Due Diligence Process: What Businesses Can Expect

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Updated on Sunday, September 22, 2019

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Before selling a business, you’ll first need to go through the due diligence process. The amount of research required may seem onerous, but it’s designed to protect both the seller and buyer.

Potential buyers would request access to your business financials, contracts, inventory, equipment, intellectual property and outstanding legal matters, which you would need to provide within a reasonable amount of time. The business acquisition would be contingent on the buyer’s investigation.

Continue reading to learn how to prepare for the scrutiny and inspection of the business due diligence process.

Rodger and Ann Lenhardt, owners of Norm’s Farms in Hartsburg, Mo., sold a majority stake of their family-owned elderberry operation in 2017. The business sells a range of elderberry products made from berries grown on the farm, which has been in the Lenhardt family for decades. Selling a large portion of the family business to another company, Missouri-based Innovative Natural Solutions, was emotionally challenging, but it was a necessary step for growth.

“Norm’s Farm needed a big infusion of capital to scale up,” Ann Lenhardt said. “And these guys had the money.”

The due diligence portion of the sale process could be intimidating and overwhelming for first-timers, Rodger Lenhardt said. Typically, you’d need legal or financial guidance to gather the necessary documents and information for buyers to analyze.

“The buyer is going to want to dig into your underwear drawer,” he said. “If your house is a mess and your financials aren’t in order, you’re not going to get a buyer.”

What is due diligence?

The purpose of due diligence is to ensure all information exchanged between a buyer and a seller is accurate and fully disclosed, said Paren Knadjian, who heads the capital markets and mergers and acquisitions group at KROST. Through due diligence, a potential buyer would hire an attorney or business broker thoroughly investigate all aspects of your business.

“It’s essentially understanding how the company operates on a day to day basis,” said Knadjian, who is based in California.

Due diligence typically occurs after the buyer provides a letter of intent, a non-binding two- or three-page document outlining the terms of the transaction, including how much would be paid for the business. The letter of intent would state that the proposed terms of the deal would be subject to due diligence.

The complexity of both the deal and your business records would determine the length of the due diligence process, although the average time frame is 30 to 90 days, Knadjian said. After due diligence is complete the buyer would then draw up legal documents to finalize the sale.

Do sellers investigate buyers?

Sellers should do their own due diligence on the prospective buyer as well, Knadjian said. The process would be less formal, but it would provide insight into the company that’s buying your business.

The Lenhardts hired advisors to aid in researching the buyer of Norm’s Farms, Ann said. They wanted to make sure the business would thrive under new ownership.

“When you put your heart, blood and tears into a business, you’re attached to it,” she said. “That’s why due diligence on our partners was so important to us.”

Make sure you understand how the buyer plans to pay for your business, and whether they’ll be borrowing money to finance the purchase, Knadjian said. If you plan to stay involved with the business after the sale, either as a shareholder or an employee, you should understand how the debt from the sale would impact operations.

Due diligence preparation for small business owners

Before putting your house on the market, you would likely spruce up the property to make it more attractive to buyers, Knadjian said. Consider doing the same for your small business.

“Knowing what’s ahead of you in terms of due diligence and correcting any errors will speed up the due diligence and reduce the risk of something going wrong,” he said.

Expect a buyer to dissect several areas of your business during the due diligence process. You may be able to request that they sign a non-disclosure or non-compete agreement to protect sensitive information.

Next, we’ll discuss what you can expect to share with a potential buyer.

Legal documentation

A buyer would look into all current and future legal obligations, including outstanding judgments or tax liens, licensing, permits and zoning compliance. Contracts with suppliers and employees would also be up for review.

You may have to turn over any invoices from lawyers from recent years to show what issues had been addressed. If your business is a corporation, a buyer may also ask for shareholder or board meeting minutes to review past company decisions.

Financial statements

Financial information such as revenue, accounts receivable, tax returns, existing debt and stock ownership would be analyzed. Be prepared to submit documents such as:

  • Annual financial statements
  • Cash flow analysis
  • Cash restrictions
  • Expense reports, categorized as non-operational
  • Public filings, if applicable
  • Audited financial statements, including any disclosures or management letters suggesting recommendations

A buyer would check to make sure your business followed Generally Accepted Accounting Principles, or GAAP, when generating financial statements. Companies that adhere to GAAP standards have created their statements using the same set of accounting rules. Meeting GAAP standards would make it easier for a buyer to review your financials, avoiding a potential hitch in the due diligence process.

