Before you take your business out to market, it is important to understand what due diligence involves and how to prepare for this crucial step in selling a company.
What is Due Diligence?
Due diligence is the process a buyer uses to assess your business before agreeing to acquire or invest in it. The objective is to confirm that the information you disclosed early in the sale process is accurate and avoid any surprises that could increase the buyer’s risk, especially when it comes to financial, accounting, tax, and legal issues. It can take anywhere from 45 days to six months to complete this process, depending on the deal complexity.
Due diligence has become increasingly rigorous, complicated, and intense over the last decade, partly in response to mishaps of the past. There was a time when mergers and acquisitions often proceeded without proper due diligence, resulting in problems that could have been foreseen, like pending lawsuits, outstanding tax obligations, or unrealistic revenue projections.
To avoid unpleasant surprises like these and make the most informed decision as to whether to proceed with a business purchase, today’s buyers take a more demanding approach to evaluating target companies. Not only does rigorous due diligence reduce post-sale regret (or worse) for the buyer, but also it paves the way for a smooth deal closing for you as the seller and reduces the odds you will get caught up in a post-sale dispute. Given the volatility of the current economic environment, sellers should expect even greater scrutiny from potential buyers now.
What Does the Process Involve?
First, recognize that the due diligence process is not something you should tackle on your own (unless you have chosen to sell the business yourself, which is uncommon). Instead, the investment bank you partner with to market your company and handle the sale transaction will manage and coordinate the due diligence process.
Preparing for due diligence begins with gathering and developing the documentation and information that buyers will expect to review while assessing your company as a potential acquisition target. The investment bank will use this information in two ways: to populate a secure data room and to develop the teaser and confidential information memorandum that are key tools in marketing your business to buyers.
Later, buyers that sign a non-disclosure agreement receive access to the data room, typically in stages. The further along they get in the process—and the more serious their interest, as evidenced by submitting an Indication of Interest—the more information they gain access to. For example, a handful of interested buyers might see copies of your income statement, cash flow statement, and balance sheet. Later, one finalist will receive access to the entire data room after signing a Letter of Intent.
How Can a Seller Prepare for Due Diligence?
The smoother the due diligence process goes, the better your odds become of closing the deal and achieving the best outcome. Two best practices can help you prepare for due diligence effectively.
- Lean on your team. Preparing for and managing due diligence is nearly a full-time job, which is why you cannot do it yourself. Instead, your accountant, attorney, and investment bank will do the heavy lifting. For instance, the accountant may develop more robust financial projections than you currently use in operating the business, while the attorney may need to review contracts and assess litigation risks. Once your senior management team is aware of the sale, they may be used to pull together information on sales, marketing, products, or operations. Through it all, your investment bank will “quarterback” this complex process and keep it moving on a fast timeline (which is always in your interest, since the more time that passes, the more likely the deal could fall through).
- Start early. As soon as you engage an investment bank, they will provide guidance on the information you need to gather or develop. The earlier you begin to prepare, the more smoothly the sale process will proceed. Starting early also gives you time to proactively address issues that could thwart the deal—before buyers begin examining documents and finding roadblocks. Ideally, due diligence is merely a confirmatory exercise, not a discovery process that leads to surprises, more negotiations, and a lower sale price.
What Should You Expect to Gather?
Each deal is unique, so there is no generic list of due diligence documents or activities that covers every situation. In fact, some due diligence checklists total over 60 pages! However, the following reviews the categories of information that due diligence typically covers and provides examples of the types of documents normally requested or developed to satisfy a buyer’s requirements. (Note that this is not an exhaustive list.)
- Financial: For example, historical information (such as several years of financial statements and tax returns), forward-looking information (such as revenue and expense projections, typically for a three-to-five-year horizon), a quality of earnings audit, and details on how your company is currently capitalized may be required. A buyer also is likely to contract for an independent business valuation.
- Management: For instance, management team bios, credentials, and possibly background checks will likely be needed.
- Employees: To illustrate, a detailed organizational chart, employee agreements, compensation plans (including stock or other incentives), and potential HR-related risks are likely to be provided.
- Products: For example, product descriptions, details on how your products are differentiated in the market, your product roadmap and pipeline, and any R&D activities underway or planned may be requested.
- Sales & Marketing: Information such as key customers, target market segments, customer acquisition and retention rates, competition, and sales and marketing strategies is often requested.
- Legal: For instance, articles of incorporation, customer and supplier contracts, leases, pending or previous litigation, patents, copyrights, trademarks, or other intellectual property could be provided.
Getting Due Diligence Right
An efficient due diligence process improves the odds that the transaction will close and that you will receive the optimal price and terms. That is where choosing the right investment bank can pay big dividends.
Your investment bank will ask the right questions upfront and help to gather and develop the information buyers will review as they conduct a rigorous evaluation of your business. With the current economic environment causing buyers to be even more diligent in assessing a target company, it is more important than ever to partner with an investment bank that has a proven process for managing due diligence effectively.
If you are considering selling your business and want to learn more about what to expect in the due diligence process, contact the investment banking experts at Chesapeake Corporate Advisors.
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