If you are trying to sell your company and have selected the buyer, the following signs suggest things are moving ahead. The first is the letter of intent (LOI) between you and the buyer. Once it is clear that the sale of the business is going through, aware buyers will want to know as much about your company, its assets, and its financial standing as possible so that they are not unpleasantly surprised by any business liabilities. The buyer will conduct an extensive diligence investigation to uncover such liabilities.
Due diligence is an investigation through which the buyer reviews documents, data, and other critical information. In addition, due diligence is done to identify possible roadblocks, threats, or potential business liabilities. Due diligence findings may lead to the buyer demanding a substantial reduction of the company’s purchase price or even a complete withdrawal of the purchase offer.
Traditionally, there are three types of due diligence, and it is advisable to hire different advisors (each an expert in their domain) for each category:
- Legal, due diligence: This is part of the sale and purchase contract between the two parties. Due diligence uncovers whether the company has title ownership to sell or not and determines whether other aspects, such as ownership of business assets and regulatory and litigation issues, have been entirely and duly addressed.
- Financial due diligence: All past financial records and balance sheets are thoroughly investigated to find any hidden financial issues.
- Commercial due diligence: This investigation determines the business’ standing in the market, its positioning among its competitors, and that regulatory conditions are in order.
Why Is Due Diligence Necessary?
Due diligence is an integral part of the buying process, as it informs both the buyer and the seller what the sale of the company entails. Each buyer wants to answer the most critical question is whether the company is worth the purchase price. Due diligence answers this question.
The company’s financial position is thoroughly audited to find if the information given by the seller is accurate or not. As part of due diligence, the business’ assets, liabilities, cash flow, and financial management are analyzed. However, this is not the only aspect under scrutiny. An examination of the business’s legal structure, which includes elements like property, tangible assets, employee records, and other business processes, is also conducted. In addition, the intention is to identify whether the business has any potential or ongoing litigation that remains undisclosed. Other than these, broader industry and competitor research is also conducted to understand the business’ standing in the market.
Due diligence is an essential step in the buying and selling process. As a seller, it is important to bear in mind that critical withholding information may indicate there is something to hide, which prolongs the process and may also affect the deal terms and the purchase price.
On the other hand, due diligence can benefit the seller. The thorough and rigorous financial examination may reveal that the business’s fair market value is much more than its thought.
As a business owner, the first thing you should find out is what information the buyer will review. Ideally, a cautious buyer will want to review all the business aspects. Let’s go over a few tips for successful due diligence.
Tips to Successful Due Diligence
1. Gather All Financial Documents
Also known as accounting due diligence, financial due diligence is one of the important aspects of an M&A deal. For a buyer, the state of a business’s financial health and future projections is the critical differentiator between a good investment or a bad business deal.
The buyer audits the seller’s financial statements and other related financial metrics, as well as the business projections of future performance. Topics of concern will include the following:
- What do the seller’s annual, quarterly, and monthly financial statements reveal about its financial performance and condition for at least the last three years?
- Are the seller’s financial statements regularly audited and, if so, for how long?
- Do the financial statements and related notes disclose all the seller’s liabilities?
- Are the revenues and margins for the business growing or deteriorating?
Most business owners tend to think of financial due diligence as primarily a buy-side practice; however, sellers should also conduct a sell-side financial due diligence which can act as an internal audit to uncover potential issues previously hidden or unchecked. The other objective is to primarily answer what the buyer would want to see in the financial records.
Even though the scope of due diligence varies as per the industry, all business owners should focus on conducting thorough financial due diligence regardless of the industry. When done correctly, financial due diligence tells the buyer as much about the acquisition target as all other types of due diligence together.
Related: Vendor Due Diligence.
2. Organize All Company Assets
Financial, operational, and technical viability are the foundations of any business transaction. What the buyer uncovers during due diligence confirms whether or not the business will capture and capitalize on the opportunities available in its market niche.
To prepare for asset due diligence, business owners should identify risks and potential outcomes (according to the range) in a structured and disciplined way. Since all inputs, such as operating performance and project budgets, are directly related to the business’s operational and financial model, owners should make sure these are well documented for review.
The scope of due diligence includes a detailed review of:
- Balance sheets for three to five years, including all documents related to assets to be purchased (including accounts receivable, prepaid assets, fixed assets, deferred assets).
- The income statement, statement of cash flows, and stockholder’s equity statements.
- All contracts, agreements, and equity investments.
- Employment agreements with founders, executives, and employees.
- All lawsuits and challenges to the asset’s title, if any. Competent legal counsel reviews this.
The due diligence of assets primarily determines that any issues related to the business assets are uncovered and addressed or accounted as potential defects in the title.
3. Resolve Any Litigation Issues Before the Sale
Any buyer acquiring your business automatically associates themselves with the company’s legal reputation. Therefore, they will want to be completely aware of its legal status and any future possible legal risks. Legal, due diligence ensures that any such issues are uncovered, investigated, and analyzed, ensuring the buyer has a fair chance to make up his mind before proceeding with the sale transaction.
Legal, due diligence is the process of collecting and assessing all the legal risks associated with the business during an M&A process. The buyer thoroughly reviews all the documents related to a target company during the process. If needed, they also interview key people associated with the business.
The objectives of the investigation are to:
- Assess the working conditions in the company and the capabilities of employees and business associates.
- Uncover any legal risks, assess them, and look for viable solutions.
- Study all agreements and contracts signed and understand the legal obligations.
- Draft an excellent negotiating agreement after acquiring complete knowledge.
4. Work With an Advisor to Ensure You Don’t Miss Any Steps
As a business owner, you have the option of going over your business matters with a fine-toothed comb and conducting due diligence yourself. However, understanding the implications and the extent of due diligence investigation, we recommend that you work with an experienced consultant or exit planning advisor who will guide you through the details of the process.
Due diligence identifies the weaker areas of the business so you can fix them promptly. Understanding the critical importance of due diligence, it’s best to leave the job to trained professionals.
Serve Your Business’ Best Interest
Even though the due diligence process takes time and costs money, the benefits of this investment cannot be underestimated. With planning, due diligence can be completed well before taking the company to market, giving the business owner the chance to streamline the transition. As a result, the business owner has time to maximize the price of their business and reduce transaction costs.
To do this:
- Spread the due diligence preparation work over a number of years so that each questionable aspect can be adequately resolved.
- Involve experts early and manage the associated costs.
- Identify and resolve the business issues.
- Gain a better strategic understanding of the business to address issues uncovered by due diligence.
- Negotiate the sale of the business from a position of strength.