Sell Side M&A Blog Series - Vol 2 - The Due Diligence Process (From the Seller's Perspective)
Due diligence in the context of a business sale is the process that a buyer goes through to verify that the representations about a company made by a seller are materially accurate. Buyers seek to satisfy themselves and their stakeholders as to the current condition of the business, thus reducing the chance of any post sale surprises.
It is common for a buyer to make a purchase offer based upon general financial and operational data that has been supplied during the marketing phase of the sale process. For confidentiality reasons, these representations are all that a seller should be expected to make until such time as there is a "meeting of the minds" or a business agreement between the parties. Such an agreement should include purchase price, terms and transaction structure and will generally be confirmed in a Term Sheet or Letter of Intent, signed by both buyer and seller.
Performing financial due diligence prior to a price and terms agreement would be putting the "cart before the horse". A seller should only divulge sensitive information about his or her company if it is known that there is a financially acceptable transaction in place. Buyers typically want to perform due diligence prematurely, so as to minimize their risk in proposing a deal. Allowing this process to begin before a formal offer is made is one of the most common and costly mistakes that an inexperienced seller makes. A seller’s primary objective in due diligence is to emerge with the deal intact (i.e. with no revision in price or terms). A seller can maximize the probability of a successful outcome by preparing for the due diligence process. It is critical that the seller receive in advance, a due diligence checklist from the buyer, to facilitate having the information organized and ready for review. Well organized and complete information increases the seller’s credibility and a buyer’s confidence in the business. If a seller notices any inaccuracies during this preparation phase it is preferable to bring it to the prospective buyer’s attention in advance to preserve credibility. In the event certain negative information turns up during due diligence, one of three things will happen: the buyer may be willing to follow through with the agreed upon price and terms anyway; the buyer may opt to pull out of the transaction; or the buyer may agree to proceed with the transaction conditioned upon renegotiating price, terms or deal structure. Typically, unless material information was omitted or misrepresented in the marketing phase, deals that were properly prepared emerge from due diligence relatively unscathed.
Due diligence can be classified as external or internal. External due diligence relates to industry factors such as economic conditions, demand forecasts, trends, pending legislation, industry risk factors, expansion opportunities, new technology, competition, etc. and are not company specific. External due diligence can and should be done by the buyer at an earlier stage since it is not reliant on specific company information and is not sensitive or intrusive to the company.
Internal due diligence relies on information specific to the subject company. The following are the most common areas reviewed: Financial – accuracy of financial statements and recast profit adjustments; Tax & Payroll – up to date and historical tax filings; Operational – general business structure and risks; Inventory – confirming no stock obsolescence; Legal – existence or status of any lawsuits; Regulatory – compliance with applicable agencies; Environmental – ISRA compliance; Employees – status of key employees; Customers – in good standing and likely to remain post transaction, etc. Certain aspects of due diligence are more sensitive than others. Customer and employee due diligence typically fall under this category and should be put off as an end phase of the process. It may be the final step prior to closing, perhaps after contracts are signed and all other contingencies have been satisfied, including any required financing. This affords the seller a comfort level that once this final aspect of due diligence is addressed the deal will immediately proceed to closing, assuming there are no significant unexpected findings.
Every due diligence varies depending upon the complexity of the company, size of the transaction, the specific buyer and a buyer’s familiarity with the industry and company. The process can range from a few hours to several business days. If an "insider" such as an employee is buying the company, there may be little need for due diligence since he or she is already intimately familiar with the business. In summation, due diligence is an inevitable part of the business sale process. To insure that everything will go smoothly, make sure that all representations made during the selling process are materially true and correct. Take the time to properly prepare for due diligence and keep in mind that as a seller, your goal is to survive it with your deal intact.