If you’re a business owner looking to sell at some point in the future, you may be discouraged to hear that many sale transactions fall apart during the due diligence phase. You have the ability to minimize the risk of this happening by being a diligent business owner before putting your business on the market.
Due Diligence – What Is It?
Due diligence may be the most critical stage in a business purchase and sale transaction. It is during this process that the prospective buyer will do its best to learn the intimate details of your business – its strengths, weaknesses, opportunities for growth, and areas of concern. The buyer’s objective is to uncover as much as possible about the business before buying it to ensure the purchase price is justified and to avoid unwelcome surprises after the closing.
Most businesses are not perfect, so we recommend that a business owner go through a “pre-sale due diligence” exercise before putting the business on the market in order to get a feel for the issues a buyer may raise. It’s like doing an inspection of your home before listing it for sale so you have an idea of the repairs a buyer may request that you make, or for which the buyer may want a reduction in price, or any items that may be so significant – like a faulty foundation – that the buyer may just walk away from the deal.
This exercise in business self-awareness requires that the business owner dig into legal, financial, accounting, tax, operational, administrative and other business matters that a buyer might consider relevant in its purchasing decision. The scope of due diligence will vary based on the nature of the business, and one buyer may have different requirements than another. A business owner can start by gathering documents based on a rather general but comprehensive due diligence checklist provided by a trusted resource.
Robust due diligence consists of a methodical review of a long list of documents and information, including the following:
- Corporate records for the corporation or LLC documenting ownership of the business, subsidiary and other affiliated companies, approval of non-routine business transactions through entity minutes, restrictions on selling the business, and permits and other business qualifications and authorizations
- Material commercial contracts, such as contracts with customers, suppliers and contractors
- Contracts with third parties that restrict the sharing of information, such as non-disclosure agreements
- Employment records, benefit plans and compensation arrangements
- Intellectual property ownership and licensing documentation for patents, trademarks, technology and trade secrets
- Agreements concerning the ownership or leasing of property, plant and equipment
- Correspondence and other documents relating to pending or threatened litigation, disputes that could lead to litigation, and regulatory proceedings or investigations
- Environmental, health and safety records
- Compliance policies and compliance training records
- Financial statements and tax returns
- Documentation of third-party and affiliate loan transactions
- Sales and marketing plans and materials, including warranty information
- Insurance policies and claims history
The document collection will take time and odds are that some documents will come up missing, so the sooner you start collecting documents the better.
Getting Prepared and Using Expert Resources
Generally speaking, it is prudent to begin pre-sale due diligence one to three years before putting a business on the market. If you are unsure how prepared you are for the exercise and the lead-time you’ll need to get organized, take that comprehensive due diligence checklist we mentioned earlier and initially assess your preparedness by rating your confidence in your ability to locate documents as “low”, “medium” or “high” – “low” meaning you’re not sure where the documents are and you’ll need to set aside extra time to find them, and “high” meaning you know exactly where the documents are and could provide them immediately if you had to.
All of this may seem overwhelming, especially for a business owner who is trying to run the day-to-day business operations and who may have little or no experience with due diligence. But professional advisors like lawyers, accountants, financial advisors, business brokers, and experts in business administration can provide much-needed assistance at a reasonable cost. Also, depending on the size of the business, there may be a group of key managers who are knowledgeable about the business and can facilitate the pre-sale due diligence effort for the seller, including interacting with the team of outside advisors.
As for the collection and initial review of documents and information, these tasks can be performed by an experienced and objective non-legal professional who can lead the team of outside advisors, identify areas where legal expertise is needed, help address issues and gaps in documents and information, and manage the internal virtual data room where documents would be systematically organized, stored and updated regularly (more on virtual data rooms later).
Gaining Value and Confidence
A careful review of the business well ahead of an anticipated sale will enable the due diligence team to identify and resolve issues before the prospective buyer uncovers them. There may be issues that can’t be resolved. For these, you will at least have given yourself a chance to prepare responses or propose potential resolutions when the prospective buyer asks about them, as opposed to appearing tentative, disorganized or as if there’s something to hide.
The reality is that you simply can’t afford to be addressing document or information gaps when trying to instill value and confidence in the business and close a deal with a prospective buyer. So it is critical to get things in order as soon as possible. Issues that arise during a prospective buyer’s due diligence investigation can cause delays in closing, reduce the price a buyer is willing to pay, or even kill the deal.
Tackling your business housekeeping ahead of time should put you in a more favorable negotiating position and increase the likelihood of a successful sale at the highest possible price. And it will give you peace of mind and confidence as you continue operating your business until you’re ready to sell to a third party or hand over the baton to a family member or valued employee.
The same efforts should be taken by a business owner who may be raising capital at some point in the future, since a prudent investor may be conducting robust due diligence of its own, just as if it were buying the business outright.
Building a Virtual Data Room
For decades, large transactions began with sellers populating a physical room with mounds of paper documents in preparation for the due diligence phase of the transaction. Sellers then gave physical and tightly controlled access to prospective buyers. Over the past 15 years, the use of electronic, or “virtual”, data rooms has become common.
A virtual data room provides an organized, secure, cloud-based document repository that can be remotely accessed at any time by users who have been given permission. It is one of the many tools available to business owners and their professional advisors in sale, investment and loan transactions. A virtual data room also serves as a useful management tool for businesses that aren’t preparing for a transaction anytime soon, by providing an accessible, organized, secure and affordable way to archive critical business information needed for its operations.
Building a virtual data room should be done over time, starting well before a sale transaction – and ideally at the inception of the business – rather than on short notice when a transaction comes along and there’s a flurry of other activity requiring the attention of the business owner and the management team. This will help to ensure that documents are collected and organized appropriately and in a way that might make sense to a prospective buyer, using electronic file folders that correspond with the pre-sale due diligence checklist you’re using.
Once the virtual data room is built, it will almost be as easy as “flipping a switch” to open it up to members of a prospective buyer’s due diligence team. This advanced planning ease and swiftness with which the buyer is given access to due diligence materials will instill trust and confidence at the outset and present the business and its owner as competent, professional and credible.
A disorganized, poorly structured, or sparsely populated virtual data room will be a source of frustration for everyone. It will be confidence-shattering and could negatively impact the perceived value of the business or worse, prove fatal to the deal.
Art or Science?
There is an art to negotiating and closing a deal. Preparing a business for sale – specifically due diligence planning – is more like a science that involves processes that need to be developed early on and implemented systematically over time. It’s easy for a business owner to get overwhelmed by the thought of the housekeeping task ahead if things aren’t already in order. But you don’t have to go it alone. Seek the help of external resources now so that you can be in the best position for your business to get top dollar later. You can’t afford not to.
If you’d like On Point Business Administration to help you get started with your due diligence trial run, please contact us.