Due Diligence: Preparation Saves Time and Money

Due Diligence

Due Diligence: Preparation Saves Time and Money

When talking about selling a business, we talk a lot about a buyer doing their due diligence. What does that mean for the seller? What will the buyer be looking for? The answer is actually contained in a long and thorough checklist.

As a seller, it means you must be prepared to present paperwork or reports that answer due diligence inquiries, and that any area where you are not prepared can potentially delay the sale or worse, derail it altogether.

This is one of the reasons due diligence is such an important thing to understand. If you are working with your deal team — an M&A Advisor, your accountant, an attorney, and other team members to sell your business, they can help make sure you are properly prepared.

Here is the checklist, with an explanation of each item you likely will face during due diligence, which can be used for preparing your business for sale.

Organization and Good Standing

Of course, the buyer will want to know how your company is organized, from an LLC to an S-Corp and that your company is in good standing. This includes these items:

• The company’s Articles of Incorporation, and any amendments.
• The company’s bylaws.
• The Company’s minute book from the meetings of all groups, like the board of directors, shareholders (if you have them), etc.
• The Company’s organizational chart.
• The Company’s list of shareholders if you have them and number of shares held by each.
• A Certificate of Good Standing from the Secretary of State.
• Copies of annual reports in the state of incorporation.
• A list of all states where the Company is authorized to do business, if more than one.

Some of these items can be tricky depending on the type of business, and it’s best to have a professional help you prepare them.

Financial Information

As M&A Advisors we often also talk about ‘recasting’ your books. This item of due diligence is where the buyer may or may not accept the adjustments that have been presented to normalize the earnings:

• Audited, reviewed or compiled financial statements for three years. The primary documents used for recasting.
• The most recent internal, interim statements and two years of full internal statements. This is to show line item account details, growth and company health.
• The Company’s credit report, if available or applicable.
• Any projections, capital budgets and strategic plans.
• A list of company debts and when they mature.
• As up-to-date an inventory as possible, and the date of your last physical inventory.
• Aging reports of accounts receivable and accounts payable.
• Showing the buyer your accounting methods and if you have changed them over time.
• An expense report, both fixed and variable.
• The Company’s general ledger and/or Trial Balances for prior periods.
• Review of internal systems and control procedures.

This list will help the buyer determine how sound your business is on the financial management side of things.

Physical Assets

This is pretty simple. Basically, what assets do you own? What assets do you lease? What purchases or upgrades have you made recently? What capital or operating leases will continue even under new ownership? All of this helps the buyer understand what comes with your business when they purchase it.

Your CPA will typically provide a detailed Asset Depreciation Schedule that outlines the tangible assets of the business.

Real Estate

This is another fairly simple category. What locations does your business have? Do you own or lease them? Are leases transferable? Did you have to get variances or other legal exceptions to do business in that location? Will those things continue when a new owner takes over? This helps the buyer understand if your locations are secure and viable for the future.

Intellectual Property

Are their patents that go with your business? If your name is trademarked and you own any copyrighted items, those need to be listed as well. Do you have proprietary knowledge and expertise? How do you protect those IP assets?

Also, if you have any consulting agreements or work-for-hire agreements, these are a part of due diligence too. This is important to the buyer because it is often what sets your company apart from your competition. And the buyer will want to know who owns what in the creation of any value from IP.

Employees and Employee Benefits

Employees and benefits are an area that can be challenging when buying a business. The reason? Sometimes the business owner does not want to let employees or even family members know when they are selling a business for fear they will leave, and the business might be disrupted.

However, the buyer needs to know at least some information about employees, including their salaries and any benefits they currently receive. A sanitized report without names is usually provided to the buyer for analysis. There also needs to be a discussion at some point about the likelihood that at least key employees would stay through the transition to a new owner. Any key employee employment contracts need to be provided in redacted form to protect the possibility of poaching.

Often, buyers will want to see the resumes of all employees, all non-disclosure and non-compete agreements, and any other documentation related to your employees. Buyers also may want to know about any disciplinary problems you may have had, and even employees you have terminated. Essentially, everything that has happened personnel-wise for the past three years may be under scrutiny.

Licenses and Permits

This is especially important with contractor and service type businesses or if you are selling a medical practice. Not all licenses and permits are transferable. In fact, in California, not many are transferable at all. The buyer must obtain their own licensing and, in some cases, new permits.

Still, the buyer will want to see your licenses and permits, and then determine what they need to obtain on their own.

Environmental Issues

There are two parts of Environmental matters. The first is the buyer will want to examine any environmental studies of your property or property that you rent or lease. This is a Phase I report typically done by an environmental expert. This report ensures the buyer will have no issues after the purchase and that everything is in order with no remediation required.

