchaser has been identified, the advanced due diligence on the part of the seller cannot be over emphasized. When you really think about it, buyers in this current economic environment are feeling increasingly uncertain about the reliability of revenue and profit projections.

Moreover, I am seeing more deals subject to revenue and profit earn-outs, which often lead to purchase price disputes down the line. Through planning and analysis, many potential threats can be mitigated. This may afford sellers greater assurance that they will realize and keep a larger portion of the expected proceeds. Presuming that we have a deal in place, the first order of business is to define key terms and expectations in the purchase agreement. A frequent cause of disputes in purchase agreements are definitions used in the agreement, which often are couched in broad terms. Vague definitions may be construed as being positive since they result in a catch-all for all of the gray areas.

However, the lack of specificity is what inevitably leads to different interpretations, resulting in divergent expectations between buyers and sellers. One example of the above is how to deal with working capital issues. A typical sales agreement has a targeted working capital to be measured against a benchmark. If this amount exceeds the closing balance sheet figures, it would result in amounts due to the seller. That is why a clear definition of working capital is essential in every purchase agreement.

Another key issue that needs to be resolved is whether the financial reporting by the seller is being handled according to GAAP (generally accepted accounting principles). It is imperative that this is resolved in the negotiation and contract stages so that misunderstandings and inconsistent reporting of financial data don’t create other potential disputes that lead to possible litigation. Other areas that need attention in purchase agreements revolve around what assets and possible liabilities are not to be included in the transaction. Vehicles, art work and — believe it or not — season ticket licenses are some of the oddities that have come up in disputed sales transactions when the specifics were not handled correctly.

On the liability side, the biggest contingent liability that is often overlooked deals with toxic waste issues. Full disclosure of this critical issue and who is ultimately responsible is imperative to any well-prepared purchase agreement. In summary, there are a few of the "do’s and don’ts” that the seller of a business needs to be aware of before entering into any purchase/sales agreement for his or her business. Remember: Most of us only get one chance to sell what might be our most treasured asset — our personal business. Since this is often the final chapter in hopefully securing your financial future, you need to make sure you have dotted the "i’s” and crossed the "t’s” with all the details in order to avoid unwanted disputes and litigation that can often damage or destroy your financial future.

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