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M&A Due Diligence | Checklist & Overview

Once you’ve accepted an offer or a letter of intent (LOI) for your business, the buyer will initiate due diligence. In essence, due diligence is the meticulous process of gathering and scrutinizing information. Its purpose? To guide both parties in making an informed decision about proceeding with the business transaction.

Typically, this phase unfolds over a 30-day period, but it can be extended if mutually agreed upon. In most cases, the buyer retains the prerogative to exit the deal during due diligence if they encounter any unsatisfactory aspects.

So, what’s the savvy seller’s approach? It’s akin to embracing the motto of the Boy Scouts: Be prepared.

Conducting a thorough due diligence of your own business serves two essential purposes. First, it uncovers any latent issues, affording you the opportunity to rectify them proactively before the buyer stumbles upon them. Second, it equips you with the knowledge to navigate the process effectively.

In this article, we’ll not only guide you through conducting your due diligence but also provide answers to critical questions such as:

  • What documents should typically be furnished to the buyer before they extend an offer?
  • What documents are customary for the buyer to receive post-offer (during due diligence)?
  • How should the seller manage requests for excessive information from potential buyers pre-offer?
  • What is the usual duration of the due diligence period?
  • How can the seller expedite the due diligence process?
  • What role do representations and warranties play, and how do they influence due diligence?
  • What does the typical due diligence process entail?
  • What steps should you take to prepare your business for the due diligence scrutiny?

Don’t forget to explore our comprehensive due diligence checklist in the article below. It encompasses over 70 items divided into seven broad categories. Buckle up; this phase may be more intricate than you anticipated.

What is the Purpose of Due Diligence?

Businesses are inherently intricate entities, and when it comes to making decisions about purchasing one, buyers find themselves contending with a myriad of factors to weigh.

In contrast, the process of evaluating a home for sale is relatively straightforward. Prospective homeowners can swiftly assess a property’s value and suitability, often calling upon a home inspector for a conclusive evaluation. These tangible purchases typically demand minimal due diligence. However, the realm of business acquisitions involves a multitude of intangible factors that elude easy assessment and evaluation.

The heightened complexity inherent in business transactions necessitates an extensive and meticulous due diligence process before sealing the deal. This process, crucial for making informed decisions, only commences once both parties have agreed to an offer.

In the business arena, the seller’s assertions and representations undergo thorough verification during the due diligence phase, a stage that transpires post-acceptance of a mutually agreed-upon letter of intent. Were buyers to initiate due diligence prior to extending an offer, it would entail a considerable investment of time and potentially jeopardize confidentiality.

Simultaneously conducting due diligence with multiple parties can also divert the seller’s attention from the core business, potentially diminishing its value. Hence, the buyer typically accepts the seller’s initial representations before their offer is accepted, with the opportunity to validate these assertions emerging post-acceptance.

Before embracing an offer, sellers should exercise prudence in disclosing information to potential buyers. While they should undoubtedly cooperate with and assist buyers, revealing every detail upon request may not be advisable. At a certain juncture, it becomes appropriate for the seller to gracefully request the buyer to formalize their offer, navigating the transaction with professionalism and tact.

List of Documents and When They are Shared

When it comes to sharing vital information during the intricate process of business transactions, timing and discretion play pivotal roles. Here’s a comprehensive breakdown of what to disclose both before and after the offer is accepted:

Before the Offer Acceptance:

  • Confidential Information Memorandum (CIM): Offering a strategic overview of your business without delving into overly sensitive details.
  • Profit and Loss Statements (P&Ls): Providing insights into your financial performance without exposing every nuance.
  • Balance Sheets: Offering a snapshot of your financial health, allowing prospective buyers to gauge stability.
  • Summary or Abstract of the Lease: Sharing essential lease information without divulging the entire document’s contents.
  • Equipment List: Enumerating your assets without overwhelming the buyer with exhaustive details.

