The small business sale process is an exciting and significant milestone for owners, but the term “due diligence” is rarely associated with a glamorous acquisition process. Instead, when sellers receive a diligence checklist they often feel like they’ve collided with a wall of tedious work. While this stage lacks appeal relative to earlier stages in the deal process, it is one of the more significant steps on the path to closing.
The process involves a comprehensive evaluation by potential buyers to verify information that has been shared leading up to diligence. Topics of review range from the business's financials, accounting accuracy, and operations processes, to legal documents, incorporation documents, and tax returns. Preparation for due diligence not only facilitates a smooth transaction but also enhances the odds that a sale process is completed on a timeline and with terms amenable to the seller.
Understanding Due Diligence
Due diligence is an exhaustive appraisal conducted by a potential buyer to assess the assets, liabilities, and overall health of a business. It serves to confirm the accuracy of the seller's representations and to identify any potential risks or liabilities. Each diligence process is unique and the process varies depending on the nature of the business and areas that an acquirer has deemed to be high risk, or requiring further exploration to validate an idea about the business.
The Role of Legal and Accounting Advisors
Sellers should engage experienced legal and accounting professionals during the due diligence process. These advisors provide expertise in their respective fields, ensuring that no aspect of the transaction is overlooked. Accountants assist with financial due diligence, analyzing financial statements, tax returns, and cash flow to validate the business's financial integrity. They can also help assess transaction tax consequences for buyers and sellers. Legal advisors focus on reviewing contracts, ensuring regulatory compliance, drafting the purchase agreement and identifying potential legal risks. Their involvement is vital in navigating complex legal landscapes and in drafting and negotiating the terms of the sale. Merger and acquisition law is specialized and an experienced attorney will expedite legal document creation, negotiation, and execution.
Quality of Earnings (QoE) Report
A Quality of Earnings report provides an in-depth analysis of a company's earnings, cash balances, accrual accounting adjustments, revenue composition, expense validation and other granular assessments of a company’s books. This report offers a clear picture of the sustainable financial performance of the business, which is essential for confirming valuation and assumptions used by buyers to structure the deal. With a QoE, which is typically provided by a third party accounting or finance firm, buyers should understand the true earning capacity of the business by adjusting for anomalies that may distort profitability. For sellers, preparing a QoE report in advance can expedite the due diligence process and build buyer confidence.
Working Capital Targets
Working capital represents the difference between a company's current assets and current liabilities, reflecting its short-term financial health and operational efficiency. In business transactions, establishing a working capital target, often referred to as a "peg," is common practice. This target ensures that the business has sufficient capital to maintain operations post-sale. Negotiating the appropriate working capital peg is crucial, as it affects the final purchase price. Sellers should analyze their working capital trends and be prepared to justify their proposed targets during negotiations.
Identifying and Mitigating Key Risks
A thorough due diligence process involves identifying potential risks that could impact the business's future performance. These risks may include legal disputes, compliance issues, financial inconsistencies, or operational inefficiencies. Buyers will scrutinize these areas to assess the potential impact on the business's value and to determine necessary mitigation strategies. Sellers should proactively address these risks by ensuring compliance with all legal and regulatory requirements, maintaining accurate financial records, and streamlining operations (i.e. reducing or removing non-business related expenses or other personal items intertwined with the business). Transparency about existing challenges and the steps taken to mitigate them can foster trust and facilitate a smoother transaction.
Preparing for Due Diligence: A Checklist
To effectively prepare for due diligence, sellers should organize and compile comprehensive documentation in the following areas:
Financial Records
Financial statements for the past three to five years (income statements, balance sheets, and cash flow statements if available)
Tax returns
Bank statements
Accounts receivable and payable schedules
Detailed schedules of fixed and variable expenses
Legal Documents
Articles of incorporation and bylaws
Operating agreements
Shareholder agreements
Contracts with customers, suppliers, and employees
Leases and titles for real estate and equipment
Documentation of intellectual property rights
Operational Information
Operating procedures
Employee manuals
Organizational charts
Inventory lists
Customer and supplier lists
Regulatory Compliance (if applicable)
Licenses and permits
Environmental compliance records
Health and safety records
Records of any past or ongoing litigation
By meticulously organizing these documents, sellers can facilitate a more efficient due diligence process, instilling confidence in potential buyers and paving the way for a successful transaction.
Summarizing an Important Step on the Path to Closing
The due diligence process is a pivotal component of selling a small business, even if not the most glamorous part of selling a company. By understanding the elements of the diligence process and proactively preparing, sellers can navigate this phase with greater ease and confidence. Engaging qualified legal and accounting advisors, preparing comprehensive financial analyses like the Quality of Earnings report, setting appropriate working capital targets, and transparently addressing potential risks are all integral steps in this journey. Thorough preparation not only streamlines the sale process but also maximizes the value and attractiveness of the business to prospective buyers.
