Chapter 10
Due Diligence
In the initial chapters we talked about marketing your business to find a qualified buyer, and at this point you have completed the positioning needed to prepare your business for due diligence. You completed your down select to the buyer you hope to close a deal with. This is the buyer who offered you the most acceptable deal. Even though you have a purchase agreement or letter of intent (LOI) with them, the deal isn’t done yet. Now you are at the point where your buyer will want to perform a detailed assessment of the business that goes much deeper than the marketing information you previously provided in your marketing “Book.” The detailed assessment the buyer performs of your business is called due diligence.
“Everything I have been telling you about my business is true. . .. Trust me.”
Preparation for due diligence was done in parallel with your marketing activities and, by the time you get to due diligence you should have completed all of the work to fully position your business.
Due Diligence Is a Continuation of Negotiations
Don’t confuse the fact that you have already negotiated a price and accepted a written offer from the buyer with the price you may eventually be paid for the business. You may find they are two different things. Your buyer will use the due diligence process to verify that all the marketing information you provided is true and that the business has the transferrable value you advertised to justify the price they offered. While the offer you negotiated with the buyer may determine where the bar is set and how high the price will be, many experienced buyers will try to use due diligence as an opportunity to further renegotiate in an attempt to drive the price down.
“Based on what we found during due diligence we are going to lower our offer.”
Your buyer will use the due diligence process to verify that all the marketing information you provided is true and that the business has the transferrable value you advertised to justify the price they offered.
During due diligence, buyers will try to identify any warts your business may have (i.e., discover where the risks are). They will perform due diligence to ensure they are entering the deal with their eyes fully open, but that may not be their only purpose. They will dig to find areas where potential for risk exists, and they will use that information to help negotiate a better price (that is, better for them). Most people overlook the second part of that statement. If the due diligence team discovers a wart that you were not aware of, you will likely lose the discussion point during negotiations.
“The buyer gave us a letter of intent with an offer of $10 million but during due diligence they discovered that a critical supplier was raising their prices and renegotiated the price down to $9 million.”
Many buyers try to use due diligence to devalue the business and use that information to justify lowering their offer price. To avoid finding yourself in this situation, you need to identify any outstanding issues (all businesses have warts) and resolve as many issues as possible during your positioning to mitigate or avoid discovering any new risks. Then you should be upfront about any remaining known or outstanding issues. Be prepared to address any of the warts your business has well in advance of due diligence, and do not try to rationalize your way around them if they are raised first by the buyer. You also need to enter the due diligence process with your eyes fully open so that you can “take the wind out of the buyer’s sails” during negotiation.
“Yes, that is a known risk, but we are already taking steps to mitigate it.”
“Here is our plan, which is already reflected in our price.”
The Due Diligence Process
In the prior chapters, we talked about some of the key things you can do to prepare for the legal, financial, and operations assessments of your business. But first you need to understand a little bit about the due diligence process itself.
Due diligence is sponsored by the buyers. It is their event, so they will provide you with a schedule and a request for the information they need to perform their assessments. It will include a list of documents to be reviewed and a schedule of any other activities the buyer wants to request. They will ask for a visit to the business to observe the operations first hand along with providing a list of questions they will want written responses to. They may also ask you to set up meetings with some of your customers either in person or by phone and possibly meetings with some of your vendors. Due diligence will kick off a flurry of activity that will make it difficult to keep the events secret.
This flurry of activity is usually the point where some of the employees first become aware that something is happening. News about this type of event will spread quickly in a small business so, even if you have tried to keep the sale from your employees up until this point, you should be ready and anticipate their questions. Without elaborating, a simple explanation that “We are speaking with investors and appreciate any help you can give” may suffice to answer their immediate questions.
This flurry of activity is usually the point where some of the employees first become aware that something is happening.
