Due Diligence And Understanding The Process
Selling A Business And Getting To The Closing Table
Due Diligence becomes the “Acid Test” that defines the worth of your business after you enter into a Buy-Sell agreement. For a buyer, the due diligence process is their final opportunity to “Kick the Tires” and make a decision to write a check. For sellers, the due diligence process is the most intense, nerve wracking, and important part of the selling process. For some Sellers, the process can be a nightmare, scrambling to provide information and answering question after question. For buyers, the due diligence process is an opportunity to continue negotiations, or worst, find an excuse to get out of a deal.
So…. what the heck is due diligence? Here is how BusinessDictionary.com defines Due Diligence:
1. General: Measure of prudence, responsibility, and diligence that is expected from, and ordinarily exercised by, a reasonable and prudent person under the circumstances.
2. Business: Duty of a firm’s directors and officers to act prudently in evaluating associated risks in all transactions.
3. Investing: Duty of the investor to gather necessary information on actual or potential risks involved in an investment.
4. Negotiating: Duty of each party to confirm each other’s expectations and understandings, and to independently verify the abilities of the other to fulfill the conditions and requirements of the agreement. Also called reasonable diligence.
Here’s an example of what I might hear from a buyer contacting me to conduct the due diligence investigation:
“I’ve entered into a Letter of Intent (LOI) and need your help checking out the facts. I want to make sure that they haven’t lied to me and or left out something that would change my mind. This is a really good deal if it all checks out. It’s a real opportunity for me and I want you to make sure I’ve got all the facts right and have considered every angle.”
The buyer is excited and proud to have an executed LOI, no doubt about that. Next comes the due diligence investigation and the general charge is to “examine and verify”; a prudent objective. But there is more, it is an “investigation”. Depending upon my findings, the buyer may want to renegotiate; which often causes sellers great concern. Sellers generally feel that the negotiations are complete and all that’s left is the confirmation of information provided to the buyer. Many times, buyers enter into a Letter of Intent and actually plan to renegotiate the deal as they find weaknesses in the sellers business. In my experience, renegotiations of some sort occur in almost every transaction; some minor, some that have significant financial impact to the transaction.
From my perspective, the Due Diligence process is an opportunity for a buyer to discover everything about the company being acquired; not just what’s covered in the LOI. Due Diligence is an investigation not an audit; and there is a difference. An audit seeks to verify information while an investigation seeks to uncover all facts; the facts that have been disclosed and those facts undisclosed. Maybe a fine point, but an important point. A seller must be prepared to be put under the microscope and thoroughly examined; it’s simply part of the process.
PREPARING FOR THE DUE DILIGENCE INVESTIGATION
The preparation should start on the day that the seller decides to sell his or her business. Every presentation, every prospectus, every offering memorandum should contemplate the questions that will be asked in the due diligence process. Those documents, ads, and presentations need to be thoroughly scrutinized for accuracy. The seller will be asked to provide supporting evidence that will confirm the assertions made in the sales process. In other words, sellers must be able to “back up” what they say.
I’ve seen some very innocent claims made in a prospectus that were simply not true. The seller wasn’t trying to lie about anything, they told their business broker their company story, the business broker wrote it up, and parts of the story were wrong; actually innocent, with no intent to deceive. In a recent investigation, it was about who owned the shares of stock. The prospectus misrepresented the correct ownership and had left out some minority shareholders. That could have been a big deal. The buyer spent over $100,000 on due diligence in this case. What would have happened if the minority shareholders had refused to sign? Do you think the buyer would have wanted his due diligence money back? We worked it out, added the minority shareholders to the LOI and eventually closed the transaction. Everyone ended up happy.
My due diligence checklist is about 15 pages of questions. Yep, 15 pages. I try to cover every aspect of the business financials, operations, insurance, safety programs, and on and on and on; after all, that’s what the buyer asked me to do. Most sellers audibly moan when they receive my questionnaire. That’s not my intent. My intent is to be thorough.
