Selling your business is one of the most significant financial and emotional decisions you’ll make. It’s a complex process that requires careful planning, strategy, and execution to ensure a successful outcome. Unfortunately, many business owners make avoidable mistakes that can reduce the value of their business, delay the sale, or lead to unfavorable terms. This […]
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Due Diligence: What to Expect When Selling Your Business
By
Don Woodard III & Alex Sims
Due diligence is a critical phase in the sale of a business. Once a Letter of Intent (LOI) is signed, buyers conduct an exhaustive review of your company’s financial, operational, and legal aspects to verify that the business is as represented. This phase can be challenging, but understanding what to expect and preparing in advance can ensure a smooth process and increase the likelihood of closing the deal. In this article, we’ll explore the purpose of due diligence, the areas it covers, how to prepare, and tips for navigating this phase effectively.
What is Due Diligence?
Due diligence is a comprehensive review conducted by the buyer to confirm the accuracy of the information provided during initial discussions and in the LOI. It involves a thorough examination of your business’s financials, operations, legal compliance, and potential risks. While it can be time-consuming, both parties must identify any red flags or discrepancies before finalizing the transaction.
Why Due Diligence Matters
Due diligence is important for several reasons:
- Risk Mitigation: It helps buyers identify and evaluate potential risks, such as financial discrepancies, legal issues, operational weaknesses, or environmental issues.
- Verification of Information: Buyers use this phase to verify that the business is performing as stated and that all financial, legal, and operational information is accurate.
- Deal Structure Refinement: Based on the findings, buyers may adjust the purchase price, deal structure, or other terms.
- Builds Buyer Confidence: Successful due diligence builds trust between buyer and seller, increasing the likelihood of closing the deal.
As the seller, your goal is to be transparent and cooperative during this phase, address concerns promptly, and maintain credibility with the buyer.
Key Areas of Due Diligence
Due diligence typically covers several critical areas of your business:
Financial Due Diligence:
Financial due diligence is one of the most detailed aspects of the process. Buyers will review all financial records to confirm the business’s financial health, cash flow, profitability, and revenue trends.
What to Expect:
- Income Statements: Buyers will review your income statements for at least the past three years to verify revenue, expenses, and net profit. They’ll look for trends in revenue growth, cost control, and profitability.
- Balance Sheets: Expect buyers to examine your balance sheets. They will assess liquidity, solvency, and working capital needs.
- Cash Flow Statements: Cash flow analysis is crucial for assessing a business’s ability to generate and sustain cash flow. To understand cash flow patterns, buyers scrutinize operating, investing, and financing activities.
- Tax Returns: Buyers typically request three to five years of tax returns to verify tax compliance and uncover potential liabilities or issues.
- Accounts Receivable and Payable: Aging reports for accounts receivable and payable provide insight into payment trends, collection effectiveness, and potential credit risks.
Preparation Tip: Before due diligence begins, ensure your financial records are accurate, organized, and up-to-date. Work with your accountant to identify and address any discrepancies or issues.
Operational Due Diligence
Operational due diligence assesses the day-to-day operations of your business, including processes, systems, and efficiency.
What to Expect:
- Supply Chain Review: Buyers will evaluate your supply chain to assess reliability, potential vulnerabilities, and cost management. They’ll look at supplier contracts, logistics, and inventory management.
- Production and Quality Control: For product-based businesses, buyers will review production processes, capacity, and quality control measures to understand operational efficiency and scalability.
- Technology Infrastructure: Expect a review of your technology stack, software systems, and data management. Buyers will want to ensure that your IT infrastructure effectively supports business operations.
- Customer Service: Buyers may request data on customer service operations, including response times, satisfaction rates, and any customer retention strategies in place.
Preparation Tip: Review your operations to identify and address inefficiencies or potential risks. Consider creating a detailed operational report that outlines key processes and performance metrics.
Legal Due Diligence
Legal due diligence ensures that your business is compliant with relevant laws and regulations. It also identifies potential legal risks that could impact the transaction or future operations.
What to Expect:
- Corporate Documents: Buyers will review corporate formation documents, bylaws, and shareholder agreements to confirm ownership structure and governance.
- Contracts and Agreements: Be prepared to provide copies of key contracts, including customer contracts, supplier agreements, employment agreements, leases, and any other binding documents. Buyers will assess these contracts’ terms, conditions, and risks.
