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Due
Diligence Process
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 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 a due diligence checklist
from the buyer in advance, 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:
1)
The buyer may be willing to follow through with the agreed
upon price and terms anyway, 2) The buyer may opt to pull
out of the transaction or 3) 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 3 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 ensure 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.
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