In the long run, a thorough due diligence investigation is in the seller’s best interest. Once a thorough investigation is conducted, the buyer cannot claim that he/she did not know or have the opportunity to know pertinent facts about the business. In order words, a thorough due diligence investigation minimizes the impact of “buyer remorse”. After a successful closing, the last thing a seller wants to hear from a buyer are the words “You didn’t tell me about that”. You can imagine where that might lead.
So preparation starts the day the decision is made to sell. Sellers should first conduct their own due diligence investigation with internal staff. Sellers can hire a due diligence investigator like myself to assist them in the preparation. Most sellers I’ve dealt with have no idea what to expect when I walk into their offices for the first time. They usually have appropriate staff convened in their conference room and anxiously await my questions; wondering what I will want to know. Once I start asking questions, it’s a mad rush to answer the questions and to complete the process. I am never in a hurry.
I have been in a couple of investigations where sellers did some homework. They provided me the obvious financial statements and general information when I met with them for the first time. I still gave them my long list, but for some reason their eyes didn’t widen and they didn’t freeze in their tracks. They looked at the questions and said, no problem, we’ll get these answers put together for you as well. I knew that those investigations would proceed timely and generally uneventful; which they did.
HOW TO PREPARE A DUE DILIGENCE PACKAGE
You can Do-it-Yourself. You can google “due diligence questions” or “due diligence investigations” and probably come up with different lists of questions typically used in the due diligence process. I’m sure there are books and articles on the subject as well. I encourage you to get familiar with the process. From there, it’s as simple as putting together the answers and documentation in response to questions typically asked in due diligence. Is it really that simple…. Welllllllll, maybe not.
Obviously I do this professionally and charge fees to clients, so this may be somewhat self-serving. You should hire a due diligence consultant to coordinate your anticipated advertising, sale, and subsequent due diligence investigation. Many times, the company’s CPA or General Counsel will take on the role of due diligence coordinator; or a member of the executive management team will do so. I have also seen the business broker take on those responsibilities, but that really isn’t their job, nor should it be their job.
When you hire a professional due diligence investigator in the beginning of the sales process, before actually listing the company for sale, that professional should be able to guide you and your listing broker on items to highlight, items to shadow, and items to be concerned with in the ultimate sale. You should know all of those things before you run your first ad, make the first statement about selling your business, and before talking to anyone. Often, I’ve seen sellers call up their CPA’s and ask them to “Polish-Up” the financials; thinking that’s the most important thing. Not in my opinion. Most buyers assume that you’ve got your financial records in order. If you don’t, you’re already in trouble. What about your litigation history? Your experience rating in workers comp? Your safety record, OSHA investigations, EPA violations, when was the last time you took a physical inventory, and the list goes on.
I usually ask for a listing of employees and brief job descriptions. I’ve done investigations where I actually had to interview the employees and write the job descriptions. What did that say about the management effectiveness of the owner that wanted a consulting agreement post sale? And what did it say about the competence of the human resources staff that the buyer would be relying upon after the sale? All of that can be avoided by hiring a due diligence investigator prior to listing the company for sale. Let YOUR consultant conduct a due diligence investigation for YOU and YOUR eyes only.
With your own investigative findings in hand, you and your business broker can work together to develop a sales strategy for the business. Interestingly, more often than not, buyers will see a “problem” in the company as an opportunity to improve financial performance. Now that doesn’t mean you want to create problems thinking a buyer will like it. Many buyers will get hands on after a transaction in an effort to see what can be improved. If you are honest and tell the buyer in advance what opportunities exist to improve financial performance and why you haven’t implemented them, your honesty can build trust and actually increase the buyers desire to acquire; especially if he sees the solution you suggest as an opportunity to make more money. Such revelations can be a slippery slope, some buyers will attempt to use that against you to lower the price. If they discover the weakness on their own, they’re going to lower the price more; in my opinion.
HOW TO HANDLE THE DUE DILIGENCE INVESTIGATION
As previously discussed, be prepared. Here are some key points to address once a Letter of Intent is executed:
• Appoint a single person within your organization to coordinate with the buyers due diligence investigator. This is a critical decision. This person must be friendly, capable of effectively communicating, knowledgeable, and with authority to respond to questions. I have experienced seller’s representatives who had no clue to the process, were defensive, and acted as obstructionists to inquiries. The right person will speed up the process and minimize conflicts.