Document List
The buyers will request an extensive list of documents that can include all the legal documents, business plans, employee folders, customer agreements—and on and on. Any document with a signature or any existing agreements, policies, or procedures relating to the operation of the business may be on the list. Responding to the request for documents really exposes the business, so it is critical that the confidentiality terms in your agreement or LOI are able to protect you. Imagine the impact of releasing your customer agreements, including end dates, to a strategic buyer. You also must have your attorney review the confidentiality agreements between your business and your customers. Releasing those agreements to a buyer may violate your customer agreements.
At one time, sellers responded to a document request by creating a “due diligence box” that contained hard copies of the requested documents. Providing hard copies had some draw backs. It was inconvenient to copy that many documents (never give an original), and typically resulted in many physical boxes of documents and lots of “trees killed” to supply the paper. It was easy to lose track of things. Documents were lost, copies could be made and not tracked, and there was no record of who had read them. It was also difficult for the buyer to search that many documents when they needed to find specific information.
“By the way, we know there are over 2,000 documents resulting from our request, so would you mind providing three copies of each for our review team?”
If the buyer does request hard copies of documents, specify that you will only provide one copy and that a record be provided of any additional copies the buyer makes (or prints). Technology has won the day on document requests and the due diligence box has given way to virtual data rooms (VDRs). VDRs are now being used to create reviewable document repositories (hard copies can be scanned into the VDR), which allow the buyer’s team of reviewers to access your documents.
Technology has won the day on document requests and the due diligence box has given way to virtual data rooms (VDRs).
As part of your preparation for due diligence you should have already have collected all the documents you anticipate a buyer will want and created a document archive to put them in. That way, there won’t be a delay while you try to find relevant documents after the start of due diligence. VDR services also offer a side benefit for buyers. The documents in the archive are now electronically searchable. Tools that were originally developed to support litigation discovery also work well for VDR discovery and allow the buyer to search all your documents for key words and phrases. This can work much more to the buyer’s advantage than the sellers and enables them to look for trends. They may know more about your business than you do by the time they are done!
Preparing an Asset List
The buyer will request a list of all the assets that will be included in the deal. Review your asset list to make sure it only includes the items you intend to deliver. I had a client that had a large, high volume, very expensive printer they had leased. When their support staff inventoried their tech equipment they included the printer on the asset list. In fact, there was no intent to include the printer in the deal, but there it was, big as life on the asset list that had been provided to the buyer. The equipment lease for the printer wasn’t identified (no one expected to deliver the printer) and the business ended up buying out the lease and delivering the printer to the new owner. Be like Santa—check your list twice, and don’t give anything away you didn’t plan on! There are numerous inventory applications that can help with this task, even some that are free. It makes sense to use one of these products since the list may be flexible during normal operations and your list will be easier to maintain if it is updated in the normal course of doing business. This activity will be needed whether you are entering an asset or an equity sale.
Review your asset list to make sure it only includes the items you intend to deliver.
The assets of your business include both its tangible and intangible assets. Tangible assets are fixed assets used to operate the business. Intangible assets are nonphysical assets that include the reputation of your business and its good will. Intangible assets also include intellectual property (IP) and add transferrable value—but you will need to discuss how they are valued with your CPA. Correctly identifying both types of assets is a critical value driver. Assets can also be categorized into fixed assets and current assets. Fixed assets include tools, equipment, machinery, property, plant etc. Current assets include accounts receivable, debts, stock, bank balances, and cash. Buyers will want to see these distinguished on your balance sheet because current assets generally change before closing in the normal day-to-day operation of the business.
Tangible Assets
Your CPA may already have a fixed asset list that is included on your balance sheet. If they have done a good job maintaining the list with sufficient detail, then you are ahead of the game. Experience has shown that the list your CPA maintains may not be of sufficient detail to satisfy a buyer. Creating a fixed asset list that inventories (and tags) every item that will be included in the sale may take some time and thought. It requires some care. It also has potential tax implications on the sale, so this is one of the areas you will need to discuss with your CPA and tax attorney. The good news is that it is a task that can be started early, before engaging with the buyer, and can be delegated to employees to complete. Depending on the size of your business, the fixed asset list can become excessive or it can be simple. Without a detailed fixed asset list, you will be taking a “what you see is what you get” approach.
