Chapter 14
Confirming Everything! Doing Due Diligence
In This Chapter
Understanding due diligence
Conveying important due diligence information
Evaluating whether to provide extra information
The Buyer conducts due diligence (a thorough review of the Seller’s books, records, inventory, contracts, and more) concurrent with the drafting of the purchase agreement (see Chapter 15). Due diligence is the “open the kimono” time when the Seller reveals intimate details of the business, including (but not limited to) financials, customer information, pricing detail, sales pipeline, contracts, and employee compensation.
In this chapter, I introduce you to the ins and outs of due diligence, what to expect, what needs to be done, and perhaps just as importantly, what doesn’t need to be done. Please refer to the appendix for a full list of information provided in a typical due diligence process.
As you conduct due diligence it’s a good idea to begin thinking ahead to the integration phase. You’ll need a dedicated team in place to help make the transition smooth, so I recommend getting a head start on that important step. Chapter 18 talks more about assembling your transition team and what pre-integration considerations a Buyer should make.
Digging into the Due Diligence Process
The goal of due diligence is for Buyer to confirm Seller’s financials, contracts, customers, and all other pertinent information. In other words, the goal is to make Buyer comfortable enough that he goes through with the deal and closes.
Buyers often have other partners (usually banks or private equity firms) who are providing some of the financing and have stricter requirements than the Buyer does. In other words, Seller may have to overcome both Buyer’s demands and Buyer’s financial partner’s demands.
The following sections look at some considerations for the overall due diligence process.
Getting the process underway
Due diligence commences the moment the letter of intent (LOI — see Chap-ter 13) is signed, or at least it theoretically should. But frankly, many Sellers are wholly unprepared at this moment; they often don’t realize the vast amount of data they have to provide during due diligence. (To get an idea of just how much data due diligence requires, check out the later section “Providing Appropriate Information” and the appendix.)
All due diligence information should be ready and available for Buyer the moment both parties have signed the LOI. Because compiling due diligence information takes time, I recommend that Seller begin to gather this information when she starts marketing the business to Buyers.
How long compiling this data takes is largely contingent upon how quickly Seller works, but I recommend planning on one full month, assuming Seller is highly motivated and works quickly. Given the inevitable delays due to the demands of running a business, she may discover that she takes two or three months to fully compile all the due diligence info.
Allowing enough time for the due diligence phase
In theory, due diligence should take no longer than 60 days. When buying or selling a business, I never submit or agree to an LOI of more than 60 days. In both cases, I want to close a deal as soon as possible
In reality, however, the due diligence phase can take longer than 60 days. In most cases, the delay is the fault of the Seller, who’s often slow in getting information out. As I note in the preceding section, Seller needs to have all the due diligence materials prepared and ready to provide to Buyer as soon as both sides sign the LOI.
Regardless of whether you’re buying or selling, push hard for a 60-day due diligence period. Stay proactive with the process: Push and prod for information, and don’t be reluctant to pick up the phone and be a pain in someone’s side. However, other people don’t always work as fast as you’d like, so mentally prepare yourself for 90 days.
Sellers can’t be afraid to remind Buyers that due diligence is confirmatory in nature, meaning Buyer should spend the time confirming Seller’s information and not planning, creating, and combining the two entities. The Buyer should take care of post-closing activities after closing! Otherwise, due diligence will drag on longer than necessary.
The length of time for due diligence should coincide with the length of exclusivity laid out in the LOI because Buyer wants to avoid Seller being able to negotiate with other Buyers while due diligence is still under way. See Chapter 13 for more on LOIs and exclusivity.
Covering the expense
Each side pays its own expenses. Buyer hires his own lawyers, accountants, investment banker, and other sundry consultants, and Seller retains her own similar set of advisors. Each side is responsible for paying only its own set of advisors.
However, Buyers may be able to negotiate with their advisors to accept payment after the deal closes, meaning a Buyer can pay the bills by either using Seller’s cash flow or perhaps by adding the cost of the advisors to the amount of money the Buyer borrows from other sources.
