You may have heard of the process called, “due diligence.” But unless you’ve been through the process, you might be unclear about what it really means. At a basic level, it’s a process of de-risking the acquisition on the part of the buyer. Their goal is to check out and validate that what you say is real and uncover problems in your business. The best analogy is that the due diligence process is like performing a home inspection before you buy a house. Sure, you could buy a house without doing an inspection. But you are taking on a ton of risk by not looking under the roof first. As a seller, it’s also worth recognizing what buyers will look for when they analyze your company. The more skeletons they find, the lower the price they will be willing to pay. So, what are the elements you can expect a buyer to look at when they perform due diligence?
- Financial — Typically, the first thing a buyer will examine are the books of the business. That means looking through the financials–income statements, balance sheets, invoices, payables, etc.–which have been hopefully audited or at lease reviewed. The buyer is looking to confirm that your business is delivering quality numbers that can be trusted. As a seller, getting your financials audited or reviewed by an accountant ahead of time can make this process much faster and easier. You can ask an accounting firm to check over and certify historical performance if you haven’t been doing it on and on-going basis.
- Legal — Most companies run on legal contracts. They define the boundaries and relationships you have with everyone from landlords to suppliers and employees. That’s why understanding those contracts is critical when you think about buying a company, especially long-term contracts like a lease. A buyer may have to live with the terms of that lease up to 10 years, so they will check all major contracts. The key clause I always look for in a legal due diligence is what’s called an “assignability clause.” This means you can assign an existing contract to a buyer without having to get permission from another party. If there are strings attached, where someone has the right to refuse a contract transfer, it can cause endless trouble in completing an acquisition. I speak from personal experience on this one.
- Customers — Evaluating the health of customer relationships can be tricky when you aren’t being public about selling the company. But, as a buyer, you want to know if the company’s major customers–those that represent 50-70% of the business–will continue doing business with the company after a sale. Ideally, the buyer will get the chance to talk to these customers and discuss ways to expand their relationship. But sellers don’t often like this approach. One way to get around this is to employ an anonymous third-party customer research team that can survey the company’s customers and produce a report on their status and projected revenues from those relationships. One of the clients at the Inc. CEO Project has a robust business in doing customer experience surveys for acquiring firms.
- Employees — One of the emerging areas in the due diligence process is for buyers looking to understand how employees view their place of work. That might mean looking at review on sites like Glassdoor or even how the company ranks in Best Places to Work lists. This step could also involve surveying employees about their feeling for working for the company. But again, some sellers are wary of taking this step, especially if they haven’t disclosed that they are looking to sell. As a seller, talking or surveying employees might be reserved for very late in the sales process when the deal looks close to conclusion to avoid exposing employees to unneeded stress and worry.
- Inventory — While inventory can be part of the financial due diligence analysis, it might deserve a focus of its own if it represents a fair portion of the company’s value, like in a manufacturer or distributor. The risk here is that the seller has not properly accounted for the value of their obsolete or slow-moving inventory that hasn’t been fairly marked down. Smart sellers will get ahead of the curve by getting rid of questionable inventory before they start the due diligence process because a smart buyer will find the discrepancies.
- Reputation — Another increasingly important component of the due diligence process is evaluating a company’s reputation in the market. This can be measured by looking at social media sites and gauging what kind of a reputation the company has with its employees, customers, and the communities it operates in. Interestingly, many customers will do similar diligence before deciding to work with a company as well.
- Culture — Sellers also need to assess what kind of culture the business has and whether it will be synergistic with its own culture. After all, most acquisitions fail due to cultural mismatches. Even if two companies operate in the same market, they might have very different ways of operating. If your company is accustomed to wearing suits and ties and you’re eyeing a company where employees where Hawaiian shirts and shorts to work, it might not be a great cultural fit. It could work, but you need to understand how it substantially increases the risk of making such a deal.
This is far from a comprehensive list of what might be looked at in a due diligence process. In smaller deals, where the risk is lower, the process might focus mainly on the financial and legal aspects of the business. But in larger deals, like when I sold two of my companies where the risk of failure is much higher, you can expect to go through much more detail and it might take months.
The reminder here to potential sellers is that you can use this list to help prepare for a smooth sales process. The greater number of red flags a potential seller finds, especially where it might contradict something you originally claimed, the less likely you are to get the price you want—or to even close a deal at all. So, if you want to maximize the chances of selling your business for the best possible price, take the time now to get rid of any skeletons you might have in your closet.
For more thoughts about selling your business, read “Lessons From A Business Exit Sale“.
Copyright ©John Trenary 2021