What about the owner’s Cadillac Escalade that is parked in a reserved spot by the back door? Is that included in the deal or will it be an adjustment you make on your income statement? The fixed asset list is a list of the hard assets, listed by model and serial number, which are used to operate the business. The Escalade may eventually become an adjustment when calculating your EBITDA.
Intangible Assets
An intangible asset is a nonphysical asset (“it is without substance”) but which has value. It’s easy to see how a machine or a building or even the furniture in the building has some value that can be assigned to it, but what intrinsic value do you assign to the goodwill you have established with your customers? Intangible assets include any stocks, bonds, or other assets held in a bank. They have value even if they can’t be physically held.
Your customers continue to come back because they know the service they get from you will be better than what they get from your competition, so you know all the hard work you put in has some intrinsic value. When customers go to the store, they ask for products with your brand name, so you know your trademark on the package tells customers they can trust the product. Doesn’t your trademark have value? You filed for a patent that has created a barrier to entry and keeps your potential competitors from creating a similar product. Doesn’t that patent have some intrinsic value?
Of course, your intangible assets add value to your business. That is why small business owners work so hard to attain them. Assigning a value and determining how to treat that value for tax purposes can vary greatly from country to country. I find that most small businesses do not, for various reasons, take the time to consider what intangible assets they have. As a result, they fail to capture those assets and are not able to benefit from the value they could add to their business. As you start preparing for due diligence, an effort to identify, capture and value the intangible assets of your business should include professional help from both an accountant and an attorney.
Preparing for the Due Diligence On-Site Assessment
After completing their document review and analysis of your response to their written questions, the buyer will have a list of items they will want to observe and validate during their on-site visit. Some buyers perform due diligence in a very formal manner and others are much less formal. In either case, whether they are looking for specific items they want to verify, or they just want to do a walk around, whether this activity is scheduled to take a day, a week, or a month, be prepared to have the buyer under foot for a bit. Make sure you have an agreement with the buyer ahead of time regarding any employee or customer discussions and be prepared to be as open as possible with them. This is not a time for contention from you or your employees (it may be a stress-driven result, but it happens), so if you find any contention building you might want to take steps to end it immediately.
“Hey boss, I know those guys who were visiting work for the competition and kept asking how we build these widgets so fast.”
This may be the first real interaction the buyer has with your management team so be sure to give your employees a chance to shine—both for their potential new boss and for the value the team you built brings to the business you are selling. You want this to be a good experience for the buyer, too. You don’t want the buyer’s due diligence team to conclude that neither you nor your managers don’t want them there.
“Those guys clearly didn’t want us there. We’d better plan to bring in a new management team after we close this deal.”
This may be the first real interaction the buyer has with your management team so be sure to give your employees a chance to shine.
The buyer may bring in one or more people to do the on-site assessment, depending on the size of your business. At Diligent we tend to use two to three people with a mix of skills (mainly financial and operations); our assessment is what would normally be termed as an enterprise risk assessment. We have found it pays to take the time to reassure the employees that we are looking for risk and not assessing their individual performance.
The buyer’s team will want to sit with individuals (but not necessarily everyone) and ask what people do and why they do it. It is easy for these questions to sound like the buyer is critiquing rather than clarifying during these interviews. This is particularly true if the buyer is a former competitor who is using their employees as assessors rather than trained assessors. Keep an eye out for this and prepare to explain to your employees that the buyer’s questions are clarifications. If you feel the assessor is critiquing, then bring it to the buyer’s attention immediately. These misunderstandings can quickly “derail” a deal or give the buyer a permanent bad taste for the deal that will show up when you complete your final negotiations.
“Oh yeah, we’re interested, but from what we’ve found out, we’re only offering $8 million instead of the $10 million we originally agreed upon.”