After the Offer Acceptance (During Due Diligence):

  • Federal Income Tax Returns: Furnishing a comprehensive view of your tax history to instill confidence in the buyer.
  • Bank Statements: Verifying financial transactions and demonstrating transparency.
  • Invoices and Receipts: Providing evidence of financial transactions and obligations.
  • Full Copy of the Lease: Granting access to the complete lease agreement for in-depth scrutiny.
  • Various Leases: Including premise and equipment leases, essential for assessing commitments.
  • Third-Party Contracts: Sharing supplier or vendor contracts for a comprehensive evaluation.
  • Sales and Use Tax Reports: Demonstrating compliance with tax regulations.
  • Staffing and Payroll-Related Documents: Offering insight into your workforce, job roles, and employment contracts.
  • Insurance-Related Documents: Covering aspects like workers’ compensation, health, and liability insurance for risk assessment.
  • Equipment Inspection Reports: Providing maintenance and condition details of crucial assets.
  • Licenses and Permits: Showcasing compliance with legal requirements.
  • Marketing, Advertising, and Promotional Documents: Revealing your brand strategy and market positioning.
  • Environmental Documents and Inspections: Addressing environmental considerations and certifications.
  • Franchise-Related Documents: If applicable, sharing franchise agreements and related documentation.

It’s important to note that the extent of due diligence varies for each business. Typically, due diligence requests encompass a broader range of documents and information tailored to the unique nature of the transaction.

How Long is Due Diligence?

The timeline for due diligence can be quite flexible, contingent on mutual agreement between you and the buyer. Typically, for small to mid-sized businesses, due diligence spans a range of 30 to 60 days.

The specific duration should be determined by several key factors:

Information Accessibility: A crucial determinant of due diligence duration is the seller’s responsiveness to the buyer’s requests for documentation. Swift responses can significantly shorten this phase.

Efficient Turnaround: The speed of due diligence is also influenced by how promptly the buyer reviews the provided information. When the seller presents data that is concise, well-organized, and transparent, it expedites the process.

Open Communication: Additionally, the seller’s accessibility and willingness to engage with the buyer can contribute to a shorter due diligence period.

In essence, an efficient and cooperative approach from both parties can streamline due diligence, potentially saving time and expediting the overall transaction.

The Importance of ‘Representations’ and ‘Warranties’

Due diligence is an essential part of any business transaction, but it’s vital to understand that it’s not a flawless process. It cannot unearth every potential issue within a business, nor can it guarantee absolute perfection. The reality is, there’s no such thing as a “perfect” business.

So, what steps can you take when due diligence falls short of ensuring a trouble-free business?

Enter “Representations” and “Warranties” — crucial components of the purchase agreement that provide assurances from the seller regarding the business being sold. These representations and warranties encompass a wide spectrum of factors, including the state of assets, liabilities, and various elements of the business.

In essence, the seller is making a commitment to the buyer that their assertions are factual. Should these representations be proven false, the buyer has legal recourse to seek remedies, potentially involving the seller reimbursing the buyer for any damages incurred. These representations and warranties act as a safeguard against undiscovered material defects that may emerge post-due diligence.

Representation vs. Warranty:

  • A representation is a statement of fact. If it’s untrue, it’s considered “inaccurate.” For instance, the seller may represent that all inventory is marketable, or that the business has operated in full compliance with all relevant laws.
  • A warranty, on the other hand, is an assurance. If it’s untrue, it’s deemed “breached.” For example, the seller may warrant that they will continue operating the business as usual until closing or that they will settle all outstanding payroll taxes.

Incorporating representations and warranties into the purchase agreement provides the buyer with a sense of security. It assures the buyer that legal remedies are available in case the seller fails to disclose material facts about the business that remained undiscovered during the due diligence process. This added layer of protection ensures that both parties are operating with transparency and accountability.

The Process

Understanding how due diligence seamlessly integrates into the sale process is pivotal. Here’s a concise breakdown:

Letter of Intent

The journey commences with the negotiation and acceptance of the letter of intent.

Due Diligence

Right after both parties give the nod to the letter of intent, the due diligence phase kicks off.

Purchase Agreement

Typically, during the due diligence phase, the parties initiate the preparation of a draft purchase agreement. This phase encompasses weeks of negotiation and finalization. The rationale behind commencing this process during due diligence is to ensure a smooth closing with minimal delays.

Conclusion of Due Diligence

At any juncture during due diligence, or upon its conclusion, the buyer may decide they’ve conducted a satisfactory investigation of the business and are ready to proceed. This could be due to contingencies being resolved or simply because the buyer feels confident in entering a definitive agreement. At this juncture, both parties sign an agreement indicating the completion of due diligence, marking the transition from investigation to the commitment of moving forward.