Due diligence means that you as a Buyer are spending a lot of money on auditors, lawyers, and other consultants, so refusing to move forward with those expenses until you know the Seller isn’t continuing negotiations with other Buyers makes perfect sense. You don’t want to show up on closing day only to discover that the Seller has picked a different Buyer!
Conveying the due diligence info to Buyer
In days of yore, back when the slide rule and rotary-dial phone ruled, M&A deal-makers conducting due diligence would sit in a room, informally called a data room, with a stack of financial statements, contracts, and all manner of information, and slowly but surely confirm what they needed to confirm.
This task wasn’t fun, so Al Gore took it upon himself to invent the Internet. Okay, I’m joking, but thanks to that non-Gore invention, the insanity of the physical data room ended. The M&A deal-makers of today use an online data room (sometimes called a virtual data room).
An online data room has numerous advantages over the old fashioned “a bunch of documents dumped in a cold, impersonal room” approach, including the following:
Seller can control who sees what information and when.
Buyer can conduct due diligence from the comfort of his cold and impersonal office instead of traveling to Seller’s facility and sitting in her cold and impersonal office.
Multiple people from Buyer’s side can access the data room. Seller only needs to grant them access (user name and password).
The online data room acts as a central depository. This function cuts down on multiple people from Buyer’s team making the same request over and over.
Seller can monitor who from Buyer’s team has accessed the online data room and which documents those people have reviewed. This helps Seller gauge Buyer’s seriousness. Is he looking at all the information or just certain bits — say, the customer list?
Seller gets a level of security. Documents loaded to most online data rooms have a watermark displaying the name of the user, the date of access, and the IP address. If Buyer breaches confidentiality and gives the due diligence materials to someone not approved by Seller, the documents clearly point out the person responsible for the breach.
Business as usual: Running the company during due diligence
Seller should continue to run the business as if she weren’t in the process of selling it. The company should buy supplies, pay bills, and make sales calls as before.
However, if Seller is thinking about making big business decisions, such as substantially increasing overhead or hiring new salespeople or executives, she should probably confer with Buyer first because huge changes to the business may affect the company, notably the profits.
Selling a business is a highly sensitive process, and Sellers need to tell their employees of the sale (or pending sale) at the right time. Furthermore, Sellers need to control that right time. Unless an employee needs to know (usually executives and certain financial personnel need to know), Seller should wait until the deal is closed before making an announcement to the employees.
Keeping the cards close to one’s vest is important for a couple of reasons. If Seller informs the employees of a potential sale that ends up falling through, Seller loses face. Worse, employees may start to wonder why the deal didn’t close. They may assume that the company is facing some sort of problem and start a mass exodus. Additionally, employees who hear about the pending deal may assume they’ll get fired after the deal closes and begin to jump ship as they look for new jobs.
If the news of a pending sale is released prematurely, the company may suffer major losses. For this reason, Sellers shouldn’t give Buyers carte blanche to contact Seller’s employees at will. Buyer shouldn’t call or contact any of Seller’s employees without Seller’s explicit approval. Seller needs to carefully control this release of information and the timing of when Buyer speaks with employees.
As Seller, if someone on Buyer’s team has caused a breach by making unapproved contact with one of your employees, immediately pick up the phone and call the other side. Don’t rely on e-mail. You need to have a conversation. Remind Buyer he’s not to make contact without your approval and ask him to adhere to protocol and the terms of the confidentiality agreement (see Chapter 7). Most Buyers immediately understand the gravity of the situation and take steps to fix the problem. In other words, someone on that team is about to get an earful!
After making such a phone call, send an e-mail memorializing your conversation and ask the other side to confirm receipt and understanding of the e-mail. This way, if the problem occurs again, you have a written record of the first breach.
Providing Appropriate Information
The expanse of due diligence information is far deeper and wider than the information that the offering document, or deal book, provides. The offering document (see Chapter 8) provides enough information for a Buyer to make an offer. Due diligence provides enough information for that Buyer to be able to close the deal. Another difference is that the offering document is intended for laypeople. It’s relatively easy to read and comprehend, and its focus is high level; that is, it contains fewer nitty-gritty details. The due diligence material is for experts and can be mind-numbingly boring!
