This is the stage in the selling process where the vendor will have to open up their business to close scrutiny. However well negotiations have been going, any hidden skeletons in the closet are liable to jump out and scare your buyer off.
Business guru and founder of the Diomo Corporation, Richard Parker, claims that a depressing 50% of small business purchases collapse at the due diligence stage and that this is largely due to an inability to maintain buyer confidence and/ or the revelation of undisclosed problems:
‘Having sold nine of my own businesses and after having been involved as a broker or advisor in hundreds more, I have seen first-hand how some sellers can undo a deal simply because they are poorly prepared for the process’ he says.
Parker also advocates the need for complete disclosure:
‘This is not the time to posture and negotiate about what information you are, or are not prepared to provide. If a seller makes this stage transparent, the odds of getting the deal close will rise exponentially.’
Before entering the due diligence phase a seller should ask their potential buyer for a comprehensive list of documents and aspects of the business that they want to have access to.
Andrew Weaver, CEO at Lawyer Fair goes a step further and suggests creating a ‘seller’s pack‘ that addresses any issues that might arise. He calls this ‘upfront DD’ and also insists that hiring seasoned legal professionals from the outset is key to success.
‘Those with experience have a much greater chance of seeing risk at an early stage and addressing it before it becomes a deal breaker.’ - Andrew Weaver, CEO at Lawyer Fair
Rob Goddard, CEO at leading business intermediaries, Evolution CBS, agrees:
‘Always, always use an experienced M&A lawyer. They are there to represent and protect you but you must disclose any sensitive issues. There’s unlikely to be anything that an experienced lawyer hasn’t dealt with before so choose your advisers with care but don’t try to hide information – it will come out so it’s better to be proactive.’
If there’s anything that a seller feels they shouldn’t have to disclose, they will need a valid reason.
It’s worth remembering that this is the final hurdle for a buyer and if they are asking to see something that might not present a business in its best light - it would be far better for a seller to prepare some positive spin on this issue, rather than leave an air of ambiguity that will cool a buyer’s enthusiasm.
There are generally three strands of due diligence; legal, financial and commercial. A seller needs to focus on all these three areas to ensure that they will stand up to scrutiny from buyers.
Firstly, a buyer will want to look at the financials – not just statutory accounts but also forecasts, budgets, and monthly management accounts. It’s important for a seller to minimise perceived risk so they must make sure to be fully conversant with the figures as well as being able to explain with confidence how the forecasts will be met.
A seller will also be asked for employee, client and supplier contracts, shareholder agreements, asset registers and a lot more. If you’re prepared and have all this ready in advance you will significantly reduce the time and costs associated with due diligence.
Weaver points out that different businesses require different types of due diligence:
‘Companies where the value is in the contracts will clearly need to have their contracts scrutinised closely. Companies where the value is in the IP will require a thorough examination of licences and trademarks.’
The key focus should be on what the buyer is paying their money for and where the danger of that value disappearing might lie:
‘If it's a share purchase then the buyer inherits the company, warts and all. This means that every liability on that balance sheet will become the buyers and so, quite rightly, their advisors will scrutinise the health of the company very carefully and address the potential of any liabilities emerging in the future. This can be boxed off via warranties and guarantees but, it's a delicate area of negotiation and is often the downfall of a deal.’says Weaver.
Despite the need for transparency, there are often buyer requests that a seller will be reluctant to grant – these usually involve demands to speak to employees, customers or suppliers.
Richard Parker advises sellers to put themselves in the buyer’s shoes:
‘Consider whether or not it would be something you would want to review if you were the buyer. If the answer is “yes", then you have to allow it. For example, if you have a limited number of clients that contribute a disproportionate amount of the revenue, the buyer needs to be assured that this relationship will endure after the sale. If they cannot meet the clients, it will invite a performance laden deal which could hurt the seller.’
However, Maung Aye, a partner at international law firm, Mackerell Turner Garrett, who specialises in business acquisitions, advises sellers to protect themselves against the leaking of confidential information:
‘Before any due diligence starts, a seller should consider entering in to a non-disclosure agreement with the prospective buyer. This is important to ensure that the buyer does not divulge any sensitive information it obtains to anyone other than its professional advisors.’
Another way to protect sensitive information is to only allow the buyer access to the seller’s management team or certain key, senior members of staff. The seller will also need to ensure its management team’s contracts of employment contain appropriate confidentiality provisions.
There are a number of ways for you to present the buyer without jeopardizing confidentiality. Meeting with suppliers or customers can sometimes be accomplished by the buyer accompanying the business owner as a ‘salesperson in training’. For employee issues, it is only necessary for the buyer to meet key personnel who have to remain with the company after a sale in the buyer's mind. Here too you can introduce the buyer as either an outside consultant, or potential investor, or as a candidate to open a second location.
A key factor in a successful due diligence process and resultant deal, seems to be early preparation on the part of the seller. Rob Goddard warns against what he calls ‘deal fatigue’,
‘Poor preparation is often the cause. If key information and documentation, such as contracts or accounts, aren’t readily available or either party doesn’t respond to queries in a reasonable time the period of due diligence will take longer (and cost more), making deal fatigue more likely.’
And sellers must try to avoid surprising their potential buyers with previously undisclosed issues:
‘An example might be a legal claim that has lain dormant for a while, a customer complaint ignored and now escalated. This causes the buyer to question other information and destroys trust’ says Goddard
Due diligence is an unavoidable hurdle in the sale of any business and it pays to pre-empt any potential problems. Always remember that surprises can also come from the buyer – like deciding to focus on a different acquisition and defer yours!
Be as honest as possible throughout the process, hire professionals and protect the integrity of your business, and, as a seller – you will have done all you can to expedite a happy outcome for all.