What Is It?
It is an investigation into your life’s work; including the underlying legal, factual, financial, and regulatory affairs of the business. A potential buyer’s purpose, whether strategic or financial, is more than identifying potential risks. They want to know if integrating the acquired business makes financial sense, and what the inherent value of said business will be. They are professional buyers who wake up everyday to maximize returns while minimizing risks.
Some shops perform diligence internally while others contract out to third-party firms who specialize in diligence. Keep in mind, outsiders are incentivized to find bad things or the appearance of bad things such as inaccuracies, inconsistencies and worse. They cannot ignore red flags, and they will leverage yellow ones! What are some typical issues due diligence uncovers?
One of the most common issues is incomplete or poorly presented financial information. Buyers want to see consistent, accurate financial data reported backed up by proper procedures and discipline. Early on, we had cases where management assured the buyer their forecasts were robust, only for inconsistencies to appear between accounts and statutory filings. How could you not undermine confidence and required weeks of clarification. Frustration causes distrust and can bring a premature end to negotiations.
Another frequent stumbling block is unresolved tax issues. The typical request for additional details surface mid-deal where management characterized as “nothing to worry about.” However, to a buyer, the fastest way to trigger pencils down is the red flags of outstanding tax liabilities. Who wants additional risk where outcomes are unclear. An early, preemptive tax review prior to going to market flushes out potential issues and applying remedial measures.
Suppliers, customers and employees are the heartbeat of any business. However, contractual blind spots rear their ugly heads when key contracts are missing, out of date or were “long-standing customer agreements” founded on little more than a handshake or an email when due diligence begins. Heaven forbid there is a contract on file, but it has a change of control clause that negatively impacts the transaction going forward. Formalizing contracts reassures everyone keeping the deal on track. Finally in this example, if the business being sold has significant legal obligations or ongoing disputes, it’s important these are made clear to buyers and both parties lean on their counsel for advice.
Before going to market, we find the most successful cases are prepared by entering sell-side due diligence to uncover any surprises, making corrections ensuring our client is as prepared as possible. The one thing a seller controls is their preparation for a sale! In performing sell-side due diligence, we enter data into our own virtual data room utilizing our master diligence checklist that’s evolved over several decades.
Inside the VDR. In the weeks leading up to publishing and distributing the client’s pitchbook or CIM, we host our own VDR up and running. It will be structured as a detailed outline of all nine workstreams. We control it for various reasons; one of which is if we decide the initial buyer is a dud, we have control of all the documentation and will delete their access in lieu of potential buyer #2. At JSP, we control the ROE, access levels, authorizations and all procedures requesting printing, additional documentation, etc.
“The standard required of a prudent man is the management of his own property.” – Justice Samuel Putnam, 1830 Harvard College v. Amory
Caps & Baskets Dancing Through Their Heads
Founders and entrepreneurs have one full-time job and when they enter a sales transaction, they assume a second full-time job, often leading to many sleepless nights. Three terms prevent restful sleep as the owner selling their business – full disclosure, transaction evaluation and limitation of professional liability. Disclosure is a matter of timing. Diligence seeks to gain an understanding a/k/a a complete picture of the business ensuring the asset is accurately and adequately disclosed or verified in the offering documents and understood.
Buyers and their reps are assigned to meaningfully understand the business and assess the risks associated with the target (you). Identifying issues that present structural or substantive problems are imperative in executing the transaction. It’s not all bad news, evaluating potential synergies determining if it makes sense to proceed further. Addressing risk allocation will undoubtedly trigger a reduction in price or expanded indemnity. Transaction evaluation can be where a deal may die as analysts dig into your case like a honey badger after a snake.
The asset target (you) will be agreeing to indemnify as a contractual remedy within the acquisition agreement. You agree to compensate the buyer post-closing for specific claims or damages, which would arise from breaches of the seller’s representations and warranties or covenants outlined in the acquisition agreement. An indemnification “cap” is the maximum amount the seller is obligated to pay to the buyer for post-closing indemnification claims. Caps can be expressed as a fixed dollar amount or a percentage of the purchase price. An indemnification “basket” is a minimum amount of losses that must be exceeded before the seller is required to indemnify the buyer. It’s enough to ruin your REM cycle for months.
