What’s worse for the sale of a business than when the prospective buyer finds a big, potentially expensive surprise in their due diligence review? The answer is easy: when that same discovery also surprises the seller. When preparing for the sale of a business, consider due diligence as a two-phase process: the first phase is internal due diligence, conducted by and for the seller; the second phase is external due diligence, conducted by and for the buyer. The best way to prevent potential problems from due diligence and to make the whole process a positive one for owners selling their company is to conduct early, thorough sell-side due diligence with enough lead time to identify and address any potential issues before undergoing buy-side scrutiny.

Metaphor of Home Inspection

A sell-side advisor’s prepping of a company to be marketed for sale is like prepping a home for an open-house showing, and internal due diligence is like a sell-side home inspection. In the same way that a home inspection would uncover any issues that have the potential to affect pricing or process for the sale transaction, sell-side due diligence is far more thorough than merely staging the home to look good on the surface. Thankfully, internal due diligence is a great opportunity for company leadership to take a detailed look at the business in a way that they may not otherwise, and the benefits can reach far beyond merely a better, smoother sale transaction.

Understanding What is “Material”

How detailed should the internal phase of due diligence be? The goal is to compile everything that is ‘material to the business’. Due diligence requests from buyers and their attorneys are commonly qualified with a materiality standard –a request for all “material supplier contracts”, for example. As a baseline, ‘materiality’ is an accounting principle describing any item that can reasonably impact a business’s financial statements. In mergers and acquisitions, materiality should be viewed more broadly as anything affecting a buyer’s investment decisions or valuation, and the standard for what is material varies widely from business to business.

For example, a faulty compressor in the soft drink refrigerator of a small-town takeout pizza parlor may be material, but a similar compressor in one of numerous staff break rooms of a very large trucking company may not be. Notably, materiality is not necessarily determined by actual cost – fixing the trucking company’s broken refrigerator may not be expensive, but doing so may be a requirement for the business’s compliance with a material labor contract.

Understanding what is material for each individual enterprise is one area where the value of expert sell-side advisors like the team at Optima M&A cannot be overstated.

Creating a Virtual Data Room

The emergence of virtual online data rooms as a repository for due diligence materials has been a major improvement for mergers and acquisitions. Having all necessary diligence materials in one well-organized and easily-accessible digital space is still time-consuming and costly, and yet it continues to be an essential part of preparing for any M&A transaction. In addition, knowing at the outset that a data room will be the end-product of the internal due diligence phase helps keep everyone organized and detailed in their work before turning to face prospective buyers. The resulting good impressions made on buyers, their advisors and legal counsel can dramatically improve their confidence in every aspect of the transaction and, therefore, their impression of value being received for price.

Subject Areas for Due Diligence

Buy-side attorneys often provide itemized due diligence requests that are exceptionally detailed and may not be tailored to the seller’s business. Those requests can feel onerous, so organizing the sell-side internal due diligence effort into subject areas keeps the process achievable, productive, and on track.

Company finances
Compiling a history of audited financial statements is the essential part of the valuation process with sell-side advisors, so beginning with them is a natural starting point for due diligence. Including some of the background documentation for those audited financials is equally important – having projections, balance sheets, materials provided to lenders, and other data available can forestall problems and address questions with ease. Done properly, all of this will be governed by an iron-clad non-disclosure agreement so business sellers can proceed with confidence and without concern for the company’s proprietary information.One of the most powerful tools for a lower middle market seller is a sell-side Quality of Earnings analysis (QofE). Having a QofE prepared before going to market can reveal meaningful issues that will inevitably surface in buyer diligence. Addressing them early prevents unpleasant surprises that can reduce value or derail a deal. A reputable QofE may cost around $30,000, but for a $15 million business that’s just two-tenths of one percent of value; an insurance policy that can pay for itself many times over.
Legal and regulatory due diligence
One specific area of due diligence that is a common source of potential issues is regulatory and legal compliance. Obviously, the size and complexity of this area vary widely between industries, sectors, and geographic areas. Regulatory compliance is a great way for buyers to get an accurate sense of what problems may lurk unseen and how effectively the seller’s team has run operations.Legal due diligence falls into two categories: (1) permits, regulatory oversight, and formative documents, and (2) disputes. Articles of Incorporation, state business licenses, and any other federal, state and local filings or governmental relations – these documents will alert prospective or current problems, provide details to the precise legal scale and scope of the business.

Litigation history, regulatory correspondence, and compliance documentation, however routine or unflattering, are essential. As much as negative outcomes of regulatory reviews may be unflattering, a willingness to remedy them and engineer the enterprise for compliance is a strong complement to any business. A good example would be a restaurant whose business performs better after remediating a health code violation.
Taxes and debt
Two areas related to financial statements but often treated separately in due diligence are taxation and company debts. In the case of taxes, the due diligence should produce more than just federal and state tax returns: documentation about local taxes; sales and use tax policy, records or issues; any tax audits, disputes or resolutions of disputes; and any opinions or advice of accountants relating to the treatment of taxes should all be produced for the data room. The tax component of internal due diligence can be instrumental in helping the seller and the sell-side advisor design the sale transaction in a way that minimizes its tax implications.Compiling information about any debt of the company should include the obvious – loan documents and filings for security interests, for example – and also a deeper dive into any liens, disputes, and the like. To be clear, this also should include relations where the company is the lender or security holder and not just the debtor.
Real and intellectual property
All documentation governing real property and intellectual property – whether owned, leased, or licensed – is always an essential component of due diligence produced for the data room. Blueprints, surveys, easements, and use agreements regarding real property are as important as the software licenses held by the company. Maintenance contracts, zoning modifications and agreements with municipalities, are all fair game and should be produced as well.
Commercial and contractual relations
Commercial and contractual relations are the real nuts and bolts of the business being sold and often require a bit of sleuthing around for complex businesses conducting internal due diligence. Contracts for services and goods, invoices and receipts, balance sheet items reflecting technology expenditures and investment, and any issues relating to any of the foregoing are some examples. Legal counsel in M&A transactions pays particular attention to any change in control provisions in material contracts that may require notice of or consent to a sale of the business.
Labor and employment
Employment agreements, collective bargaining agreements, payroll history, contractor arrangements and performance details, and any disputes about the foregoing do vary from company to company. Producing relevant documentation for all of these areas is essential. Even data about employee tenure, pay scales, benefits, training and education expenditures by the company, uniforms, and workplace safety are material for purposes of selling a business.

In Summary

Investing time and effort into thorough internal due diligence is essential for a successful sale. By working with experienced sell-side M&A advisors at Optima Mergers & Acquisitions, you’ll be able to prepare well in advance, identify potential issues early, and ensure a smoother, more successful sale. Get in touch with us today to start preparing your business for a seamless transition.