After you accept an offer or letter of intent (LOI) on your business, the buyer will begin due diligence. Due diligence is the process of gathering and analyzing information to help the parties determine whether or not to proceed with a business transaction.
This period of time normally lasts 30 days but can be extended if both parties agree. In most circumstances, the buyer can walk away from the transaction if they are unsatisfied for any reason during due diligence.
So, what’s a seller to do? Start by conjuring up your best Boy Scout. Start by being prepared.
Businesses are complicated — there are hundreds of factors buyers must take into consideration when deciding if they would like to move forward with the transaction.
When evaluating a home for sale, buyers can quickly form an opinion on the value and suitability of a home and hire an inspector to conduct a home inspection. Homes and other tangible purchases often require little to no due diligence. However, buying a business involves assessing many intangible factors that are not readily apparent and are more difficult to assess and evaluate.
As a result of this increased complexity, purchasers of businesses go through a lengthy and thorough due diligence process before completing the transaction.
This process does not begin until an offer is accepted by both parties.
With a business, the seller’s representations are verified during due diligence only after a letter of intent is mutually agreed upon. If all buyers conducted their due diligence before making an offer, sellers would spend a tremendous amount of time with many buyers and would risk a leak in confidentiality.
Conducting due diligence with multiple parties simultaneously may also lead the seller to lose focus on their business, and the value of the business may therefore decline. The buyer must accept the seller’s initial representations before an offer is accepted — only after an offer is accepted does the buyer have the opportunity to verify the seller’s representations.
Before accepting an offer, the seller should be cautious regarding what information is shown to a buyer. The seller should be helpful to the buyer, but they shouldn’t show them everything they ask to see. At some point, the seller should politely and tactfully ask the buyer to make an offer.
Here’s what to share BEFORE the offer is accepted:
Here’s what to share AFTER the offer is accepted (during due diligence):
The list above isn’t typical for every business. Each business will have its own unique due diligence structure. Most due diligence requests are more extensive than the list above.
How do I handle a buyer who is requesting too much information (e.g., bank statements and tax returns) prior to submitting an offer?
Before receiving an offer, you should be cautious with what you show to buyers. You should certainly be helpful and engage with the buyers but do not give them everything they ask for. At some point, you should politely and tactfully ask them to present you with an offer.
Explain to the buyer that a thorough investigation can be conducted only after an offer is accepted. Tactfully point out that once an offer is accepted, the buyer will have plenty of time to perform their due diligence and verify the accuracy of your representations.
Explain to the buyer that you are making representations and that these representations are verified during due diligence.
Due diligence can take any period of time as long as both you and the buyer agree. The typical due diligence period for most small to mid-sized businesses is 30 to 60 days.
The length of due diligence should be based on the following:
Due diligence is never perfect — it can never uncover every potential problem with a business. You can never be absolutely assured that the business is without problems. In fact, there is no such thing as a “perfect” business.
If due diligence doesn’t ensure that the business is problem-free, what can be done?
“Representations” and “warranties” are statements and guarantees by the seller of a business relating to the assets, liabilities, and other elements of the business being sold. In the purchase agreement, the seller will have to make factual statements regarding the condition of the business, covering nearly all aspects of the company. These are referred to as “‘reps and warranties.”
Essentially, the seller is assuring the buyer that their representations are true, and if proven to be otherwise, the buyer is entitled to seek legal remedies, which could result in the seller reimbursing the buyer for damages. The representations and warranties collectively serve to mitigate the risk of any material defects that were not discovered during due diligence.
For example, a seller may represent that the assets of the business are in good repair, that all inventory is salable, that there are no hazardous substances used in the business, that the business has operated in compliance with all laws, or that the seller has the legal capacity to sign the purchase agreement.
For example, a seller may warrant that they will operate the business in a regular and normal manner and will comply with all laws until closing, or that they will pay all payroll taxes that will come due from past operations up to the time of closing.
Here’s a summary of how due diligence fits into the sale process:
The parties negotiate and accept the letter of intent.
The due diligence period begins immediately after the letter of intent is accepted by the parties.
The parties normally begin preparing a draft of the purchase agreement during due diligence. The purchase agreement often takes several weeks to negotiate and finalize, so the process usually starts during due diligence to ensure an efficient closing with minimal delays.
Conclusion of Due Diligence
At any point during due diligence or upon its expiration, the buyer may decide they are satisfied with their investigation of the business and will proceed with the transaction. The buyer may do this because the buyer and the seller have resolved the contingencies, or even if there are pending contingencies, the buyer may feel confident enough to enter into a definitive agreement.
When this happens, the buyer and seller will sign an agreement stating that due diligence has concluded. This signifies the completion of due diligence and the parties’ decision to end the investigation and proceed to a definitive agreement.
For smaller transactions, the buyer will place an additional deposit with the escrow company upon signing off on the completion of due diligence. If the transaction is canceled due to the buyer’s fault before a definitive agreement is signed, the buyer will forfeit both the initial and additional deposits. Otherwise, these deposits will be applied to the final purchase price.
There are often contingencies that survive due diligence, such as bank financing, franchisor approval, lease assignment, or license transfers. These remain as contingencies and are resolved between the conclusion of due diligence and the closing. The buyer may cancel the transaction if these contingencies are not met.
Once the contingencies are met, the closing may occur. In most cases, the purchase agreement is signed at closing. However, it may sometimes be signed prior to closing.
Here is a sample due diligence checklist:
Be Emotionally Prepared. Due diligence can be a grueling time for the seller. You must be prepared to commit a substantial amount of time and energy to the process. Some buyers’ objective is to wear you down, discover problems, and then attempt to renegotiate the terms of the deal. Be prepared for this possibility by preparing for due diligence so problems are uncovered and resolved before a buyer discovers them. You should also attempt to remain emotionally unattached to the process so you can negotiate from a detached, objective perspective.
