If you are thinking of selling your business and you are not sure what due diligence entails, how long, what to look out for and / or more importantly, if you are not feeling excited about the actual due diligence process, read on. I am certain this will of significant help to you.
This should apply to every size of business, but I am writing this more in terms of small businesses. It can be across any industry.
Due Diligence during the sale of a business should feel exciting and liberating. It is another step closer to realizing all the blood, sweat, tears and investments that went into your business. If it does not feel exciting, you can be certain it will not yield the results you are hoping to get from the sale. Fortunately most of this can be fixed!
To start with, hopefully, you have gone through the process of vetting your business so that it is ready to get the premium it deserves, secured a good buyer (or better still, buyers) and signed a good LOI. If you are not sure, I wrote an article on how to ensure you get the best value of your business —highly suggest you read it here.
Let’s get into it!
What is due diligence exactly?
Due diligence is the process a prospective buyer (after signing a letter or intent to buy) will get into the weeds of your company to ensure that his / her investment is going to bring the profits and / or strategic benefits desired post-sale. In other words it is a complete inspection of your business. Typically the due diligence will entail thorough inspection of your financials, operations, legal structures, risks and opportunities, historical and future projections and assumptions.
There are many due diligence checklists you can find online — mostly written from the point of view of the buyer. Suggest you go through a few of them. They will give you a good idea of what the seller will seek and want from your business during the process. Broadly there are 3 categories.
Financial due diligence — typically deep inspection of the last 3 years of financial statements, sales and profits by customer / business unit / product line / region / territory etc, A/R and collections, inventory, real estate and equipment, projections with assumptions, risks and opportunities. There could be several other financial documents that could be requested. Have your CPA handy. Be prepared to provide a full back-up of your accounting file and be ready to answer any question — “show me the full trail of order to cash for these sales”, “show me the details of this inventory write down” etc.
Operational due diligence — this would be done by deep inspection of the day to day activities of your business — sales, marketing, customer service, manufacturing, procurement, R&D etc. Most importantly the buyer will ask you for your day to day involvement in detail because he / she will assume that you are going to exit the business; if not immediately, at least some time in the future. Typically the buyer will go through different processes, staffing, hiring, recruiting and other HR functions, equipment, technology, systems, communication channels, process documents, reports — basically the nuts and bolts that hold your business together as it has been and as it will continue to grow in the manner you have projected to the buyer.
Legal due diligence — this would entail founding documents, structure of business, shareholder statements, legal entities (if more than one), debts, investments, all contracts with customers, vendors and partners, leases, all types of agreements, NDAs, employment contracts, trademarks, copyrights, patents, IPs etc.
Every buyer will have a due diligence checklist that they will want you to follow. They will have a “data room” where they will ask you to deposit all documents, which is basically a secure online document management system to organize all documents.
If a buyer does not have a proper due diligence checklist and / or a document portal setup, it is an early sign that the buyer is either not organized, or not an experienced buyer or not serious about commitments and meeting deadlines.
If you have not gone through an M&A process from start to end, it is an absolute must that you do some thorough reading on the whole process of due diligence, read case studies, ask around or you can always ask me — I am happy to discuss. Going into the process blind will only cause unnecessary delays, unintended concerns or even risk losing an exciting buyer or not getting the premiums you are hoping for from your company’s sale.
Why is due diligence important for both the buyer and the seller?
Every buyer will do some form of due diligence and almost all of the time it will be pretty intensive as I have summarized in the prior point. Without a proper due diligence most buyers will not be able to assess the value your business will fetch for them, longer term, past the sale. So for the buyer it is a extremely important process and should be the most important process. It is kind of obvious.
However, for you the seller due diligence is equally or even more important. Why you might ask? Especially, if the goal is to sell your business and move on, why should you get into due diligence thinking it is really important?
Firstly, if a proper, as explained above, due diligence is not being done, then most likely it signals that the buyer is either not very serious or is disorganized. If the buyer is not serious you need to poke deeper and ask why the due diligence is not going as planned — hopefully you have setup proper expectations with the buyer about due diligence prior to signing the letter of intent (see point 11 in my prior article). If the buyer is disorganized, ask yourself this — do I want this person / group to run my company after I am done? Your employees, customers, partners, vendors and extended network, that have trusted you, would have to work with this new ownership.
Secondly, if a well-planned due diligence is not done, most likely a lot of issues will come up post due diligence during the final stages of the sale. It will waste a lot of time and most likely money with attorneys on both ends duking it out on issues that should have been sorted out in due diligence by both buyer and seller.
Finally, and most importantly, you will end up spending a lot of time and energy, get to the finish line and then feel like signing the closing documents. One of the documents will be an indemnification contract, which can really trip you up post sale. You are still liable after the sale. Hopefully your attorney will represent you well and will negotiate on your behalf such clauses in the contract. However, if the due diligence was not done properly, there is a chance your buyer might come back later (especially a disorganized one that will not be able to reap the benefits of the purchase) and indemnify you. You may be able to defend yourself fine, but if you can avoid any such headache and risk, it is better to do that early on while you still hold the reins of your company.
How to be prepared for a successful due diligence
It is actually not hard. Here is my take on this having gone through many such processes, from billion dollar organizations to my own small business recently.
Step back for 7 days and see how the business runs on its own. When I say step back, just let go as if the sale has already happened. If you cannot do this, that is the 1st sign that your business is extremely dependent on you as opposed to other personnel or processes. You have to fix that asap as best as you can.
