The Inner Workings of a Deal: Tips for a Successful Transaction
Part VII – Due Diligence
Last month, you got engaged. You found the best of your suitors and entered into a Letter of Intent. Now the real work starts. As you will soon find out, you didn’t just get engaged to your buyer, you also got engaged to his lawyer, his accountant, and his HR, environmental, and insurance consultants, among others.
Welcome to everyone’s least favorite part of a transaction – due diligence.
It Too Will Pass.
By the time due diligence is over, you will hate the buyer, your M&A advisor, your lawyers, the buyer’s lawyers, and probably even yourself for ever thinking about selling your company.
The only advice I can give you is due diligence will pass. So, smile, and be as cooperative and efficient as you can be. The best description of this aspect of the M&A process I have ever heard came from a private equity buyer in a deal I worked on. He said that “the seller needs to understand that we are asking for a certain quantity of information. The deal won’t close until we get that amount of information. It can take weeks, or months, but eventually, if the deal is going to close, we are going to get the information.”
From the deals I have worked on, I have found that buyers generally fear and hate entering bad deals more than they enjoy and profit from completing good deals. Consequently, most buyers would prefer to lose a deal now and again rather than chance leaving any risk unearthed and entering into a bad transaction.
For this reason, buyers and their capital sources (most often, lenders), will want to know everything about you and your company prior to closing on a purchase of your company.
What Will the Buyer Ask for?
Due diligence can largely be divided into three parts:
- Business due diligence
- Financial due diligence
- Legal due diligence
Each of these areas will occur somewhat independently of the others, and they will most often occur in roughly that order, but with some aspects of each area overlapping the whole process.
Unfortunately, most business owners are not capable of responding to all of the requests that they will get at this stage by themselves while continuing to operate their business. For this reason, sellers often bring additional people into the process at this stage to assist with due diligence. Sometimes the additional people are internal to the company, and sometimes they are external advisors like lawyers and accountants. Both have their pros and cons, but you’ll likely need someone else to help you succeed at this stage.
Business Due Diligence.
During this part of the process, the buyer’s business professionals will ask for much more information about your company than you have likely provided to date. This will include detailed customer, product, employee and and sales information. The buyer will want to make himself comfortable that your company is sustainable, and doesn’t have any significant risk to future profitability and growth. Depending on the buyer and the nature of your company, expect to have visits from the buyer’s operational experts, who will be working to get a complete picture of your operations. Also, expect to disclose all of your material contracts at this stage so that the buyer’s investment professionals can better understand how you make money and how the buyer can expect to grow the company going forward.
Many buyers also want to conduct customer or vendor due diligence. This usually takes place late in the process (often just before closing). The buyer will want to talk to your customers and/or vendors to ascertain whether there is any risk that they will discontinue their relationship with the company in the event of a sale to the buyer. Because this part of due diligence is particularly sensitive, it is often conducted anonymously, and sometimes in the form of a customer satisfaction “survey.” In any event, while a buyer who asks for this will likely not take no for an answer, be very thoughtful on how this proceeds. Your lawyer and your M&A advisor can guide you on how best to protect you while getting the buyer the information he needs to complete the transaction.
Financial Due Diligence.
Once the buyer has confirmed that he is satisfied with your company’s risk profile, the buyer will likely commission an external accounting firm to do a mini-audit of the company known as a “Quality of Earnings” or “QofE” review.
At this stage, the buyer will want to confirm that your company’s financial performance is as good as you have portrayed it to be. The buyer’s accountant will check every aspect of your performance, including confirming revenues, costs, and cash receipts.
In today’s deal environment, these QofE reviews are very commonplace and I expect to have them requested in every transaction. For this reason, saavy sellers will have engaged their own accountants to perform a similar review in advance of due diligence so that they will have flushed out any issues in advance. It is important to remember that a buyer is not looking at your financials in the same way you are. A buyer most likely will want your financials in compliance with GAAP, and any divergence from GAAP will create a reason to renegotiate the transaction.
Legal Due Diligence.
Assuming that the buyer’s accountant confirms the financial performance of your company, the buyer’s lawyers will enter the fray to ensure that every I is dotted and every T is crossed. Frankly, this occurs last because it is often the most expensive for the buyer and most buyers wait until the other issues are settled before involving their lawyers.
At this stage, be prepared to provide every meaningful document that the company has in its possession, including:
- Corporate records
- Federal, state, and local tax returns
- Customer contracts
- Real Estate documents (leases, deeds, etc.)
- Vendor relationships
- Information about disputes
- Employee records
- Insurance documents
The buyer’s lawyers will review all of these to make sure there aren’t any hidden risks for the buyer.
Also during this stage, it is common for the buyer to involve other experts in due diligence. Depending on the nature of your company, you will likely encounter environmental consultants, and experts in HR, IT, and Insurance.
The due diligence phase of your transaction will be the most demanding part of the transaction on you and your company. But, it is a phase you’ll have to get through if you want to complete your transaction. Be prepared to enlist help at this stage, whether from internal resources or external advisors.
Next Month: Part VIII – The “Docs”
Michael Schwerdtfeger is a managing director at Chapman Associates. Michael and his team are focused on providing exceptional results through sell-side mergers and acquisitions advisement to entrepreneurs and business owners exclusively. Michael leverages his 20 years of diverse experience handling complex business transactions to help guide his middle-market clients to the best possible deal outcomes.