Please review the appendix for a very, very detailed listing of due diligence items. The due diligence items I list in the following sections are only a recap of typical due diligence items and are intended to give both Buyer and Seller an idea of the depth of materials needed to conduct due diligence.
Corporate info
Buyers want to pay close attention to a bevy of legal paperwork to make sure Seller actually has the legal right to sell the business to Buyer. Not having the legal right to sell something poses a wee bit of a problem in selling a business!
Here are some of the items Sellers should provide for the review of corporate information:
The company’s articles of incorporation, bylaws, and minutes from board meetings
Annual reports
Names and contact info of shareholders and number of shares held by each
Names and contact info of directors and officers
Listing of the jurisdictions where the company is incorporated or qualified to do business
Listing of any assumed names or DBAs (doing business as) of the company
Listing of all federal, state, local, and foreign governmental permits, licenses, and approvals
Listing of all law firms, accounting firms, consulting firms, and similar professionals engaged by the company
As you may be able to tell from reviewing this list, Seller’s lawyer be involved with this part of due diligence. Many Sellers, when faced with some of the items on this list, respond with a blank expression and mumble, “Huh?” Sellers should check with the lawyer who incorporated the business if they’re unable to locate these documents.
Operations
A company’s operations are highly important. That should go without saying. But what does “operations” mean, and more specifically, how does a Buyer conduct due diligence on operations?
In a typical due diligence process, most Buyers seek the following information for evaluating operations:
Listing of all existing products or services, all products or services under development, any major operations discontinued or expected to be discontinued, and copies of all complaints and warranty claims
Correspondence related to any product or services regulatory approval (or disapproval)
Detail on any rebate programs or other special deals with customers (discounts, terms, and so on)
Contracts or agreements with customers, whether formal or informal
Customer quality awards, plant qualification/certification distinctions, quality certifications, or other awards or certificates
Listing of all business application software, vendor and version, number of licenses, and approximate acquisition date
In addition to reviewing a slew of operations-oriented documents, Buyers often want to see Seller’s facility, especially if Seller is a manufacturing or distribution company — in other words, a business with inventory and/or involved with fabrication. Flip to Chapter 10 for more thoughts on meetings between Buyer and Seller.
Financials
I hope no one is surprised to hear that financial information is the cornerstone of M&A deals. As you can probably guess, Buyers conduct a thorough review of Seller’s financial information. In all likelihood, the financial review will be the most intensive and important of the due diligence process.
Buyers also want to analyze Seller’s accounting policies for various procedures, including, but not limited to, capitalizing assets, depreciation and amortization methods, and adjustments to EBITDA, as well as reviewing any changes in accounting methods.
The following list is simply an abridged list of typical financial due diligence, but it gives you an idea of the amount of data typically required to close a deal.
The usual trio of financial statements (income statement, balance sheet, and cash flow statement), preferably prepared by an outside accountant
Accounts receivable and accounts payable information, including aging schedules and details on bad accounts
The general ledger
Projections, capital budgets, and business/strategic plans
Listing of all bank accounts and safety deposit boxes, including authorized signatories
Schedule of prepaid expenses with backup documentation and accumulated amortization
Schedule of deferred income at most recent year-end and month-end
Schedule of security deposits at most recent year-end and month-end
Schedule of all indebtedness and contingent liabilities
Detail of accrued expenses as of the most recent year-end and month-end
Detail of any customer advances, deposits, and credit balances as of the most recent year-end and month-end
Accrued vacation is often the one lurking problem Sellers don’t think about. If employees are due vacation time but haven’t yet taken that time prior to the closing, Buyer will demand a reduction in the purchase price equal to the value of that vacation time.