It’s a Good Time to Build the Relationship
You are trying to sell your business. The best way to sell is to establish a relationship with the buyer. Allow plenty of time to visit with the buyer, offer to answer any questions, and in general, make yourself available.
“Hey, these are good guys; I look forward to working with them.”
As the on-site assessment ends, it is a good time to host a dinner with your management team and the buyer, pay for a round of golf at your club, take a day off for offshore fishing, or whatever venue works best for your area. Your goal is to build a trust relationship. If nothing else works, make it a barbeque in your back yard.
The best way to sell is to establish a relationship with the buyer.
If you have two or three customers that you trust will not panic at the news of the sale and who will be willing to say why they use your products or services rather than a competitor’s, consider asking them to join you and the buyer.
Post–On-Site Activity
After completing the on-site visit, the buyer’s due diligence team will leave to prepare their due diligence assessment report. Less formal buyers may simply use a “thumbs up/thumbs down” method but more formal buyers will have their team develop a risk/opportunity assessment report where they document their findings. The advantage of the more formal method is that the report can be used by the buyer to optimize resources to mitigate identified risks following the purchase. You, as the seller, will likely never see this report.
Following their analysis, the buyer may request a second on-site visit to verify some of their findings. Their activity during the second visit will give you some indication of where they may have some concerns. You may also get some additional document requests or questions. Don’t panic. These requests are normal. Remember, the assessment is looking for opportunities as well as risks.
“On our first visit we thought we saw an area for improvement, so we went back to satisfy ourselves this was an oversight of the seller and would be a real opportunity for us.”
“I guess after running the business for twenty-five years he was just too close to see the opportunity.”
At some point following their assessment, the buyer will notify you of their findings (positive and negative) and what their intentions are. Some buyers will provide feedback in the form of a letter where others will want to have a sit-down meeting. Neither by itself is a sign of success or failure. Attend these meetings, learn what you can, and don’t get defensive. Have your attorney and your CPA attend with you to take notes
“Based on what we found during due diligence we are prepared to move ahead, pending discussions about our original letter of intent (LOI).”
Read that as “we want to negotiate the price.” It may be inconsequential, and you can agree to accept their modified offer and shake their hand on the deal or you can accept their offer for consideration. Of course, you also have the option to dig in your heels and take the position you’re not ready to change their last offer. They could also say:
“Based on what we found during due diligence we are not prepared to move ahead and are going to rescind our original offer.”
Well, that’s a “bummer”! You had more than one offer and after selecting them and dropping the other offer(s), they have now decided they are dropping out. For this reason alone, when you write the agreement with them, you need to specify how long the buyer will have to complete their due diligence as one of the terms. You may be able to return to your second choice (if they haven’t moved on to another purchase), but even if you move quickly the deal may already have gone cold with them.
You need to specify how long the buyer will have to complete their due diligence as one of the terms in the LOI.
Jim’s Bakery Example
After agreeing on the terms of their deal, Jim signed an LOI with one of the buyers. He was anxious to have the buyer begin their assessments. The buyer sent him a due diligence schedule they intended to follow along with requests for a list of documents for review, a list of assets to be included in the deal, and a list of questions they wanted written responses to.
The schedule showed a sixty-day due diligence period, which seemed excessive. Jim worked through his intermediary and was able to reduce that to forty-five days. Part of the justification was due to the asset list request. Jim’s Bakery had prepared a list and hadn’t waited until a request arrived to prepare one. The same was true of the document request. They had already created a document archive, so most of the requested documents were already in a secure online repository. The buyer asked for a couple of documents Jim’s team hadn’t thought to include but it was an easy task to add them to the existing repository. Jim had his CFO and COOs provide written responses to the written questions.
An office was set aside in the commercial bakery for the buyer’s due diligence team to work. Employees were simply told the due diligence team were from investors who were assessing the business without elaborating anymore and the employees accepted this explanation. The employees were asked to cooperate as much as possible with the assessment team. The work they had been doing to clean up and improve the efficiency of their operations seemed to have positioned the business perfectly to impress the due diligence team.