The (irksome) due diligence process
The excitement of receiving a letter of intent (LOI) for your business is something everyone selling their business looks forward to. The LOI maps out the price a buyer will pay, the terms and timing of the payment, and—if your investment banker has done a good job—the LOI should even get into early important specifics, such as how the working capital PEG will be calculated. When the LOI is finally negotiated, agreed to and signed by all parties, then starts the due diligence process.
The due diligence process is designed to give the buyer a chance to a) verify everything that was stated in the Informational Memorandum, and b) process a long list of clearances and legal issues that need to be resolved before the sale can move to close.
Make no mistake, as I have written previously in this space, the due diligence process is time-consuming, and it often distracts the most important people in the business with information retrieval and financial reporting. Before I get into a sampling of what the due diligence process entails, keep this in mind: This time-consuming nature of the process presents a unique problem for the seller. Here’s why. The due diligence process can take upwards of two or three months. During that time, your company has to hit the financial performance that was predicted in the Informational Memorandum.
If you miss those numbers, the buyer has the right to reexamine the deal and potentially reprice their offer based on the new numbers. (The buyers will almost never go higher if you beat your predictions, but they often go lower if you miss them.) Unfortunately, the people needed to make those numbers are often the very people distracted by the due diligence process. So, time management and multi-tasking are the watchwords of success here. This is especially true of the CEO, COO, and the CFO (as well as the bookkeepers and your accounting firm).
When the due diligence list comes over from the buyer, be sure you’re sitting down when you open it. The list is often a dozen or more pages long, and can have 200 line items for your team to address. Each line item is a request for information. With this sample, let’s take a look at the level of detail that is often required in the due diligence process.
HR and benefits: A full accounting of every employee’s earnings, commissions, bonuses, last raises, and benefits (including 401k plans, and raise/bonus policies) will be required, including their hire date and duration of employment.
IT: All software licenses will need to be current, at your expense; descriptions of security, backup, disaster recovery, and extra capacity plans for databases will be required, as well as all vendor contacts.
Security: “Anyone who touches money” will be subject to a thorough background check, and they will be required to sign a waiver allowing the research to be done.
Safety: Many buyers that are acquiring a workplace like a distribution center, warehouse, or lumberyard may be implementing new safety protocols, and they may want to test all employees for, say, hearing, to establish a baseline that limits their liability down the road.
Customer interviews: Buyers will want to interview a sampling of customers. A request for 100 names is not unusual.
Site visits and environmental inspection: Got a toxic spill on your site? A buried tank? Asbestos? This part of the process will ferret all of that out.
I’ve listed just six of what might be 200 requests. And I haven’t even gotten into the financial reporting required, e.g. trial balances, balance sheets and profit and loss by division (to be supplied each month during due diligence), receivables aging, inventory and inventory reserve balances, etc. The list really does go on and on.
Ready to handle that, as you run a successful business? The companies that handle this process well are the ones who exclusively dedicate an employee or two to rounding up the material and dogging the information and data. You can’t handle the process by paying attention to it for a few minutes each day.
We’ve found that DropBox is a superb tool for managing the process. Secure access can be granted to multiple parties, and folders and sub-folders can be set up for each line item, so compliance can be readily checked. Email alerts can let all parties know every time a file is added. Also, with DropBox, you won’t be emailing files around.
All of that said, the relief when this due diligence process is completed is almost better than the thrill of seeing funds wired to you at closing. Almost.