Preparing for Due Diligence

There’s a sense of relief when a buyer and seller have agreed upon a letter of intent, and it may seem like the hard part is over. The LOI is a significant milestone to be celebrated, but the work is just beginning. We do our best to prepare our clients in advance for the rigorous process of due diligence so they go into it with eyes wide open and there are no unpleasant surprises. 

The purpose of due diligence is for a purchaser to confirm the financial statements and other business information provided verbally and in the Confidential Information Memorandum (CIM). Buyers want to minimize their risk and make sure there are no skeletons in the closet, confirm customer and supplier relationships, search and understand any legal issues, get a good understanding of key management and many other things.

Many buyers like to perform some of their due diligence before they make an offer on the company. We strongly recommend that due diligence take place after execution of a letter of intent. Our rationale is that if a buyer and seller haven’t agreed on some major issues such as price and terms, there is no need to spend thousands of dollars and hundreds of hours to confirm everything about the business. The LOI should state that the offer is contingent on a satisfactory due diligence outcome. Due diligence is not a period for the buyer to be trained to run and operate the business; it’s solely an investigative process to confirm information that has been supplied.

Many buyers would like to speak with key employees and customers during the due diligence period. We recommend that this be done after closing, or if necessary, once the other contingencies have been eliminated -- and just prior to closing. Contingencies like financing should be approved, key components of the purchase agreement should be agreed to and most of due diligence completed before a buyer has access to key employees and customers.

Providing data and answering questions from buyers can be a full-time job for owners who don’t have a CFO to assist with the process. One solution might be to conduct pre-due diligence (or reverse due diligence) prior to going to market to sell. This would involve going through the process of gathering information that a buyer would want and having most of the questions answered, issues worked out and have the data prepared and waiting in a data room. Pre-due diligence can increase the value, assist in negotiations, minimize surprises and help get to closing faster.

Just how rigorous the due diligence will be is dependent upon what is already known about the company and industry, how organized a business owner is and the condition of the financial statements. Having audited financial statements, a strong management team and a low concentration of customers could make the experience milder.

If the transaction includes the seller’s vested interest in the success of the business after the sale, such as an earn-out, retaining an ownership interest or a seller note, an owner may want to conduct their own due diligence on the buyer.

The buyer wants to come away from due diligence with enough confidence in the future of the company to continue negotiating the deal and complete the transaction. If due diligence reveals too many problems and too much risk, the offer could be renegotiated or terminated.

If you would like a sample due diligence list or have any questions about the process, please call us at 913.648.0185 or email michael@ok-om.com.