The Importance of Seller’s Side of Due Diligence
For someone interested in buying a business, due diligence provides a precise picture of the quality of that business. The buyer checks all relevant aspects of the planned investment. This examination includes systematic analysis and evaluation of the strengths and weaknesses of the object of purchase (the business and its assets) to secure the planned investment. In this way, due diligence provides the investors with clarity about the traded values–and risks.
Hence, due diligence is a significant step in the process of selling a business. While it’s crucial from the buyer’s side, due diligence helps ensure that no issue will arise later to derail the transaction.
Related: Quality of Earnings: the Cheat Code for Due Diligence
What Is Due Diligence?
Growing a company is always associated with a certain level of risk. To make this risk calculable, we have due diligence. Due diligence summarizes various aspects of a company’s purchase and sale. Initially, due diligence focused on the company’s finances: annual financial statements, audit reports, planning figures, etc. Today, the financial review remains a central part of the due diligence process.
The process of selling a business should not be taken lightly, including due diligence. Preparing for this step is essential for a seller to ensure the financials are in line before a sale to avoid any issues during negotiation. This allows the seller to be ready for the buyer’s due diligence. This preparation enables the seller to identify gaps or weaknesses before the buyer’s due diligence and take prompt remedial action.
Related: De-Risking in the Pre-Transaction Window
What Does Due Diligence Entail?
The due diligence check describes the process of examining, for example, when buying or selling a company stake. In the context of a due diligence check, the company’s weaknesses and strengths are systematically analyzed before the negotiation begins. The examination subject includes, but is not limited to, technical capacities and conditions, annual financial statements, personnel capacities, strategic positioning, and legal relationships. Depending on the type of transaction, a distinction is made between different functional forms: e.g., strategic due diligence, commercial due diligence, legal, due diligence, or technical due diligence.
Due diligence usually refers to different sub-areas, which include:
- Financial due diligence
- Commercial due diligence
- Legal, due diligence
- Tax due diligence.
Financial Due Diligence
No buyer neglects the financial due diligence part of the examination, regardless of the size and type of business. It usually makes sense for the seller to perform initial due diligence in preparation for the company exposé.
Financial due diligence helps to work out questions to be answered in the context of the preparation of the prospectus. It also helps identify any errors in company figures and planning, so the seller can correct them before making the financials available to the buyer. Financial due diligence often results in the development of an intensive corporate plan.
The following checklist contains the necessary information included in financial due diligence:
- List of all bank details with account numbers, bank loans and their security, current account lines, guarantee lines
- List of all loans received with loan agreements
- Presentation of bill liabilities
- Security transfers
- Presentation of all guarantees granted, guarantees for third parties
- Display of all third parties acquired in favor of the company’s bonds, guarantees, mortgages, security transfers
- A list of all loans extended (to employees, shareholders, etc.) with loan agreements
- Presentation of subsidies and grants and their repayment obligations.
Commercial Due Diligence
Commercial due diligence makes up the majority of a company profile and sales prospectus. It is, therefore, worthwhile to take a closer look at commercial due diligence in addition to financial due diligence.
Commercial due diligence is also known as strategic or market due diligence. It helps to ensure that buyers will be able to achieve the strategic goal they are pursuing with the company’s acquisition. It provides answers to the following questions:
- Are there synergies that make the purchase attractive (e.g., merging locations, sales, or administration)?
- What strategic advantages does the purchase confer? In other words, does it make more sense for the buyer seeking to enter that market to buy an existing company and/or build a business themselves?
- Are there any red flags or deal-breakers that speak against pursuing these goals, e.g., country-specific or competitive law restrictions?
Legal Due Diligence
Buyers and sellers cannot avoid legal due diligence because contracts form the framework for action. Legal due diligence focuses on the legal review and assessment of the company and covers various areas of law.
- Corporate law includes examining enterprise formation (deed of incorporation, articles of association, registration in the commercial register, and deposit receipts) and shareholder lists.
- Contract law forms a large part of the legal review, particularly the examination of customer contracts (current and future assignments, framework contracts, essential old contracts), supplier contracts, and loan agreements (covenant, collateral, “change of control” provisions).
- Labor law concentrates on individual contracts, worker’s agreements, and collective bargaining regulations.
- Trademark law is concerned with examining the protection of trademarks, registrations, enforceability, licenses, the software used, domains, websites, logos, etc.
The buyer’s legal, due diligence findings can considerably influence the financial due diligence, such as when legal risks are assessed differently than depicted in the financial figures.
Tax Due Diligence
The analysis of a company’s taxes is an essential part of the due diligence examination. It’s carried out in every M&A transaction to uncover tax risks and discover possible areas of tax optimization. The results affect the negotiation of the purchase price. At the same time, they are the basis for the contractual drafting of the purchase contract since tax guarantee and exemption clauses deviating from statutory provisions can relieve the buyer of taxes and liabilities.
A tax due diligence may include the following analyses and services:
- Tax assessment of matters in the company’s annual financial statements that may differ from the legal opinion to such an extent that this could result in significant, additional tax burdens on the next owner
- Assessment of the tax risks associated with losses and restructuring in the past of the company
- Analysis of transfer pricing issues and other tax peculiarities of internationally operating companies/target companies.
What Does Completing Due Diligence Ensure?
Due diligence ensures that a company’s numbers, facts, and projections are correct and complete as part of its buy/sell process. It verifies that reasonable care has been taken to present and assess a company fully and correctly. In particular, due diligence seeks to uncover risks and protect a buyer and seller from material and immaterial damage.
Therefore, due diligence forms the basis of company valuation and subsequent purchase price negotiations. Its thoroughness eliminates any surprises that could persuade the buyer to drop out. Due diligence justifies the purchase offer for a company and ensures that all relevant risks have been identified.
Prepare for Due-Diligence Now
As you can see, there are many specialized areas and audits found under the term due diligence. If you are preparing for a classic company due diligence, concentrate your energy on these four most important types of due diligence: financial, commercial, legal, and tax. For complex examinations, consult specialists who come from a background in M&A transactions.
If you’re selling your company, you can’t avoid due diligence. Therefore, performing the seller’s due diligence is in your best interests to ensure a safe and profitable sale.
Quantive’s Business Performance Group helps business owners determine whether their current business value matches their exit needs. Business owners who successfully achieve an exit are proactive about exit planning and deal structuring. Contact our BPG team today.
