As discussed in previous articles, there are lots of different factors which can kill a deal, most of which can be easily avoided. Last month, we looked at Working Capital Adjustments. This month, we look at another potential deal killer: 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 each of the aforementioned definitions is humorous, none are technically correct nor accurate. According to Websters, “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 mergers and acquisitions, 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.
Over the years, we at Corporate Finance Associates have learned the two top deal killers are time and surprises. Time kills deals more often than any other factor, but surprises are a close second. No one really like surprises, especially surprises uncovered during the due diligence process.
For example, several years ago we represented a seller client whose CEO and majority shareholder had a criminal record from his youth. His was a very successful business and growing rapidly. He was going to sell to a Private Equity Group who was very excited about the business and made a fabulous offer to acquire and recapitalize the company. Our client was to stay and run the company for the acquirer as well as retaining a minority shareholder interest in the business.
Unfortunately, during due diligence, the CEO’s felony record came out in a background investigation ordered by the buyer. Ultimately, this “surprise” to the buyer proved fatal to the deal. Sadly, the head of the Private Equity Group said, “If we had known about the problem in advance, no problem. However, finding out the way we did and when we did made it impossible for us to move forward. We wondered what else the seller was hiding from us.”
Given the costs to buyers and sellers, both in terms of money and emotions, involved with closing a deal, we strongly recommend all of our seller clients go through a pre-market due diligence process…before they ever 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 financial statements? If you expect to sell to a public company, you may need audited statements.
- 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. Many buyers also require statements prepared according to GAAP. 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 and 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. One way to avoid this is by selling the stock of the company, but most buyers of middle-market companies prefer asset purchases.
- 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.
- 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; this delayed closing by 30 days.
- 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.
- 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
- Has a Phase I environmental survey recently been completed on your property? If not, it might help to order one now. We had two transactions delayed this year because of environmental issues which came up in the Phase I survey. Had we ordered the surveys before we went to market, the issues would have been obviated.
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?
Jim Zipursky is the Managing Director of CFA-MidWest, an investment bank serving the middle market. Jim is a registered representative of Silver Oak Securities, Inc., member FINRA/SIPC. For more information visit www.cfaw.com/omaha. Follow Jim on Twitter (@jazcfane) for articles and information about M&A. For more information about Exit Strategies or Selling Your Business, feel free to contact Jim at (402) 330-2160 or jaz@cfaomaha.com.