Sales and marketing info
Who are Seller’s customers, and how does she market to them? Who are her competitors? The following are some of the sales and marketing basics any Buyer wants to determine during due diligence:
Complete customer list, including name, address, telephone number and contact name
Listing of any major customers lost
Listing of open orders and copies of all supply or service agreements
Surveys and market research reports
Schedule of the company’s current advertising programs, marketing plans, budgets, and physical marketing materials
Listing of the company’s major competitors
Sellers should provide customer data by major product line and by percentage of sales. A customer with sales that represent more than 5 percent of the gross sales should be considered major.
One of the most sensitive bits of information for any company is its customer list. Most companies would give their corporate eyeteeth to learn their competitors’ intimate customer details. If you’re a business owner, I’m sure I don’t have to do much to convince you that your customer list is highly confidential.
Due to the sensitivity surrounding the customer list, I recommend Sellers release customer information on a staggered basis, especially if Buyer is a direct competitor at the beginning of due diligence.
Initially, Seller should provide Buyer with an anonymous list (using a code such as “customer 1,” “customer 2,” and so on). Only if and when Seller believes Buyer will close the deal should Seller release specific customer names. For convenience, that list should match the anonymous list (that is, customer 1 should be the first customer on the list, and so on). Release of the specific names of customers should occur as late as possible in the due diligence session, ideally as close to closing as possible, to minimize any potential problems.
If Buyer is asking to speak with some customers prior to close, Seller should only grant that request as a last and final step before closing. In other words, all other due diligence should be finished and the purchase agreement should be completed.
Real estate and facilities info
A business isn’t a business unless it has a place to operate from. Providing Buyer with the following details on the business locations and the nature of those locations is another key responsibility of Seller during due diligence:
Listing of all business locations
Listing of all owned or leased real estate, including locations
Copies of all real estate appraisals, leases, deeds, mortgages, title policies, surveys, zoning approvals, variances, or use permits
Lease terms, including date signed, termination dates and rights, renewal rights, rent amount, and unusual provisions (such as purchase option), as well as any defaults or breaches
Listing of current and pending construction in progress, including date commenced, expected completion date, and any additional financial commitment necessary to complete the project(s)
Who owns the facility, and is it part of the deal? Is Buyer also buying the facility, or will she be leasing it from Seller? In most cases, the parties need to conduct any real estate transaction outside the business sale.
Fixed assets
Fixed assets can play an enormous role in financing an acquisition and helping an owner to obtain a loan. For this reason, Sellers need to spell out any and all of the company’s fixed assets to Buyer during due diligence. This information includes the following:
Listing of all fixed assets, with separate lists for owned assets and leased assets
Information on the assets, including a basic description of the asset, date acquired, original purchase price, depreciation years, accumulated depreciation, net book value, and asset location
All Uniform Commercial Code (UCC) filings (any time a lender makes a loan secured by the assets of a business, that lender files a document stating it has a claim against the business’s assets)
Listing of sales and purchases of major capital equipment
Listing of unpaid balances and open purchase commitments for any capital equipment
Listing of any surplus or idle equipment and the equipment’s dollar value
Vehicle registrations
Consulting and service businesses likely don’t have much in the way of fixed assets (desks and computers are about it). Buyers of these types of companies shouldn’t expect much in the way of fixed assets.
Inventory
Inventory is another key component of a company’s assets and therefore impacts the ability of an owner to obtain financing for the company. Buyers need the following information:
Listing of all items in inventory listing (by location, if applicable), including item description, item number, acquisition date, number of units, and acquisition cost
Description of practices regarding inventory aging, valuation, and obsolescence, and any methodology changes
Details of inventory reserves and/or write-offs
Details of any consigned inventory arrangements
Companies with inventory likely need the Buyer to inspect the inventory in person. In fact, the Buyer may require the Seller to conduct an inventory prior the closing of the deal.
Supplier info
If a company has inventory (see the preceding section), that inventory must come from somewhere. Therefore, Buyer needs to know all about a company’s suppliers and how that company makes purchases. Required information includes
Listing of major suppliers and dollar volume of purchases from each supplier
Listing of open purchase orders
Summary of the company’s purchasing policies
Contracts with suppliers or descriptions of any significant supplier agreements
Buyer may want to contact certain suppliers, but as with making contact with customers, I recommend waiting until the end of the due diligence process before Seller grants this request.