Buyer Type Determines Thoroughness. Individuals are generally less thorough than companies in conducting due diligence. However, some individuals can be especially thorough if they are detail-oriented, are very risk-averse, or have a CPA or attorney advising behind the scenes. Most companies are thorough, especially if they have completed multiple acquisitions in the past.
Exclusivity. Keep your business on the market even once you’ve received an offer unless you have negotiated an exclusivity period with the buyer.
Don’t lose your focus. You must be prepared to spend significant time and energy during the due diligence process. By the time you reach the due diligence stage, you may feel as if you are almost done, but this is a critical stage where the sale can be made or lost. If you lose focus at this point, the deal can die. You are only on the fifty-yard line at this point. There is still a lot of work to be done before the sale is complete. It’s important that you stay engaged and actively involved in due diligence in order to reach your ultimate goal of a smooth closing.
Involve Your Accountant. Since much of the documentation needed for due diligence is financial in nature, you should consider including your accountant or CFO in your plans as early as possible to help prepare for due diligence. The more cooperation you have from your team, the smoother the process will go.
Designate a Point Man. The point man should be the quarterback during the transaction and should orchestrate the communication with all parties involved and review all information before it is released to the buyer. Many professional advisors will lose you as a client if the transaction is successful and they may not be inclined to conclude the transaction as quickly as possible due to their hourly-rate fee structure. Being the point man yourself or appointing someone within the company will help simplify the due diligence process.
Contact the Landlord Early. The lease is one of the most critical elements of the process and needs to be carefully orchestrated. Issues around the transfer of a lease are common, so the process must be handled with care. Landlords are not required to approve the lease transfer, and delaying the landlord’s involvement can create issues that delay the closing or prevent it altogether. We recommend involving the landlord as early as possible in the process.
Prequalify the buyer. Be sure that you have pre-qualified the buyer before negotiating and accepting an offer. You want to be sure that you are negotiating with a buyer who has the financial capacity to close the transaction.
Tell the Buyer You are Prepared. If you’ve prepared your business for sale and organized all the documents, be sure to mention the same in early conversations with buyers. You could say something like this:
“I’m a motivated, serious seller who has prepared my business for sale with the help of a certified public accountant (CPA). I have all the necessary documents ready for due diligence, including tax returns, leases, equipment lists, financial statements, and more.”
Can’t I just prepare the documents when the buyer requests them?
Preparing your business for sale greatly increases your chances of success. Laying the groundwork for due diligence helps convince the buyer to agree to a shorter due-diligence period and decreases their perception of risk in your business.
By organizing the documents so they are ready for review, you’ll ensure the process is quick and simple. Immediately after you accept an offer, the buyer can start reviewing the documents. Time is your greatest enemy. Time can kill all deals. By preparing for due diligence, you potentially speed up the process and dramatically improve your chances of closing the deal.
You also increase the chances of receiving an offer. Many times, buyers are reluctant to make an offer on a business because they don’t want to risk the time and financial investment in performing due diligence only for there to be an undisclosed problem. Preparing for due diligence mitigates these concerns for buyers.
We highly recommend that you prepare for due diligence as early as possible. This is where your accountant or CFO can really help with gathering the documents you need.
In one recent transaction we worked on, due diligence was significantly delayed because the seller did not have copies of bank statements on hand and it took several weeks to obtain copies from the bank. This delay ended up resulting in a price concession because the economy took a dip during this time period.
You also demonstrate to the buyer that you’re serious when you take the time and effort to prepare your business for sale. Buyers prefer dealing with motivated, prepared sellers. Buyers are more likely to spend time with a seller whom they know has prepared for the sale.
Preparing your business for due diligence is straightforward.
It involves assembling and organizing the documents that most buyers request and review during the due diligence period. You should then retain a third-party expert to review these documents and uncover any issues the buyer may discover during due diligence. You should then address any issues once they are uncovered.
The advantage to preparing for due diligence is that you will have the opportunity to resolve any issues on your own time, without the added stress of the transaction being dependent on its outcome. The need for having your financials prepared and organized as well as ensuring everything is ready from an operational and legal standpoint cannot be understated.
Preparing for financial due diligence is one of the most important parts of successfully closing the sale of your business. Because the number one deal-killer of business sales is incomplete or inaccurate financial records, this should prompt you to make it a priority to ensure that your financials are in order. Otherwise, you risk losing the buyer since financial inaccuracies will likely be discovered during due diligence.
No one wants to invest enormous amounts of time with a buyer only to lose them due to something that could have been prevented. Pre-sale financial due diligence should be conducted by a third party, preferably a CPA. Ideally, this should be conducted at least three to six months prior to beginning the sale process. This will give you ample time to resolve any issues that are uncovered during the process.
We strongly recommend that you invest time preparing your business for due diligence. Most business owners skip this step altogether. By preparing for this process, you will greatly improve the chances of a successful sale. Additionally, demonstrating to the buyer that you have prepared for due diligence increases the buyer’s confidence in your business and reduces their perception of fear.
Due diligence can be heaven or hell. If you have your financials in order, and all is well from an operational and legal standpoint, chances are due diligence will be uneventful and your business deal will take flight and bring you one step closer to the closing of your dreams. If you are unprepared and the buyer finds things amiss during due diligence, you will find yourself on the horns of a dilemma. Being prepared can go a long way in facilitating the outcome you want.
Less than a third of businesses on the market actually change hands. So what does this mean for you? Think about it – with a significant amount of your wealth tied up in your business, planning your exit is one of the most critical decisions you’ll make.
Written by Jacob Orosz, President of Morgan & Westfield
