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The business owner selling his or her business often finds it surprising to learn how much time, money, and energy it takes to endure the buyer’s due diligence process.
This process can be particularly difficult because it’s the last step in a very long journey, one which introduces new emotions to the seller, and in many cases, their spouse or significant other.
Today, I asked a two of our Featured Advisors a few questions during our online roundtable session to help business owners considering the sale of their businesses prepare for due diligence.
Mark Fazio is an attorney who specializes in M&A transactions and Neal Isaacs is a business broker in North Carolina. There’s great wisdom in their advice:
From your perspective, what is most difficult for business owners when they are in the due diligence phase of selling their business? And how can a business owner prepare for it?
Mark Fazio comments that the due diligence phase of selling a business can really be a test of a business owner’s patience. Depending on the nature of their business, the due diligence phase can really be a long, grueling process.
Business owners are faced with request after request, and question after question. Contracts, claims, or practices that were seemingly never an issue before (and probably never will be) are examined and questioned by a potential buyer, and business owners often start wondering whether the buyer is stalling or playing games. But a prudent buyer will not want to leave any stone unturned – just because something has not affected the business to date does not mean that it won’t result in liability down the road!
To prepare for the due diligence phase, a business owner should get all of his/her ducks in a row. Pull all documents, scan them and set up a data room. If your accountant or lawyer keep records for you, obtain them as well (except for documents that may be subject to attorney-client privilege). Track down answers to obvious questions, such as whether you are still operating under contracts that may be expired by their terms. Cross every “T” and dot every “I”.
Finally, it may seem cost-efficient to wait to engage your business lawyer until you are more certain that you have a deal, but a good business lawyer can really add value and help you during the due diligence phase to make your business more attractive to potential buyers. Many issues that come up during the due diligence phase could have been an easy fix if discovered previously, but instead sometime result in a deduction to the purchase price.
Neal Isaacs adds that business owners often feel annoyed or frustrated at the demands of due diligence. It includes a lot of document wrangling for files they may not have thought about others reviewing, or they may have challenges finding them altogether. Having a good system for organizing documents, preferably virtual, for items such as tax returns, employee records, policies & procedures, sales/employee tax filings, and the like will not only make running their business easier, it will also keep them compliant in the event of an audit, and prepare them for the demands of due diligence.
When advising your business owners during the selling process, what do you see as a common misunderstanding about due diligence?
The most common thing business owners fail to understand is that just because something hasn’t become a major issue to date doesn’t guarantee that it won’t become a major issue in the future, warns Mark. And for that reason, a prudent buyer has to dig in and get the full picture surrounding the issue.
For example, an employee may have been let go a month ago and never threatened to sue. But absent a signed release, a potential buyer will want to understand the facts surrounding the termination to evaluate whether the terminated employee may have a potential claim.
Another common example involves contractual relationships: how binding is a contract to a third party, and how may a sale of the business impact future business with such third party?
Neal indicates that most owners are understandably concerned about what will be shared early. Neal finds that explaining the process in detail helps them feel more comfortable with this.
Specifically, explaining the length at which buyers must be screened before receiving confidential information, and the fact that they only get to see the intimate documents of the business in due diligence after they have submitted an offer that’s accepted by the buyer.
How do you advise your business owners with regard to the other advisors they need when selling their business — especially those advisors who are needed during the due diligence phase?
Mark suggests that a business owner needs (i) an experienced financial expert/representative who can help find potential buyers and get the maximum value for the business and (ii) an experienced business lawyer who can negotiate the best terms of the sale of the business. In both cases, the advisor can add the most value if they are given full access to the business and the opportunity to gain a full understanding of the business prior to entering into negotiations with potential buyers.
Without good financial representation, a business owner may get 70-80% of what the business is truly worth . Without good legal representation, a business owner may be giving back 50% of purchase price proceeds to the buyer after the sale for indemnity claims, etc. Many people dabble in these areas but are not truly experts – a business owner wants a financial expert and a business lawyer whose bread and butter is M&A.
Neal asks his clients to communicate closely with their accountants/bookkeepers regarding the necessary documents needed, and to authorize him or her to communicate with others assisting the business owner. Often a broker can save an owner a lot of time and stress by allowing a business broker to go to the source for the documents needed for due diligence. Similarly, the client’s business attorney should review the due diligence list to ensure that the items being shared don’t violate any laws, especially payroll documents which could include employee’s personal information.
How much control do you exert over the documents which are released to the buyer during due diligence and how do you do this?
Everything should go through a business owner’s lawyer before being released to the buyer, says Mark. The last thing a business owner wants is the buyer learning about or discovering an issue before his/her own lawyer does. As stated above, a good business lawyer may be able to jump out in front of an issue and deal with it before presenting it to the buyer. ‘
A business owner must remember that, during the due diligence phase, even though he/she may have an LOI with the buyer, nothing is a done deal. If smoking guns are released to the buyer without being properly addressed then it could really shake the buyer’s confidence in the business owner and make them question how the business owner has been running the business.
More importantly, timing and presentation of an issue could make the difference between the buyer dismissing the issue or asking for a purchase price reduction and/or special indemnity from the business owner relating to the issue.
Neal adds that the due diligence should enable the buyer to see the flow of money from the client through the business into the bank accounts and ultimately reported to the federal government. There are many ways to prove this, and often buyers ask for everything because they don’t know what to ask for.
Sharing reports from third parties that support the advertised representation and explaining to them how the business makes money should be enough to overcome document request overload with a reasonable buyer. Furthermore, documents that owners have invested money in such as attorney reviewed Policies and Procedures, employee manuals, and the like can be sampled or watermarked until after the closing, and customer lists should always be converted to a format that reveals qualities of the list without giving away the actual list; a chart of the percentage of customers by county is an example of this.
Is there a common issue discovered during due diligence that inevitably kills the deal? If so, what is it and how could it be avoided?
Mark cautions that most issues can be dealt with if discovered in time, whether it be through merely getting the buyer comfortable with the issue, allocating the risk surrounding the issue or through an escrow or holdback. In some cases, an adjustment to the purchase price may be inevitable. The most common “big ticket” issues involve litigation claims, tax defaults or non-compliance, ERISA non-compliance or contracts with key customers or vendors.
Anytime there’s a discovery that the business could be run in a manner that is not legal, it presents a major issue warns Neal. Examples may include when payroll taxes aren’t commensurate with wages paid, independent contractors are treated as W2 employees, or employees lack proper documentation. All of these type of issues should be mitigated before a business is taken to market and should not be discovered in due diligence. One of the major roles of a business broker is to anticipate challenges that an owner will have before the business is taken to market.
If you were in the shoes of your client who is selling their business, what is the single most important thing they should understand about the due diligence process?
Mark comments that business owners must always remember that the due diligence phase is like a courtship – a business owner really need to focus on getting the buyer comfortable with the business and the risks surrounding it. So even though it can be a long, grueling process – and at times it may seem like the buyer is beating a dead horse – it is well worth the time and patience!
Neal adds that the due diligence process is the buyer saying, “I want to buy your business; I just need to confirm that you really do own it and that it actually makes the money you represented.” They have to check because they’re writing you a really big check and validating these things gives them the confidence they need to sign it!