In previous articles, we discussed valuations, buyer types, mistakes buyers and sellers make, and deal killers. Many themes permeate the M&A process, but one of the most misunderstood is Due Diligence. What exactly is “Due Diligence” as it pertains to deals? We hear the term all the time and have heard various definitions, including:
- Due Diligence is the opportunity for Buyers to beat up Sellers on price, or;
- Due Diligence is the opportunity for lawyers and CPAs to kill deals, or;
- Due Diligence is the time for Sellers to come clean with the truth about their companies
While the aforementioned definitions are all humorous, none are technically correct or accurate. According to Webster’s, “Due Diligence is (1) the care a reasonable person exercises to avoid harm to other persons or their property, or (2) research and analysis of a company or organization done in preparation for a business transaction.”
In our world of M&A, both definitions apply. Most often, Due Diligence is the detailed process we go through once buyers and sellers have agreed upon transaction terms. But, Due Diligence is also the process where sellers need to exercise reasonable care not to hurt their shareholders or the acquirers of their businesses.
As you may recall from my prior article on Biggest Deal Killers, the two top deal killers are: Time and Surprises. No one really like surprises, especially surprises uncovered during Due Diligence.
Previously, we represented a seller who had a criminal record from his youth. He was the co-owner of a business which was growing rapidly. The buyer we found was very excited about the business and made a fabulous offer. Our clients were to stay and run the company for the acquirer. Unfortunately, during Due Diligence, the co-owner’s felony record came out in a background investigation ordered by the buyer. This “surprise” proved fatal to the deal. Sadly, the Buyer’s CEO said, “If we had known about the problem in advance, no issues. However, finding out how and when we did made it impossible for us to move forward.”
Given the costs (financial and emotional) to buyers and sellers to close a deal, we strongly recommend all of our selling clients go through a Pre-Market Due Diligence process…before they begin speaking with buyers or investors. We have identified four specific areas in which our clients can help themselves by ferreting out problems and surprises before they turn into deal killers. What are these four areas and some of the potential problem spots you should investigate?
FINANCIAL
- Do you have audited or reviewed financial statements? Many buyers, especially those using “leverage” in the deal, may require you have something more than tax returns and internally prepared statements. Investing in an audit or review of your annual statement by your CPA is a very good investment.
- Are your financial statements true, accurate and prepared according to GAAP? All sellers will be expected to represent their financial records as true and accurate. If you have problems or errors, clean them up now.
- Do you have personal expenses you run through the business? If so, these should be identified and segregated.
CONTRACTS & INTELLECTUAL PROPERTY
- If you have contracts with key customers or key vendors, review the contracts to see if they are assignable. We have seen many deal closings delayed or even killed when vendors or customers were uncooperative regarding contract assignments. This is especially true in the office equipment industry since a significant portion of your value is based upon service contracts with customers.
- Do you have valid, current contracts in place with your vendors and customers? We have had several instances where our clients said they had a contract with a customer or vendor only to find out the contract had expired several years before. While a handshake may be good enough for you, it will not be good enough for the buyers and/or their legal advisors and lenders.
- Do you need any third party approvals to sell your business and/or the assets? Most, if not all OEMs reserve the right to approve the sale of the dealerships and distributors. Review your contracts with your OEMs to determine how you need to work with them in the sale process. This is especially critical in the office equipment industry.
- Do you own any intellectual property? Think again if you said “no,” since you probably have registered your trade name and use a website. If you do use a trade name and it isn’t registered, you might have a problem.
ASSETS
- Do you own motor vehicles or trailers? If so, do you know where the titles and registrations are kept? Are all titles in order? We recently closed a deal where we learned our client did not have proper titles in place for its rolling stock.
- Do you lease your equipment? If so, and the buyer expects you to pay down the leases prior to closing, check to see how to pay off the leases. Several years ago, we had a closing delayed because our client had more than $2 million in lease obligations to one of the major automakers (the client had a fleet of 200 service vehicles on lease). Unknown to us, the OEM’s finance arm would not accept a wire transfer and had to have a certified check four days prior to closing in order to pay off the leases.
- Do you own the property personally in which the business is located? If so, is your lease up to date and at market value?
ENVIRONMENTAL
- If you are located in a stand-alone building, the buyer or its bank will require a Phase I environmental survey. Have you completed a Phase I recently? If not, it might help to order one now since environmental issues (most of which can be easily fixed) can delay or kill a deal.
Of course, our Pre-Market Due Diligence list is much more encompassing than what is presented here. But the picture should be clear: do your own Diligence so there are no surprises in the Due Diligence process.
I am happy to answer any of your questions regarding this subject or any previous articles. In my next article, I’ll discuss the subject: Is Now the Time to Sell?