Additional Deposit, If Applicable

For smaller transactions, the buyer often places an additional deposit with the escrow company upon completing due diligence. If, for any reason, the transaction is canceled by the buyer before a definitive agreement is inked, both the initial and additional deposits may be forfeited. Otherwise, these deposits will be credited toward the final purchase price.

Contingencies that Survive Due Diligence

Certain contingencies may persist post-due diligence, including matters such as bank financing, franchisor approval, lease assignments, or license transfers. These linger as contingencies to be tackled between the conclusion of due diligence and the closing. If these contingencies aren’t met, the buyer retains the option to cancel the transaction.

Closing

Upon the successful resolution of contingencies, the closing phase may ensue. In most instances, the purchase agreement is signed during the closing; however, there might be cases where it’s executed before the actual closing date.

Due-Diligence Checklist

For a thorough due-diligence process, here’s a comprehensive checklist covering key aspects:

Operations

  • Advertising contracts
  • Customer list
  • Inventory count
  • List of key competitors
  • Marketing material
  • Operations manual
  • Preliminary equipment inspection
  • Premises lease
  • Summary of key lease terms
  • Supplier and vendor list
  • Supplier/vendor contracts

Insurance

  • Health insurance policies
  • Liability insurance policies
  • Workers’ compensation policies and history

Assets

  • Description of any real estate owned
  • Equipment inspection
  • Equipment leases
  • Equipment list
  • List of all assets included in the price
  • Inventory list

Financial/Tax

  • Accounts payable schedule
  • Accounts receivable aging schedule
  • Annual personal property tax certificate
  • Backup data of adjustments to financials
  • Bank statements
  • Breakdown of sales by customer
  • Breakdown of sales by product type
  • Copies of existing loan or financing agreements
  • Customer or client agreements
  • Documentation for add-backs to financial statements
  • Federal income tax returns
  • Financial budgets and projections
  • Full QuickBooks or accounting software file
  • General ledger or detailed list of all transactions and expenses
  • List of monthly sales since inception
  • Merchant account statements
  • Payroll tax reports
  • Profit & loss statements
  • Sales and use tax reports
  • Utility bills

Staff

  • Benefit plans
  • Compensation arrangements
  • Detailed schedule of payroll expenses
  • Employment, agency, and independent contractor agreements
  • Job descriptions
  • List of outside contractors
  • Other employment-related agreements
  • Overview of personnel turnover
  • Schedule of owners, officers, employees, independent contractors, consultants, and their titles, length of service, and compensation benefits
  • Summary biographies of key management

Legal

  • Articles of incorporation/organization
  • Business license
  • Certificate of status/good standing from Secretary of State
  • Copies of licenses, permits, certificates, registrations, and other from all governmental authorities
  • Copy of all key contracts
  • Corporate/LLC by-laws or operating agreements
  • Corporate/LLC minutes
  • Description of environmental liabilities
  • Fictitious business name statement (DBA)
  • Financing agreements
  • Information for copyrights
  • Information for patents
  • Information for trademarks and service marks
  • List of liens against the business
  • Other third-party agreements or contracts
  • Pending lawsuits
  • Phase 1 and 2 environmental studies
  • Preliminary UCC search results
  • Previous purchase agreement and related documents for business
  • Resale permit
  • Seller’s disclosure statement

Tips for Conducting Due Diligence

Be Emotionally Prepared: Due diligence can be an intense phase for sellers. Expect to invest a substantial amount of time and effort in this process. Some buyers may aim to wear you down or uncover issues to renegotiate terms. Prepare by proactively addressing potential problems before they become buyer concerns. Maintain emotional detachment to negotiate objectively.

Buyer Type Determines Thoroughness: Buyers vary in their diligence levels. Individuals tend to be less thorough than companies, although detail-oriented, risk-averse individuals or those with professional advisors can be exceptions. Companies, especially those experienced in acquisitions, tend to conduct thorough due diligence.

Exclusivity: Unless you’ve negotiated an exclusivity period, consider keeping your business on the market even after receiving an offer.

Stay Focused: The due-diligence stage is crucial, and losing focus can jeopardize the deal. It’s a pivotal point where the sale can succeed or fail. Recognize that you’re only halfway there; there’s still significant work before a smooth closing. Stay engaged and committed throughout the process.

Involve Your Accountant: Due diligence often revolves around financial documentation. Engage your accountant or CFO early to streamline preparations. Team cooperation is key to a seamless process.

