Understanding the Due Diligence Process

by Dave Clark

When selling your business, the due diligence process is a critical part of completing a transaction. Due diligence is an essential step once you agree on the buyer’s price and terms outlined in a Letter of Intent (LOI). The buyer’s primary purpose is to validate their offer by understanding critical areas of the business’s financials, operations, organization, and contractual obligations. 

If the business has been confidentially marketed, once the Letter of Intent is signed, the buyer will request that the company be taken off the market. Typically, an LOI will require an exclusivity period of about 60 to 90 days where you cannot talk to other potential buyers. Buyers will be expending significant time and money during the due diligence period. They do not want to be competing with other potential buyers while making this investment. 

Areas for Review 

The first step in this process is for the buyer to provide a checklist of areas they will want to review in detail. Included on the list would be: 

– Corporate Records 

– Contracts 

– Property and Equipment 

– Financials – past five years and future projections 

– Legal 

– Employees and Benefit Programs 

– Environmental & Regulatory Review 

– Sales and Marketing Plans 

– IT Systems 

The buyers will include several advisors in their process, including accountants, attorneys, and possibly some specific specialists in areas such as equipment valuation, insurance, and employee benefits, as examples. 

Data Management 

With all the sensitive company data being exchanged electronically for the buyer to review, it is important that this information is shared on a secure platform. You do not want to be emailing important confidential documents. Suppose you are working with an M&A advisory group. In that case, they will provide a safe data room that allows access only to those individuals that the buyer needs to review the information. As the business owner, you need to determine who within your organization will know about the possible company sale and then assist in collecting and loading the data for the buyers to review. 

Building a Relationship 

Due diligence is an excellent opportunity for both parties to communicate and build a relationship. In many instances, the buyer will want the owner to stay on for a certain time to ensure a smooth transition and possible integration of another business the buyer owns. It could also be the buyer will want the owner to stay on for an extended period and continue to operate the company. So, establishing a rapport and understanding cultures is a critical part of moving forward with a sale. 

Further Negotiations 

An important aspect of due diligence as an owner is understanding that the process will lead to many more questions that the buyer will want to get answered in greater detail. This new learning can lead to further negotiations of the LOI, and adjustments made to the original offer price and terms. At times, the deal will not go through, as the buyer becomes aware of things that make the acquisition too risky or no longer a fit for them. As the owner, you may no longer be interested in the revisions based upon your thoughts on your company’s value or the revised terms. However, a serious buyer who likes the company will often try and make adjustments that will work for the owner. 

Certain open items must be quantified in due diligence that the parties need to agree upon before closing. The deal may be originally structured as an asset purchase, but upon further review, given contracts or certifications that must transfer, the structure may change to a stock purchase. This has tax and liability consequences for both parties, so it must be worked out. Another area to be finalized is working capital targets. The buyer will want sufficient funds to remain in the business, so it has adequate funds to continue operating post-closing. The purchase price allocation identifies how the company’s closing price is split among various areas such as fixed assets, non-compete agreements, inventory, and goodwill and must be quantified. How this is applied can determine tax implications as well. 

Closing 

Once the due diligence process is complete, the buyer’s attorney will generally draft a purchase agreement and present it to the owner and his attorney. This document should reflect everything in the LOI, and everything discussed and negotiated throughout due diligence. This step typically takes a few weeks to finalize after all the reviews between the parties. 

Due diligence is a critical step in selling a business. When handled with discipline and an appropriate sense of urgency by both parties, it will result in a successful closing and the start of a successful transition.

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