Due Diligence When Selling a Business

An easy definition of due diligence is “serious investigation.” When selling a business, due diligence plays a pivotal role, representing the buyer's in-depth investigation into various aspects of the business. This comprehensive examination ensures that the buyer's expectations align with the business's reality or that any identified issues are addressed to satisfaction. This article delves into the nuances of due diligence, outlining the key steps, documentation requirements, confidentiality considerations, and the seller's role in assessing the buyer's capabilities.

Understanding Due Diligence

Due diligence is a rigorous investigation integral to the buyer's offer. The buyer commits to the purchase only after ascertaining that the business conditions align with expectations or that issues are appropriately addressed. The removal of the due diligence contingency marks the commencement of the sale closing.

Seller’s Role in Due Diligence

As the seller, your role is twofold:

• Information Access: Prepare to provide access to all relevant information the buyer wishes to examine.
• Buyer Examination: Simultaneously assess the buyer's financial condition and managerial experience, especially if engaging in seller financing or agreeing to deferred payments.

Assembling the Necessary Documentation

A crucial aspect of due diligence is presenting a comprehensive set of documents for inspection. The buyer, accompanied by their accountant and attorney, will scrutinize various facets of your business. Ensure you have signed confidentiality and non-disclosure agreements before proceeding. Some essential documents include:

• Federal tax returns for the past three years, allowing the buyer to verify the revenues shown on financial statements. If your business is a C corporation, present corporate tax returns. If your business is a sole proprietorship, LLC, or S corporation that passes revenue through to you personally, present Schedule C of your personal return.
• Business income statements and balance sheets for the current and the past 2-3 years, plus a current cash flow statement, all presented as professionally reviewed reports following industry standards.
• Statement of seller’s discretionary earnings or owner’s cash flow, presenting how much money the business generates annually for the benefit of its owner.
• Financial trends and ratios, including revenue and profit growth trends.
• Accounts receivables/accounts payable lists.
• Inventory list, including value.
• Major equipment and furnishings list, including value.
• Supporting financial information, such as inventory turnover rate, receivable collection rate, and current or liquidity ratio.
• Current building lease, including lease duration and transferability.
• Fixtures, furnishings, and equipment list, including all items included in the sale with photos of major items, titles confirming ownership, lease and maintenance agreements, and depreciation schedules from the most recent tax return.
• Copies of contracts and agreements with employees, customers, suppliers, distributors, and others.
• Intellectual property documentation for patents, trademarks, and other items, each showing ownership by the business rather than by individuals.
• Management and operational documentation, including procedure manuals, product and price lists, other reports, and agreements.
• Staffing records, including a description of employee benefits plan, organization chart, employee policy manual, and a list of employees with hire dates, salaries, contracts, and benefit summaries.
• Client information, including relationship descriptions and agreements.
• Supplier and distributor lists, including relationship descriptions and agreements.
• Business and marketing plans or summary descriptions.
• Current business licenses, certifications, or registrations, including verification of transferability.
• Business formation documents.

Balancing Confidentiality with the Buyer’s Need for Business Examination

Maintaining confidentiality during due diligence is important. The buyer will want to meet staff, business clients, and suppliers, but you will not yet be ready to make your sale public. The following approaches can help you manage interactions.

• Consider revealing sale intentions to a very few key managers if you and the buyer will need their help during the business examination. Seek an agreement with the buyer that these top-level employees will be offered bonus compensation for assisting in the sale process and transition. When informing these select staff members, stress the buyer’s strong qualifications and positive plans for the future of the business. Also, convey the due diligence timeline and the importance of keeping the sale confidential during that period.
• Reduce the buyer’s presence in your own business setting by relying on your broker, if you are using one, or your accountant. Their offices can serve as a repository for the documents the buyer needs to access. They can also provide the setting for meetings with you and key staff members.
• Keep interactions with the buyer private. Confirm with the buyer how to contact you, likely through the email address and phone number you established specifically for sale purposes. While initially those contact approaches were to conceal your personal name and your business name, at this point they can keep the buyer’s interactions less visible to staff members and others.

Preparing for the Buyer’s Investigation

Plan to devote significant time to prepare for and assist with the buyer’s investigation. Plan also to invest in the services of your accountant and attorney, who will help you determine what information to divulge and how to protect confidentiality if, and most likely when, the buyer requests to share sensitive information with third-party advisors.

The buyer’s due diligence will likely focus on an examination of three aspects of your business:

• Financial condition, looking beyond previously provided financial statements to assess financial management and growth potential.
• Business operations, including production and other processes and how easily they will transfer to a new owner, the nature and transferability of clients or customers, billing and collection procedures, banking relationships, details about staffing and management, and current business and marketing plans.
• Legal issues, including information on legal obligations or potential legal problems ranging from pending litigation, pension liabilities, claims, tax audits, zoning issues, and a wide range of other possible issues that your attorney can help you list and prepare to discuss.

Investigating the Buyer’s Capabilities

Due diligence is not just for buyers. Especially if seller financing is part of the payment structure, due diligence provides sellers with another opportunity to verify the ability of the buyer.

• Obtain the buyer’s personal financial statement and credit report. Work through your broker or obtain this information on your own. Then ask your accountant to review the information, examining the buyer’s financial strength.
• Conduct an online search for the buyer’s name to view online mentions, posts, and publicity that might reveal facts the buyer has not shared. Additionally, search for the buyer’s name along with the names of businesses the buyer was previously associated with to learn more about the buyer’s business history.
• Request and contact personal, financial, and business references in an effort to determine whether the buyer presents a management or loan risk. If you and the buyer have decided not to reveal purchase intentions until after the sale, confirm with the buyer how to introduce yourself. For example, you could tell the reference you are conducting reference checks regarding a top-level position in your business.
• Interview the buyer regarding plans to significantly alter your business, perhaps by changing its location, product line, pricing, or staffing. This information will help you determine whether the buyer’s plans are consistent with assurances you may have recently given to key staff and customers. Also, the information will help you assess whether you believe the business is likely to succeed after such changes, and therefore whether it is likely to generate the earnings necessary to make any deferred payments you are agreeing to accept. (Chapter 6 includes specific information on how to protect yourself when self-financing part of the purchase price.)

Be Patient

Due diligence investigations can easily take a month or longer, especially if the sale involves difficult-to-evaluate assets or if it will be structured as an equity sale that involves the transfer of stock – and therefore the transfer of all known and unknown liabilities of the business.

The buyer’s letter of intent likely stated the due diligence timeframe – normally a month or longer – so you will go into it knowing roughly what to expect. What you may not anticipate is how intrusive and tiring it may feel. Remind yourself, repeatedly, if necessary, that this is necessary to get you to the next step – the negotiations that lead to the sale closing and the transfer of your business.

In navigating the due diligence phase, sellers must be diligent, patient, and proactive. By providing comprehensive documentation, managing confidentiality, and assessing the buyer's capabilities, sellers set the stage for a successful business sale.