Appoint a Point Person: Designate a point person to quarterback the transaction, ensuring efficient communication among all parties involved and thorough review of information before it’s shared with the buyer. Some professional advisors may not be incentivized to expedite the transaction due to hourly fees, so having an in-house point person simplifies the due-diligence process.

Early Landlord Communication: Initiate contact with the landlord early in the process, as lease matters are critical and often require careful handling. Landlords may not be obliged to approve lease transfers, and delays in involving them can lead to closing delays or even deal failures. Involving the landlord from the start is a prudent approach.

Prequalify Buyers: Before accepting an offer, ensure the buyer is prequalified financially. Verify that they have the capacity to complete the transaction, minimizing the risk of negotiations with an unprepared buyer.

Highlight Preparedness: If you’ve diligently prepared your business for sale, convey this to potential buyers from the outset. Let them know you’re a motivated and well-prepared seller, having organized all essential documents for due diligence. Mention your readiness with statements like:

“I’m a motivated seller who has meticulously prepared my business for sale, with the assistance of a certified public accountant (CPA). I have all the necessary documentation readily available for due diligence, including tax records, leases, equipment lists, financial statements, and more.”

Why Should I Prepare for Due Diligence?

Wondering if you can simply prepare the necessary documents when the buyer requests them? While it might seem like a reasonable approach, the truth is that preparing your business for sale well in advance significantly enhances your chances of success.

By laying the groundwork for due diligence ahead of time, you achieve several critical advantages. First, it can lead the buyer to agree to a shorter due-diligence period, which can expedite the entire process. Moreover, it reduces the perceived risk associated with your business in the eyes of the buyer.

Organizing your documents in advance ensures a swift and straightforward process. As soon as you accept an offer, the buyer can dive into the review process immediately. Time is a crucial factor; any delays can jeopardize the deal. By preparing for due diligence, you have the potential to streamline the process, vastly improving your odds of a successful closing.

Additionally, this proactive approach increases your chances of receiving offers. Potential buyers often hesitate to make an offer because they fear investing time and money in due diligence only to uncover undisclosed issues. When you’ve adequately prepared for due diligence, you alleviate these concerns for buyers.

Early preparation is strongly recommended, and your accountant or CFO can play a pivotal role in gathering the necessary documents. In one recent transaction we managed, a significant delay occurred because the seller lacked readily available bank statements. Obtaining them from the bank took weeks, leading to a price concession due to economic fluctuations during the delay.

How Should I Prepare for Due Diligence?

Preparing your business for due diligence is a straightforward process that can significantly impact the success of your transaction.

First, gather and meticulously organize the documents most commonly requested by potential buyers during the due diligence phase. Then, enlist the services of a third-party expert to conduct a comprehensive review of these documents. This proactive step helps unearth any potential issues that might arise during the due diligence process.

The key advantage of this preparation lies in your ability to address any uncovered issues on your terms and timeline, without the added pressure of the transaction’s outcome hanging in the balance. Ensuring your financial records are well-prepared and organized is paramount, as it can make or break the sale of your business. Incomplete or inaccurate financial records consistently rank as the top deal-breaker in business sales.

Recognizing this, it becomes evident that prioritizing the meticulous organization of your financials is a must. It’s crucial to avoid the risk of losing a potential buyer due to avoidable financial discrepancies that could surface during due diligence.

No one wants to invest substantial time with a prospective buyer only to see the deal fall apart over issues that could have been proactively managed. Financial due diligence should ideally be conducted by a third party, preferably a Certified Public Accountant (CPA). It’s advisable to initiate this process at least three to six months before embarking on the sale journey. This timeframe allows ample opportunity to address and resolve any issues that may come to light during the review process, ensuring a smoother and more successful sale.

Summary

Investing time in preparing your business for the due diligence process is a step often overlooked by many business owners. However, this oversight can be a costly mistake. By meticulously preparing for this critical phase, you significantly enhance the likelihood of a successful sale.

Furthermore, your preparedness sends a strong signal to potential buyers, boosting their confidence in your business while alleviating any concerns they may have.

The due diligence phase can either be a smooth journey or a tumultuous one. Having your financial records impeccably organized, coupled with airtight operational and legal compliance, often results in a seamless due diligence experience. This not only sets your business deal on the path to success but also brings you closer to realizing your dream closing.

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