Due Diligence: Making ‘Pre-Diligence’ a Part of the Company’s DNA

Due diligence is one of the most critical aspects of exit planning. If you are thinking of leaving your business, it is necessary to understand what buyers are looking for and how they will look at the company you have built. In M&A, the due diligence process helps you know what you should do before accepting a potential buyer’s offer.

What Is Due Diligence?

Due diligence is a thorough, systematic audit or investigation that helps to mitigate risk from a business investment. In the M&A world, due diligence involves the examination of the target business’ financial records, contracts with suppliers and customers, employment agreements, documented sales, operational processes, legal documents, etc.

In the US, due diligence became a common practice after the Securities Act was passed in 1933. Both the securities dealers and brokers were responsible for full disclosure of material information about their selling tools. Full disclosure protected both dealers and brokers against a material fact that was not known at the time of the sale. The act was their legal defense: as long as both parties conducted due diligence and had fully disclosed the results, they were not held liable for any information not uncovered during the inspection.

In M&A, due diligence is conducted before the deal is closed to assure the buyer of what they are getting from the deal. It helps make informed business decisions, as the quality of the information exchanged between the buyer, and the seller remains uncompromised.

The Buyer’s Perspective

All buyers want to know well in advance what business obligations they are assuming. For this, they need to examine the target company’s litigation risks, liabilities, problematic vendor contracts, and physical and intellectual property issues. Some buyers also want to know more about the management team and how they operate the business; others might be more interested in the sales pipeline, as it directly affects the business prospects in the future. Similarly, business investors want to identify potential risks before they enter the deal.

The end objective of due diligence is to uncover hidden information about the target company. The Latin phrase caveat emptor remains true: Let the buyer beware. For buyers/investors, due diligence is critical, as some business owners might intentionally hide damaging information about their business.

The Seller’s Perspective

Due diligence activities help to anticipate issues that may arise later and derail the transaction. Despite being the company’s biggest investor, the business owner cannot possibly know every aspect of the business. Internal due diligence helps unravel risks and opportunities, and benefits to mitigate potential business risks that would otherwise impact business valuation.

For example, by performing an operational assessment, a business owner might uncover bottlenecks that would benefit from more streamlined, efficient processes. This comprehensive outlook acts as a shield during the negotiation process and enables the owner to prioritize resources toward improvements that will enhance the business’s valuation over time.

The due diligence process begins once the buyer presents a letter of intent to the seller. Conducting and completing due diligence is a condition of the sale. However, conducting due diligence is a daunting task, but companies can prepare for it by performing “pre-diligence.”

Understanding Pre-diligence

Since prospective buyers will scrutinize all aspects of your business, the best approach is to take time to assess all business operations, financial documents, and arrangements before embarking on the sale journey. The whole process may seem time-consuming and invasive, but doing so will position the seller to maximize the business’ value. This will include financial statements and documents, corporate documents, personnel and employee records, business contracts, patents and intellectual property rights, licenses, etc.

Failing to conduct pre-diligence could lead to a situation like the M&A between Mattel and The Learning Company. When Jill Barad ascended to the CEO of Mattel, the Barbie brand was rejuvenated under her guidance. She erred, however, in taking on the purchase of The Learning Company, an educational software firm, for $3.5 billion in 1999. The strategy was simple and made sense: Mattel had numerous incredible brands which The Learning Company could digitize. However, management soon found that integrating a software company with a traditional toy company was very difficult. The Learning Company lost $1.5 million each day. Mattel eventually sold the company for no down payment in late 2000.

Several independent analysts found that due diligence red flags were missed. According to Hayley Kissel, Analyst at Merrill Lynch, “It’s a function of overpaying for acquisition and bad due diligence. They (Mattel) should have had a better sense of what the accounting was like at the Learning Co.” Other issues included slowing sales, the rising level of account receivables, and a lost licensing agreement.

Benefits of Conducting Pre-diligence

Business owners must undergo pre-sale due diligence before putting up their company on the market. The central idea is to identify and correct possible deal-breakers.

Save crucial time. Pre-diligence helps to identify possible issues that might take a longer time to resolve if left unattended until the actual due diligence. If the due diligence duration is time-consuming, there is a higher probability of successful sale transactions. Uncovering and correcting issues before due diligence begins will help the business owners save critical time.

Save money. Even though pre-diligence may seem like a futile exercise considering associated costs, remember a stitch in time saves nine. To use another analogy by Benjamin Franklin, an ounce of prevention is worth a pound of cure. Pre-diligence helps save money in the long run, as specific issues may take months or years to resolve, so it’s better to fix them before taking your business to market.

Safeguard and increase the purchase price. A business owner who is fully invested in the exit planning process before choosing a third-party sale exit strategy sees pre-sale due diligence as a means to save time, effort, and money. When the deal terms are satisfactory for both parties, it will eventually safeguard and increase the purchase price and the probability of closing the deal.

Protect your goals. The ultimate goal of any business owner is to exit their business on favorable terms. Pre-diligence helps safeguard the business owner’s exit goals as they get assurance that the transaction will go through as expected.

Safeguard yourself. Buyers need the seller’s guarantee regarding the authenticity and accuracy of the various documents, representations, and warranties. Should there be any discrepancy in prior records and documents, it holds the owner liable and accountable. Sometimes buyers insist that the owner indemnifies them for any losses incurred. Pre-diligence prevents those damaging discrepancies.

Pre-Diligence Tips

Consider the following points to ensure that no significant issues arise during the buyer’s due diligence phase:

Adjustments of EBITDA. Most business owners view EBITDA adjustments the same way as taxes; however, you lose business credibility with the buyer when you do so. If your accountant or CFO recommends these adjustments, keep track of all expenses and have documented proof to support the adjustment. Most buyers insist on seeing evidence to make sure that the adjustments are accurate.

Adjustment of net working capital (NWC). Buyers and sellers have been negotiating NWC for years. When there are no significant leaps and declines, it calculates NWC as a cakewalk at the time of closing. If too much capital is invested in NWC, consult your banker to help you make the appropriate changes that prove you can run your business with lower working capital.

Disclose and resolve. Identify potential deal-breakers and issues, such as pending litigation, expiring contracts, etc. Hiding potential liabilities allows the buyer no chance to mitigate the associated risks and erodes trust. It can also be a deal-breaker.

Pre-diligence Recap

Pre-diligence acts as a pre-flight security check before the sale transaction takes off. It strengthens the owners’ interests and eases the eventual due diligence process. Unprepared business owners risk losing out on a good business deal due to their inability to identify, remove, and fix problems.

Pre-diligence affords business owners a better understanding of which documents they need to have prepared for a transaction and gives them the necessary time to prepare the documents they do not have. Thoroughly working through pre-diligence can decrease the time it may take to work through the due diligence process. Working through pre-diligence also increases the company’s chances of defending its value.