Casino Royale
You know every inch of your business, the good, and the bad. It is your greatest strength until you must disclose what you’d rather not share. The one with superior knowledge in a transaction wins! Bond knew how to read the table regardless of Le Chiffre’s tell. In the beginning and up until the point where the seller signs on the bottom line of a letter of intent, he has the power! Once the potential buyer is in receipt of the signed LOI, the superior knowledge begins to shift. During this exclusive period, the superior knowledge you had will diminish throughout the process. Whoever has the superior knowledge will be in the best position to:
- Negotiate the shifting of risks and achieve the negotiation advantage,
- Quantify the probability of a particular risk,
- Determine risks they may be willing to assume, accept or concede,
- Shift the costliest risks to the other party
The Exercise. Sooner or later bad information comes to light, absent of fraud. The ugly side of selling a business exists when there are sellers less than transparent with their deal team. By insisting on a superior information advantage post LOI into exclusivity, they will be adversely affecting their credibility…you will be found out…
This is why we engage our own diligence before any transaction commences. We identify, evaluate, correct or mitigate real and perceived issues in response to live diligence to lead the procedures and processes. Buyers react poorly to delayed and late disclosures, and the consequence can be great…READ, costing you hundreds of thousands of dollars or more.
We affectionately call diligence the exercise, and for your aggrandizement, here is our sample due diligence checklist to review. There is no one perfect all-encompassing comprehensive due diligence checklist for your business case. Buyers have their diligence expectations and standards they want followed. It will be an evolutionary process dependent on the facts and circumstances of the target asset (you), the financial model and the preferred transaction structure.
“Mark my words, your deal will fail three times before it closes.” – David Reed
The Bring Down
Our #1 job is to secure the highest possible price for the business case. Job #2 is to ensure certainty to close. Nearly half of all potential business case transactions never make it to the finish line. Anyone who tells you they close 95% is full of shit; we ALL cherry pick! Once all the requested documentation has been uploaded, responded to and the like, you may think diligence is over; you survived! Not so fast my friend.
It’s vital we all continue to pay attention over the next few months as some transactions are protracted. We all have nightmare stories of something happening right before closing. The reality in some cases is the buyer uses it as a tactic when they know they have a seller with pocket 7’s. Cases have a life of their own and bringing down diligence one or more times is very important. Deals can start and stop abruptly multiple times. We’re used to seeing these tactics as Columbo will usually uncover something. Just remember, it’s not over until that fat broad sings!
I Thought It Was Over
Yes, there are more considerations. While we’re doing everything to ensure certainty to close, we are also stacking buyer tactics. It’s pattern recognition for us after selling our own and advising for decades. Buyer’s rarely change their process disciplines, habits and behaviors. Most of the universe of buyers are leading half a billion-dollar funds and it’s costly to change what works for them. For example, we recently had a buyer whose language was silent as to assignment. If a contract is silent as to assignment, then it’s generally assignable under applicable law. The key: know the governing law. It’s the attention to details that wins the final pot.
We have our own closing disciplines ensuring alignment and understanding what’s to be delivered as post-closing obligations. Post-closing diligence does exist! Buyers will ensure they have received the “benefit of their bargain.” Typically, in connection with indemnification periods (prior to the end of the claims period), or in connection with working capital adjustments or post-closing covenants. It’s over when the buyer says diligence is over.
Once the buyer is satisfied with due diligence, it’s time to proceed to the next phase. Due diligence is now concluded. The buyer will sign a document stating their intent to move forward with the transaction subject to any conditions that must be met prior to closing and memorializing the diligence phase including the seller’s signature. This article is an accelerated simplification of what a typical case will experience. Some cases can fly through in six weeks as they’re well prepared while others may drag four months or longer. As sellers, it’s your sale and it’s all within your control.