Intellectual property
Intellectual property is an area that many skip over when thinking about due diligence. But make no mistake: a company’s intangible assets may be among its most valuable. The following list covers the pertinent due diligence info:
Listing of all patents (including title, registration/application number, date of registration/application, initial expiration, and country of registration), patent registrations, trademarks, trade names, and copyrights
Listing of Internet domain name registrations
Summary of any claims made or threatened by or against the company over intellectual property
Human resources
A company’s most valuable assets, especially for consulting and service firms, are the assets that enter and leave the building each day: the employees. A Buyer is wise to understand during due diligence how the company hires, compensates, and accounts for employees. This information can include
Organizational chart for the entire company
Listing of employees with details of hire date, position, job description, and current pay rate.
All agreements with employees and consultants (typically these include employment or consulting agreements as well as non-disclosure, non-solicitation, and noncompete agreements)
Key employees’ résumés
Copies of executive compensation plans, including salaries, bonuses, commissions, vacations, club memberships, and so on
The company’s employee handbook, including all employee benefits and holiday, vacation, and paid time off policies
Documentation for retirement plans
Listing of employee benefits programs and insurance policies
Listing of all employee problems, including alleged wrongful termination, harassment, discrimination, and labor disputes
Listing of worker’s compensation claim history and unemployment insurance claim history
Debt and financial dealings
A wise Buyer needs to fully understand the Seller’s financial dealings for two basic reasons. First, Buyer wants to know what she’s getting herself into. In other words, are any hidden or unforeseen problems with a creditor on the horizon? Second, she wants to understand the company’s ability to garner financing. Required information may include
The rundown of all promissory notes, commercial paper, loan or credit agreements, letters of credit, and financial surety/performance bonds or similar credit support devices
Listing of all security agreements, pledge agreements, mortgages, and other agreements where another company has a claim to Seller’s assets
Listing of any compliance certificates, including borrowing base certificates and covenant compliance calculations
Schedule and details of any existing defaults under credit arrangements and any events that, with the giving of notice or the passage of time, will become such a default
Buyers should retain a capable and experienced accounting and auditing firm to conduct a thorough investigation of Seller’s financial dealings.
Environmental concerns
Environmental concerns are an increasingly important part of due diligence. A consulting firm or other business service company probably doesn’t have an environmental issue. Important environmental due diligence info may include the following:
Copies of any environmental reviews or inspection reports relating to any of the company’s owned or leased properties
Copies of any notices, complaints, suits, or similar documents sent to, received by, or served upon the company by the U.S. Environmental Protection Agency or other local or state regulatory body
Copies of outside reports concerning compliance with waste disposal regulations (hazardous or otherwise)
Listing of hazardous substances, including (but not limited to) asbestos, PCBs (polychlorinated biphenyl), petroleum products, herbicides, pesticides, or radioactive materials used in the company’s operations
Listing of permits, licenses, and agreements of the company relating to air or water use or quality, solid or liquid wastes, hazardous waste storage or disposal or other environmental matters.
Listing and description of any environmental lawsuits or investigations
Copies of the workplace safety and health programs currently in place, with particular emphasis on chemical handling practices
A Seller concerned about possible environmental issues should hire a qualified environmental firm to conduct appropriate tests on the real estate or facility in question before beginning the process of selling the business.
Taxes
Not surprisingly, taxes are a major concern for any Buyer. Taxes run the gamut from income taxes to payroll taxes to sales taxes. Paying taxes drives everyone mad; not paying taxes may send you to jail! The following list outlines tax information Buyers should review during due diligence:
All federal, state, local, and foreign tax returns
State sales tax returns
All employment tax filings
Real estate and property tax filings
Copies of any tax liens
Listing and description of any pending or threatened disputes regarding tax matters
Nonpayment of any kind of tax is serious, of course, but Buyers should be especially on guard for a Seller who has not made FICA payments. Nonpayment of payroll taxes is a major warning sign for any Buyer: When a company stops making FICA payments, the owners or executives can face jail time.
