A look at what happens during due diligence
Due diligence is a vital part of investing in a business, whether in whole or in part. It allows the investor to gain a deeper understanding of your business and determine what other opportunities or concerns may exist. The process itself is a bit like pulling teeth (to use an overused cliche) for both sides of the transaction with varying degrees of pain experienced by each.
As we mentioned in a previous post, "So...You Want to Sell Your Business...", the due diligence process warrants a post all its own. Here, we deliver the goods.
Properly preparing yourself for diligence as early in the process as possible will help protect yourself from certain downside risks. Two examples immediately come to mind...
A company in the hospitality industry was selling their business to a strategic buyer. They had always maintained their books on a non-GAAP (generally accepted accounting principles), cash basis, and their approach was that as long as there was cash in the bank, things were good. During diligence, the buyer did a quality of earnings review and converted the seller's books into a GAAP-complaint and accrual-based format. Once they did, they had concerns about what they were seeing in the numbers. Since the seller had never looked at the financials in that way before, it was a struggle to defend them. The buyer ended up cutting the purchase price by $2 million.
In the second example, a business in the services space was selling to an independent sponsor. Again, they struggled with getting their financials accurately into a GAAP-compliant and accrual based form. While doing so, which involved quite a bit of the owner's time, the sales pipeline slowed and certain opportunities were delayed. As a result, the purchase price remained the same, but the structure of the deal fundamentally changed to protect the investor in the event the business experienced either no growth or a decline (after having consistently grown 20% year-over-year).
The two examples above focus on the quality and format of financials, but any number of issues uncovered during the diligence process could have a negative impact on the final sale price or deal structure. That is why it is so important to get your "house" in order before getting too far down the road on a process.
With this in mind, below we offer a general overview of what happens during due diligence so you know what to expect. M&A advisors, like Fulham Partners, work closely with their clients to prepare for diligence as thoroughly as possible to help mitigate any potential downside.
Ownership and Control of the Company
Investors need to understand how your business is structured, what agreements related to that structure are in place, how it is capitalized, etc. When we talk about the capitalization of a business, we are speaking specifically of the ownership structure and, in particular, who owns what percentage of the business. Some of the items investors will want to see related to ownership and control of the company include:
Documentation and appropriate registration as to the type of company you are (LLC, C corp, S corp, etc.)
Information about all outstanding capital stock, convertible securities, options, warrants
List of all the security holders, including option and warrant holders, that sets forth the class and number of securities held
The actual ownership structure of the business
An operating agreement that outlines how the business will function, how decisions are made, who has authority to do what, how members/owners/managers can enter or exit the business, etc. (this agreement is meant to address large, important decisions about the overall business, not the regular day-to-day decisions that generally happen)
Competition
As noted in our post about selling your business, when investors are in the "deeper dive" stage, among other things, they start looking at how you stack up against the competition to get a sense of the advantages you may have in the marketplace. Once they start diligence, they want to know, specifically, how you rank among your competitors in terms of quality, pricing, growth rate, cost structures and market share.
Financial Information
Judging by the examples provided earlier in this post, you can easily see how important this review will be for you, the seller. And how much attention investors will pay.
At the heart of this portion of diligence is the quality of earnings (QofE) review. Here (typically) third-party CPAs look at your financials, tax returns, customer information, and other data that they request and you provide to determine whether the numbers you show in your profit-and-loss statement (P&L) and balance sheet make sense in light of all of the other gathered information. For them to conduct this analysis they will dissect:
Your P&L and balance sheet for the last three years, the current year to date and forecasts for the next three to five years (audited is best, reviewed is good, anything else is left to chance)
Your tax returns covering the respective company fiscal years
A description of investments made in the company with a recap of realized outcomes to date and expected outcomes in the foreseeable future
A description of any and all investments made outside of the business
Revenue
Inextricably linked to the QofE review is a much closer look at how your business generates revenue. In particular, they will assess:
Details of all forms of revenue flowing into the business
Specific information about your customers that generate the majority of your revenue
Your process for pricing, quoting, booking and collecting revenue
Details of your entire sales operation
Operating Expenses
Much like revenue, operating expenses receive additional scrutiny, most commonly:
A schedule of payroll expenses and administrative costs (in extreme detail)
All other general operating expenses
Research and development expenditures and whether they can be capitalized
A full list of outside contractors, their costs and the services they provide
Accounts Receivable
Still related to QofE, when investors (well, their CPAs...) review the details your accounts receivable (AR), they are looking for:
A full schedule of your AR for the most recent period
An understanding of which customers are the best payors and which are usually most delinquent
A statement of your credit and collection policies
What your allowance for delinquent and uncollectable accounts has been and is now
Liabilities
Staying with items tied to QofE, with respect to your liabilities, investors want to know:
A schedule of all accounts payable (AP)
Any expenses incurred (and hopefully accrued) and not yet paid
A schedule of commitments to vendors and other outside contractors
Material Agreements
Moving on from the financial aspects of diligence, we move on to what is just as important, if not more so...the legal issues surrounding the business. First, let's discuss material agreements. Investors want to have clarity about:
Any and all agreements your business might have with customers, vendors and any other third parties
Employment contracts
Marketing and distribution agreements
Licensing agreements
Regulatory Matters and Taxes
This should be somewhat self-explanatory. With that said, specifically investors want to know:
In which jurisdictions the business should and does pay taxes
They will want to see federal and state tax returns for the last three years (also related to QofE)
Details of any governmental or other audits (not initiated by the business) and their result(s)
Specifics about regulatory issues related to your industry and your particular business
Intellectual Property
Your intellectual property often speaks to the things you can protect and that give you a competitive advantage. In particular, they will review:
Your trade names, brand names, logos and slogans belonging to the company
Patents held or applied for, copyrights, internet domain names, proprietary technology and trade secrets
Any of the above that you license to others to your or that you license from others
Litigation
Lawsuits can have a tremendous impact on the future of your business, positive or negative. You will be requested to produce:
A full list of past, ongoing and pending litigation
All pleadings, filings and correspondence with any litigation
Any other known lawsuits involving other parties that could have an impact on your business or the industry as a whole
This general overview of what to expect during due diligence is what you can expect regardless of the investor. However, depending on the specific situation of your business, the industry in which you operate or the role you would play with the investor may, and likely would, necessitate a deeper look at any of the items identified here as well as additional investigations.
We will do future posts related specifically to IT and insurance and how they are assessed during due diligence.
Again, using an experienced advisor can help you be much better prepared for this stage of the process and make it, hopefully, less painful than it otherwise can be.