Business assets

A buyer may conduct an inspection of any fixed assets to determine their value. You’d need to share records of maintenance and replacements and whether any assets are no longer in use.

If any assets like equipment, vehicles or property are being leased, rented or loaned, that financial information would need to be included in the sale.

Operational information

A buyer would analyze the responsibilities of individual departments and how they contribute to overall operations.

Activities related to sales would be under a microscope. A buyer would look into how your business makes sales and how the sales department is organized. The productivity and skill level of the sales team may also be measured.

Your marketing activities would indicate how well you stack up against competing businesses. A buyer could perform a comparative analysis to examine marketing efforts such as:

  • Product packaging and quality
  • Advertising
  • Distribution
  • Pricing
  • Telemarketing
  • Internet marketing
  • Branding

A buyer may dive into your manufacturing practices as well to determine how your business builds or produces goods.

You can find a sample due diligence checklist here.

After due diligence: What to expect

After the buyer completes enough research to feel comfortable making an offer, they would then hire a legal firm to draft documents describing the terms of the acquisition. There may be several documents for you to sign, depending on the nature of the sale. Those could include:

  • Asset purchase agreement: An arrangement where the buyer purchases all business assets, including tangible property like real estate and intangible property such as patents and trademarks.
  • Stock purchase agreement: The buyer purchases the majority or more of a business’s stock and assumes existing debts and obligations.
  • Bill of sale: Document confirming the transfer of ownership on a specific date and at a specific place for a certain amount of money.
  • Employment agreement: Contracts detailing the treatment of employees after the sale, including the terms and obligations of continuing or terminating employment.

“Typically, after [due diligence], the legal documents are negotiated, finalized and signed,” Knadjian said. “When the money is transferred, that’s considered a close and the transaction is done.”

There could be back-and-forth negotiation before the final papers are signed, Ann Lenhardt of Norm’s Farms said. Financial details may be the last item to discuss, which was the case when selling Norm’s Farms, she said.

Business owners often believe the purpose of due diligence is to renegotiate the selling price, but that’s rarely the intent of buyers, who have already included price in the letter of intent, Knadjian said. However, information found during due diligence could affect how much the buyer is willing to pay for the business.

“If you’re well organized, there’s no need to be worried about that,” he said. “It’s considered bad practice to go into due diligence with the intent to change the terms of the deal as the buyer.”

What happens if the deal falls through?

After weeks or months of due diligence, there’s no guarantee a sale will occur. Although the majority of deals are successful, the due diligence process could end in a broken transaction, Knadjian said. A common reason is a lack of organization within the seller’s business.

“The cleaner the books, the better documentation they have, the much more likely that the transaction will go through,” he said.

A broken deal likely wouldn’t have any financial ramifications for either party, other than the loss of time and money spent on advisors and lawyers, Knadjian said. Buyers sometimes make a “good faith deposit” to show their intent to purchase the business, and the seller may not return that money if the sale falls through, he said.

A failed transaction wouldn’t impede your chances of selling the business in the future, unless the buyer found a problem within the operation. As long as you fix any issues uncovered during due diligence, you could attempt a sale again in the future, Knadjian said.

“Obviously, you will have to fix that problem before you go back on the market,” he said. “Otherwise, you’re just wasting your time.”

Don’t fear the due diligence process

It may seem daunting to present the inner workings of your company, including financial statements and legal documents, to a potential buyer, but it may be an unavoidable step when selling your business.

“Nobody’s willing to make an offer until the books are open,” Ann Lenhardt said.

Due diligence typically begins after a potential buyer outlines terms of the deal in a letter of intent. Before then, be careful not to disclose too much detail about your business, Knadjian said. If the interested buyer is a competitor, they may be looking for valuable information to use at their own company.

In most cases, a buyer wouldn’t set out to deceive you, Knadjian said. A buyer would be looking to check the legitimacy of your claims about the business. You should conduct due diligence on the buyer to make similar confirmations.

“I’m assuming you’re operating as an actual company,” Knadjian said. “The point of due diligence is to test those assumptions.”