Contract information
Contracts, in other words, the written and oral obligations of the company, are hugely important for any Buyer; she needs to have a clear idea before closing of what contractual commitments her new company has. This information may include
Written description of any oral agreements or arrangements
All contracts or agreements pertaining to any subsidiary, partnership, or joint venture relationship
All contracts between the company and any officers, directors, 5 percent shareholders or any of their respective families or affiliates
License, sublicense, royalty and franchise agreements, or equipment leases
All distribution, agency, manufacturer representative, marketing, and supply relationships and obligations with copies of all related agreements
Letters of intent, contracts, and closing transcripts from any merger, acquisition, or divestiture
Options and stock purchase agreements involving interests in other companies
All non-disclosure or noncompetition agreements the company is a party to
Any agreements a change in control of the company affects in any manner
All management contracts
Any brokers or finders agreements applicable to the company
Contracts relating to other material business relationships, including, but not limited to, any current service, operation, or maintenance contracts and any current contracts for purchase of fixed assets
Insurance
Insurance — that is to say, risk management — is another important factor for any Buyer. Understanding the costs of insuring Seller’s business is important, of course, but so is understanding the underlying risks associated with the business. Insurance info for due diligence may include the following:
The company’s insurance policies, which may include general liability, personal and real property, product liability, errors and omissions, directors and officers, and worker’s compensation.
Schedule of insurance claims
Listing of areas of self-insurance
Listing and description of any outstanding premium adjustments
Buyers may be able to get better insurance rates after the deal closes; larger companies are often able to warrant preferred pricing from insurance carriers.
Litigation history
Understanding Seller’s history with lawsuits, both as a defendant and plaintiff, is another must-know due diligence area for any Buyer. The following list lays out some important litigation info:
All litigation, arbitration, and other proceedings to which the company is a party
Listing of all pending or threatened claims, lawsuits, arbitrations, or investigations (including investigations by any governmental authority)
Description of settlements of litigation, arbitration, and other proceedings
Bankruptcy proceedings in which the company is a creditor or otherwise interested
All orders, injunctions, judgments, or decrees of any court or regulatory body applicable to the company
All agreements in which the company agrees to indemnify or hold harmless another person or entity for claims against that person or entity
Schedule of any litigation involving an officer or director of the company concerning bankruptcy, crimes, securities law, or business
Governmental filings
Depending on the industry and the nature of Seller’s business, a slew of government filings and paperwork are a part of due diligence. These documents include
Any governmental licenses, permits, and authorizations
All filings to any national, state, or local governmental agency or authority, including the SEC, the IRS, the FDA, and the INS, to name just a very few
Any complaints, investigations, or other informal or formal proceeding by or before a governmental agency or authority and involving the company
Considering Requests for Additional Information
Instead of simply responding to request after request from a Buyer when I sell a company, I always provide a detailed list of due diligence items and tell the Buyer that we’ll consider adding requests on a case-by-case basis.
Due diligence should focus on confirming material facts: the numbers, the ownership, the customers, the contracts, and so on. But what falls outside “material facts” can be a complicated matter. Each deal is different, of course, and although the due diligence list provided in the appendix is a comprehensive list, a particular Buyer in a particular industry may require additional items. Sellers should consider those requests from the Buyer. However, asking for sales and marketing materials from years ago is probably useless to the Buyer. Asking the Seller to construct a financial model or write a sales and marketing plan isn’t appropriate. Seller should not do Buyer’s work. If Buyer wants a financial model or sales and marketing plan, it’s the responsibility of Buyer to create those documents.
To help gauge whether a request is appropriate and covers material facts, Sellers should ask a simple question: “How does this information help close the deal?”
If there’s no clear answer to how the extra info helps close the deal, the request is likely busywork. Well-meaning busywork, perhaps, but busywork nonetheless. In this case, Sellers shouldn’t be afraid to challenge the Buyer’s request.
Buyers, make sure your advisors have all prior information from the offering document and any management meetings. Sellers quickly get ticked off if advisors ask for information previously provided.