The second aspect is your control of the materials you use to conduct your business. If you have a landscaping, pest control business, or other business where you handle chemicals and other potential pollutants, a Material Safety Data Sheet (MSDS) accompanies every product and is to be kept on file. The MSDS document contains information on the potential hazards (health, fire, reactivity and environmental) and how to work safely with the chemical product. It is an essential starting point for the development of a complete health and safety program. Additionally the buyer will want to know how you dispose of any potential hazardous material, and if you have had any contact or issues with the EPA or local regulators.

Taxes

Generally, buyers will request to obtain 2-3 years of your business’ tax returns. As complex as taxes can be, the buyer will want to see if your income numbers reasonably match up, and how you handle your business deductions and depreciations.

The key to remember in all of these areas is that the buyer wants you to be 100% transparent just as you want them to be. They need to know that there will be no surprises when they purchase your business.

Material Contracts

Whatever contracts the company has, verbal or in writing, especially those that will continue to be binding even after the company is sold, should be shared as well. This means with employees, contractors, suppliers, customers (more on this in a moment) and more.

The buyer will also want to see your past contracts at least for the last few years. They want to make sure those contracts have been fulfilled, but it also gives them insight into how the business is being run.

Products and Services

This category makes sense, but it bears repeating here, because you need to show not only what you offer now, but products or services under development: products or services that could be coming in the future.

The truth is, disclosing products and services in R&D or development can be a great advantage to you, the seller. If you have an emerging product that shows promise, and you are well into development, that can change the business valuation and therefore the price you obtain for your business.

In addition, though, the buyer wants to know what problems you have had in the past. What warranty and recall issues have you had? Have you had to offer massive refunds? If that is the case, you will need to explain what happened, how you handled it, and what steps have been taken to ensure it won’t happen again.

Are there any prepaid liabilities such as customer deposits, gift cards, or any other cash that has been received in advance of the product or service. Consider a company like Amazon and their gift card business and you can see why this item becomes an important matter. In addition, is there an obligation that extends between the seller and the customer at the point of sale and the time it takes to ship the product?

In addition, if you’ve had a recall, you may also need to explain what public relations steps you took to correct the problem and repair your public image after you had the recall issue.

Customer Information

Current and past customer and client lists are important not only to allow the new owner to continue doing business with your current customers, but to show customer history and lifetime customer value.

Customer data also helps buyers with referrals. Has your business done well and met customer expectations? This is a good way for the buyer to understand the relationships with customers.

Keep in mind that much of this information is confidential, and both buyer and seller must be under non-disclosure agreements at this point. However, disclosing customers up front may not be wise until an executed LOI is in place.

There are various ways to communicate any disclosure information, including the use of an encrypted virtual data room on the cloud. You as the seller are under obligation to protect your customer’s privacy, and this is one of the best ways to do so. Be sure anyone who has access to this information understands that obligation.

Litigation

Simple. The buyer wants to know if you are being sued, have been sued, or believe your company will be sued in the near future. All past, current, and pending litigation needs to be shared with them.

Insurance and Professional Contacts

The buyer wants to see an insurance certificate to ensure not only that you are insured, but to see what kind of insurance you carry and who your coverage is provided by. While they may choose their own insurance providers, they will often choose to go with yours and simply continue your company’s policies.

The buyer will also want to know who you utilize for advice such as accounting, an attorney or multiple attorneys, and others.

Articles and Publicity

What kind of PR is your company getting? Are their articles written by you, television appearances, radio spots, or other public appearances? The buyer will want to see these in part to see what kind of marketing and PR work you are doing.

In Summary

The due diligence process can be time-consuming, and in some cases, the most costly aspect of the buy/sell process due to the investment of time in analysis to understand your business. Due diligence is one of the primary reasons it takes time to sell a business. It is also the reason that you should not try to sell a business on your own. Distractions from operating your business day-to-day can cause you to lose momentum, management oversight and overall focus required to keep your business optimally performing.

Engaging an M&A Advisor to orchestrate the due diligence process and work with your CPA, attorney, insurance, and pension advisors will save you time and money in the long-term. The goal here is to get to closing cost-effectively, without disrupting business profits or distracting leadership. A seasoned M&A Advisor can be your most valuable ally to navigate this critical due diligence process.

Andrew Rogerson is a business expert of 26+ years, a 5-time successful business owner, Certified Mergers & Acquisition Professional (CM&AP), Mergers & Acquisition Master Intermediary (M&AMI), Certified Business Broker (CBB), author of 4 books, and he gives speaking presentations on request. Andrew helps business owners plan and execute buying or selling a business, and consults with business owners on how to make their ventures stronger so they increase in value. Email: Andrew@RogersonBusinessServices.com