Stress test: Due diligence in a business sale

If you have been through the sale of a business, you have likely experienced the tension, tedium and conflict of “due diligence” – a key phase of the deal during which the buyer truly gets to know the business they are buying.

If the sale of your business will be your first such transaction, brace yourself for a potentially bumpy ride, as the euphoria of a signed letter of intent (see related article) gives way to the aggravation of the buyer’s seemingly never-ending requests for documentation.

Anticipating what the buyer will require, perhaps with the guidance of a business broker or M&A intermediary, can help the seller smooth out the road. When the buyer issues their umpteenth request for meaningless documents or information, the seller’s ability not to take such requests personally, and to remember that the buyer really does want to buy the company and this is “just business,” can keep the deal moving forward.

The Benefits of Due Diligence. From the buyer’s perspective, due diligence is the process of ensuring that, before a deal is finalized, things actually are as they appear to be.

While it takes work, due diligence helps squeeze risk out of a sale, benefiting the buyer and, in many cases, the seller. For the buyer, the process safeguards against buying a business that doesn’t measure up to the seller’s representations. For the seller – particularly in deals involving earnouts, seller carrybacks, or other post-closing obligations – due diligence can reveal potential problems that would surface only after the deal is done.

Document review and the answers to due-diligence questions are critical. It is a complex, time-consuming process, but with so much on the line with most business sales, neither buyer nor seller should make a major decision without a solid foundation of accurate information.

Preparation. While the scope of information required by the buyer is typically very broad, in most deals the central focus is on the subject company’s financials. That should come as no surprise; the purchase price is usually based on some multiple of the company’s net revenues and adjusted earning capacity, and the buyer will want to know that they are getting what they are paying for.

The financials also serve as a roadmap to the subject company’s operations, which will lead to questions. The answers will spark more questions, and that back-and-forth, rooted in the financial records, is a major contributor to the length and emotion of the due-diligence phase.

Here is a short (and incomplete) list of basic records and reports that will provide the buyer’s starting point for financial due diligence:

• income statements, for every year
• balance sheets, for every year
• sales data, for every year
• accounts receivable aging
• bad debts
• capital equipment lists (age, condition, and value)

Your income statements and balance sheets should show both actual and “recast” financial information. By recasting your financial statements, you are able to show your business’s true earnings and net worth, in a form that buyers want to see, cleansed of personal expenses and assets that you might have run through the business.

(To take their financial review a step farther, your buyer might perform a “quality of earnings” review. Such reviews are common in larger transactions, especially where the buyer is a private equity firm or other type of professional buyer. A quality of earnings report helps the buyer evaluate the business’s true profitability by adjusting EBITDA – earnings before interest, taxes, depreciation, and amortization – to reflect any non-recurring revenues and expenses.)

After that, the types of information that a buyer (or seller) may request varies with the type and size of the business and the specifics of the deal. Here is a general list of non-financial issues and information requests that are likely to arise during due diligence.

• Employees: organizational structure, employee census (including position, hire date, DOB, wages/salaries, benefits, pending retirement), employee manuals and personnel policies, benefit plans, and retirement and pension plans
• Legal issues: entity documents, operating agreements, contracts, licenses, leases, employment contracts, pending litigation, pre-litigation disputes, etc.
• Government compliance: tax returns, payroll records and reports, company- and industry-specific issues (federal, state, local), regulatory compliance (e.g., environmental reports), etc.
• Customer lists
• Supplier lists and agreements
• Marketing materials
• Data security
• Intellectual property: trademarks, copyrights, patents, proprietary processes, operational and procedural manuals
• Product and service lines
• Insurance policies

For a more comprehensive list of information requests, see a 2019 Forbes article, “A Comprehensive Guide To Due Diligence Issues In Mergers And Acquisitions.”

As you prepare your business for sale, it’s never too early to start gathering the documents and information that you can anticipate being requested by a sophisticated buyer. Organizing your information in advance heads off surprises, casts you and your business in a positive light, builds buyer trust and confidence, and shortens the due diligence phase en route to a successful closing.

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