Before you do this talk to your key employees, customers, partners, vendors and contacts. You can tell them that you need to focus on an internal project of documenting your business (for quality standards or better process management etc).
Next imagine ourselves standing outside looking in with a lens that allows you to see every nook and cranny of your business setup, numbers, operations, people, customers, past, future and anything that can remotely touch your business. If you cannot think of such a lens, try making notes / lists. Think about this — if you are not able to do this, imagine how difficult and frustrating it will be for a buyer, one that you hope will pay premiums on your business.
Go through each segment of your business starting with financials, then every portion of your operations, ending with legal. I have detailed this out in my prior article (see point #6). You should have an extensive, documented checklist at the end. Keep all documents in a document library.
Most seasoned buyers will see how long it will take you to give them documents that they will keep asking. It just shows how organized and stellar your business is, or not.
When you feel that you are excited to get into due diligence and that you are proud to show off your business (maybe you already are which is great!), you are ready.
What to watch out for during the due diligence process
One of the most important and obvious point is that you have to extremely careful on ensuring that the word does not leak out to contacts who you believe should not hear anything about an impending sale of your business. If it somehow does, you will have to be ready with an explanation and an answer. In one case I have witnessed a key employee quitting, which resulted in the jeopardizing the sale with a very serious and lucrative buyer. If you have such dependencies think about ways you can mitigate the risks before you start the process — maybe you can bring them into the process?
Some of the other things to watch out for are as follows:
Separating yourself from the business: most small businesses, especially LLCs are run like a lifestyle businesses — your personal finances, information, data, emails and basically your life is deeply intertwined with that of your business. As harsh and extreme as it may sound, if you want this process to be as painless as possible, you have to surgically remove yourself from the business, before you start the process. It will make your buyer that much more confident.
Letting the buyer lead the process completely: this is important because it will only delay the process for both you and your buyer. It will create unnecessary discussions that can be avoided by working together in a slow but steady pace. More importantly, it will stop a buyer from getting into rat holes that may seem important, but in reality is not important at all.
Feeling uncomfortable pushing back if needed: this is especially hard if you have a serious and lucrative buyer. You will not want to offend him / her or want to create any type of conflict or disagreement. This is a completely false alarm. Your business is more important to you than to the buyer at this stage. If there are items or topics that you disagree on, explain them properly and stand your ground — it is the tone and delivery of your message in the end. Being respectful always pays off anyway in anything we do in our lives!
Not working towards a set due diligence plan: hopefully you have set a proper plan for due diligence in the LOI. If so, you have to ensure that you are sticking to plan — scope and time. Treat this like any other project, only, the most important project for your business most likely!
Getting ahead of yourself: do not start discussing post due-diligence topics like attorneys, very detailed terms of the sale, closing etc. It shows you are more desperate than you need to be. It will also take you away from the focus you need to have to complete the process as best as it needs to be, so that rest of the sale goes smoothly.
How long does the process take in general?
There is no set amount of time for due diligence. I have gone through diligence periods that have lasted from 3 months to 2 years.
There are some industry statistics on how long due diligence can take and you can find such reports on google, but I would recommend not to go by any of them. They setup false expectations.
If you are in a rush to get to a sale, then you will have to work with certain buyers that will do the diligence in a shorter period which will limit your sale from a choice and value perspective.
The best thing to do, is prepare, prepare, prepare and set up the expectations together with your buyer upfront.
No one wants to extend the due diligence period. The rush and excitement to get to the finish line is equal for everyone. But if the process is not done right, it will most likely bring serious and lasting consequences in the future for both the buyer and the seller.
What needs to happen right after due diligence
After the due diligence process is completed, (remember to have proper expectations set about what constitutes close of due diligence in the LOI) the very next phase will be to engage an attorney on your end if you have not already done so. We did not engage an attorney to review our LOIs that we received from different buyers— if you are well prepared for the due diligence you will not need to get an attorney. Remember an LOI is just an intent and not any final term of sale — it is basically a document that sets the due diligence in motion. If you are not getting an attorney to review the LOI, however, it is very important you read every word carefully. You can always discuss with your broker who is likely more experienced than you are. For more complicated and extensive businesses, it is likely that you will get yourself an attorney prior to signing any LOI.
What type of attorney is a topic that I will discuss soon, but one point I can make here is that the attorney you choose should understand your industry and has worked with businesses your size. You can ask your broker if you do not have an attorney you know.
You will also discuss with your buyer about giving you a closing date at this point. If your buyer is working with a lender, especially an SBA approved lender, there will be several other due diligence periods that might come in. You need to keep your foot on the peddle by trying to get a closing date, at least an estimated date. This will keep the ball moving in the right direction.
The sale will then move into the last stages where papers are drawn, attorneys reach agreement on the clauses and then hopefully closing.
Due diligence is the most important process in a business sale. It is equally important for both the buyer and the seller. It protects both parties as the sale process gets to the finish line and even after, when a badly run due diligence can open up unnecessary headaches for the seller based on different signed contracts (indemnification, non-competes).
If you are ready to sell your business, ask yourself this. Am I excited to have a buyer inspect all portions of my business, starting from the day I started the company to now and for the next 5–10 years? If not, you are most likely not ready, or will not be able to get those strategic buyers that will pay you a higher premium than regular financial multiples.
I would love to hear about your experiences or comments and thoughts on this. If you have any question, I am always happy to answer.
Good luck on the sale if you are considering it, or going through it. If done right, it will be the most rewarding experience for you and your business.