• ALWAYS review materials and information being given to the buyer. Ultimately, the seller will “represent and warrant” certain facts about the company in the closing documents. As a seller, you will want to make sure that everything provided to the investigator is accurate, complete, and truthful.
• Make a workspace available to the investigator that allows privacy to the investigator and minimizes his/her ability to “overhear” discussions by you and your staff. I am often amazed at the things I pick up by listening to workers talk to each other.
• Respond timely to all questions and requests for documents. In doing so, you appear to be “on top of your game” and you will hasten the investigators departure. If you don’t know something or don’t have the document, tell the investigator and tell them when they can expect the answer.
• Do your best to accommodate the investigator in every manner possible; i.e. providing info on local restaurants, break room location, restrooms, etc. In building a relationship with the investigator, he may come to you directly with a concern. If there is open communication, the investigator will have the ability to identify the concern, report your comments to the buyer, and potentially end any further discussion. Alternatively, small issues can develop into big issues as the small issues mount into piles of unanswered questions.
• Most importantly, attempt to relax. If you have properly prepared, you’ll be able to address all the questions. Give the investigator all the time required, send the clear message that you have nothing to hide.
• Respect the task the investigator is charged to accomplish. He/she has been hired by the buyer to audit the information provided by the seller and search for anything that might dissuade the buyer’s willingness to complete the transaction. The investigator is supposed to look for problems, look for discrepancies in reported info, and look into the internal workings of the company to be acquired. It’s not personal….. it’s just the business process associated with buying and selling a business. Don’t take it personally, don’t let anything get to you.
ADVANTAGES TO THE SELLER OF HIRING A DUE DILIGENCE INVESTIGATOR
First and foremost, the seller gets the benefit of experiencing due diligence with nothing at risk. The work can be conducted leisurely with no pressure on the staff to drop everything and answer questions.
Secondly, the due diligence investigator will discover things and point out items that need attention. Often, an outsider will have a different view or perspective on the business and will see things that the owner, his staff, and or his CPA may have overlooked.
Third, when that day comes for a buyer to send in his/her due diligence investigator, the seller will be prepared and the investigator will soon realize that “the house is in order”. Instilling confidence in the investigator that the information provided is correct and that the seller’s staff is responsive will most likely shorten the process and minimize the depth of the investigation. If an investigator gets the sense that something is missing, the natural instinct is to dig deeper, ask more questions, and take more time.
Lastly, upon completion of the sellers due diligence investigation, more often than not, the seller becomes acutely aware of the strengths and weaknesses of his/her business. The business broker has a clear picture of the company and can better write an offering memorandum to highlight the strengths and address concerns that may be raised with the weaknesses. In some rare instances, I have submitted my report and the seller decided not to sell until improvements could be made in the company that would enhance the ability to sell the company and increase the ultimate sales price. In one instance, the seller decided he wanted to keep his company.
Generally speaking most people think of the buyers cost of due diligence. The seller will bear their own costs as well. The seller will be consulting with their CPA, their attorney, and the staff can be overwhelmed in responding to due diligence questions; taking their focus away from their day to day duties.
Once a business owner decides to sell their business, a process is set in motion that can be challenging and expensive. I always recommend that the business owner at least consider the services of a competent business broker. An experienced business broker will be invaluable to the seller and earn every dime of their fee. While the fee’s are often considered high, the benefits to the seller generally outweigh the costs. Not all brokers are the same. Interview several and let them explain their services. Pick one you like. Pick one with experience. And pick one that can communicate in your language. You will spend a lot of time and conversation with this person, and you will pay them a lot of money; pick carefully.
As with most business activities, the selling process requires work, focus, and a plan; with the latter being critical. You’re not selling your house or your car, you’re selling your source of income, your livelihood and your career. Think things through, get the best professional help available, and make sure you stay “tuned in” to every step in the process. Your future depends on your ability to successfully navigate the twists and turns that you will encounter in the selling process. Having an experienced professional at your side will usually bring more cash to you, shorten the process, and bring you the ripest fruit for the hard work you have invested into your business.