Due Diligence: Building a Diligence-Ready Company
Most business owners consider themselves to be the final authority on their companies. They believe they know everything there is to know about their companies, all the advantages, nuances, and peculiarities. However, they are in for a rude awakening when a buyer and their advisory team steps in to conduct their due diligence before finalizing the transaction.
Unprepared owners find themselves ill-equipped to answer questions they may have never considered. Prospective buyers and their experienced teams understand the due diligence process: they know what information is essential and how to look for it. This puts business sellers with no mergers and acquisitions (M&A) experience at a distinct disadvantage, and their hasty efforts to gather the needed information are often inadequate. This lack of preparation is the reason behind the failure of an M&A deal or renegotiation of essential terms to the seller’s disadvantage.
Before delving into how to prepare the business best, it’s essential to understand the purpose of due diligence.
A company is a complex asset with many tangible and intangible aspects to consider. These aspects influence revenue, taxes, contracts, etc. Buyers want to ensure that they take on an acceptable level of risk and make the offer for acquisition based on several assumptions. These assumptions are derived from the initial information provided by the business owner in the early stages of the deal. Due diligence supports these assumptions.
Due diligence is one of the most essential and critical activities in M&A transactions. The information gathered during this process informs the buyer about the target company. With this information, both the seller and the buyer are better equipped to make an informed decision and close the deal with a sense of certainty.
What Is Due Diligence?
Due diligence is a systematic process to investigate potential M&A deals or investment opportunities and verify the information presented in the confidential information memorandum (CIM). In the financial world, due diligence is an in-depth examination of all financial records before either party enters into a proposed business transaction.
Advantages and Benefits from the Seller’s Perspective:
- Helps to ensure that the selling agreement is correct and thorough.
- Detects and removes potential complications and anomalies to get a higher purchase price for the business.
- Prevents the risk of claims relating to the transaction, which may arise later.
- Helps to verify the seller’s representations and guarantees.
- Ensures all critical information is provided, thus saving the buyer time and money.
Advantages & Benefits from the Buyer’s Perspective:
- Helps the buyer identify potential problems and avoid unfavorable business transactions.
- Justifies negotiation of a lower price for the acquisition or better terms and conditions, assuming the buyer is aware of the company’s shortcomings.
- Serves as a mechanism to control and mitigate potential risks.
- Verifies that the information provided during the deal process is correct and thorough.
- Gathers the information necessary to determine the value of the business deal.
Think Ahead and Start Preparation
Start your pre-diligence now!
A prospective buyer will verify all information and scrutinize any questionable business aspects. To ensure the absence of red flags during this process, sellers should prepare and update all necessary documents ahead of time. Even though the entire process may seem expensive and time-consuming, doing this will position them to sell their companies on more favorable terms with higher deal values.
Sellers can begin the pre-diligence process by preparing all the financial records, balance sheets dating back three to five years, corporate documents, legal contracts, personnel and employee records, patents, intellectual property rights (if any), etc. Pre-diligence assists sellers in identifying and correcting any possible barriers that might propel the buyer to reduce or withdraw their offer.
Benefits of pre-diligence:
- Identify possible issues that may need a long time to rectify. Business owners can save crucial time—and build value—if these issues are fixed before putting their companies on the market.
- Save money by fixing questionable business aspects, which, if left attended, can become significant problems needing additional time and money to fix.
- Safeguard the owner’s exit goals by ensuring that the transaction goes ahead as planned.
- Correct and rectify discrepancies in documents, which may push the buyer to ask the business owner to indemnify for losses incurred.
Organize Legal Work and Documents
Legal due diligence concerns the legal review of all documents, contracts, and information of the target company and other business assets to find any risks associated with the merger. If there are risks, then the aim is to analyze, assess, and mitigate those risks.
Legal due diligence can make or break a deal. The thorough review of legal matters and associated risks regarding contracts or litigation is the primary factor affecting whether a deal moves forward. Issues like breached contracts, noncompete clauses, compliance history, and past or pending litigation influence the structure of a deal. Since the buyer will be liable for any obligations, contingencies, and restrictions after the transaction, it’s natural that they want to understand the full scope of liabilities they will assume.
There are two focus areas of legal due diligence:
- Current status. Attorneys seek to understand the business’s current situation by investigating relevant laws, governing documents, and contracts.
- Consequences of the potential business agreement. Attorneys list the negative aspects uncovered during a legal due diligence investigation.
What will be examined during legal due diligence?
- Organizational documents include certificates of incorporation, company bylaws, limited liability agreements, stockholder agreements.
- Contractual agreement documents, including customer contracts, supply contracts, operating contracts, and licenses.
- Financial documents, like loan agreements, hedging agreements, guarantees, and promissory notes.
- Financing and equity documents, like stock purchase agreements, stockholder agreements, registration rights agreements.
Business owners should consider hiring experienced legal counsel knowledgeable in legal due diligence to complete this investigation.
Starting due diligence ahead of time can save a lot of headaches down the road. In addition, company owners should provide business information in a logical, organized format to all buyers.
3 Steps to Organize Information:
- Ensure all relevant documents are provided to the buyer. Take care not to miss anything, lest the buyers ask for it.
- Organize and clearly label all documents logically for potential buyers to review quickly. This helps save time by eliminating efforts to find the required information.
- Save all documents are in a single, secure location. Sellers can guarantee the security and availability of the necessary information.
Organization, thorough preparation, and transparency build trust between business owners and potential buyers. Pre-diligence also reduces the time a potential buyer needs to complete their due diligence analysis.
Although due diligence is a painstaking process that tempts company owners to skip or take shortcuts, this investment of time and money to conduct thorough due diligence early on can help prevent costly surprises later and result in a successful M&A transaction.