- Litigation and Disputes: Buyers will want to know about any pending or past litigation, disputes, or regulatory investigations involving your business. This includes lawsuits, intellectual property disputes, or regulatory compliance issues.
- Intellectual Property (IP): If your business holds patents, trademarks, or copyrights, buyers will conduct a detailed review to ensure IP ownership and protection and assess potential infringement risks.
- Environmental: If your business is in an industry that could impact the environment, expect diligence to focus on your compliance with relevant environmental laws and regulations. This review will also seek to uncover potential environmental liabilities.
Preparation Tip: Work with your attorney to gather all legal documents, identify potential issues, and ensure that key contracts are valid and enforceable. Address any ongoing disputes or regulatory matters before entering due diligence.
HR and Employee Due Diligence
Human resources (HR) due diligence focuses on the company’s workforce, compensation structures, and employment policies.
What to Expect:
- Employee Contracts: Buyers will review employment contracts, non-compete agreements, and confidentiality agreements to understand employee relationships and retention risks.
- Compensation and Benefits: Expect a review of payroll records, benefit plans, bonuses, and any other incentive programs. Buyers will assess the cost and competitiveness of employee compensation packages.
- Key Employees: Buyers will want to understand key employees’ roles, skills, retention, and succession plans for critical positions.
- Compliance with Labor Laws: Buyers will check compliance with labor laws, including wage and hour laws, workplace safety regulations, and anti-discrimination policies.
Preparation Tip: Ensure that all employment agreements are up-to-date and that compensation and benefits packages are competitive. Be ready to answer questions surrounding HR compliance issues or possible employee turnover.
Commercial Due Diligence
Commercial due diligence focuses on the market position, customer base, and competitive landscape.
What to Expect:
- Market Analysis: Buyers will review market data, industry reports, and growth projections to assess your business’s competitive position and market potential.
- Customer Base Review: Buyers will analyze your customer base to understand customer concentration, loyalty, and retention rates. They may review major customer contracts to assess stability and risks.
- Competitive Landscape: Buyers will assess your competitive advantages, including market share, product differentiation, and barriers to entry. They will want to understand how your business compares to competitors in terms of pricing, quality, and service.
Preparation Tip:Prepare a commercial overview that highlights your market position, competitive advantages, and customer base stability. Be transparent about customer concentration and strategies for mitigating risks.
How to Prepare for Due Diligence
Preparation is key to a successful due diligence process. Here are some tips to help you get ready:
- Organize Documents: Work with your advisors to gather, organize, and digitize all necessary documents. Use a secure virtual data room to share information with buyers.
- Be Transparent: Address any known issues or discrepancies upfront. Buyers appreciate transparency and honesty, which can help build trust and reduce surprises later in the process.
- Stay Responsive: Be prepared to answer questions quickly and provide additional information as requested. Delays can slow the process and create doubts in the buyer’s mind.
- Work with Advisors: Engage with your M&A advisor, accountant, and attorney and allow them to guide you through the process. Their expertise will help you manage the complexities of due diligence and protect your interests.
Common Challenges in Due Diligence
While every transaction is unique, there are common challenges that can arise during due diligence:
- Unforeseen Issues: Buyers may discover unexpected issues, such as discrepancies in financial statements, legal disputes, or compliance gaps. Be prepared to address these promptly and professionally.
- Information Overload: Due diligence can be overwhelming, with numerous document requests and questions. Keep the process organized and work with your advisors to manage the flow of information.
- Timeline Delays: A tight due diligence timeline can lead to rushed decisions or incomplete reviews. Ensure that the timeline is realistic and allows sufficient time for thorough analysis.
Conclusion
Due diligence is a vital step in selling your business, as it allows buyers to verify information, assess risks, and finalize their decision. By preparing thoroughly, staying organized, and maintaining transparency, you can navigate this phase smoothly and increase the likelihood of a successful sale.
Next Steps
- Explore the Western Perspective page for more articles like this.
- Explore the Western Testimonials page for stories of business owners Western has worked with.
- For more information on how to explore selling your company, visit https://western-companies.com/sell-side-ma/ or contact Western’s Chief Commercial Officer Rick Groesch at rick@western-companies.com.
Additional Reading
- Conducting Buyer Meetings & Presentations
- Tips for Negotiating During an M&A Transaction
- Understanding the Letter of Intent in the Sale of Your Business