Due Diligence When Selling Your Business

As you may have read in the past editions of this newsletter, selling a small business is a significant decision that requires careful planning and preparation. One of the most critical aspects of the process is due diligence. So, it’s super important to understand what it means and how to prepare for it. Trust me, knowing this information will save you a lot of headaches and result in a smoother transaction, and, of course, it will lead to maximizing the value of your business.

What Is Due Diligence?

Due diligence is when a potential buyer evaluates the business before finalizing the deal. It involves a thorough examination of many aspects of the company and supports all the seller's claims about it.

For sellers, due diligence is an opportunity to showcase the value of the business and build trust with a potential buyer. A hassle-free due diligence process can really help speed up the transaction and avoid last-minute surprises that could kill the deal.

What to Expect During Due Diligence

Before starting the due diligence process, the seller should create a team and choose a leader to ensure the process goes well. The project manager acts as a central point of contact, coordinating between different departments and external professionals, like attorneys and CPAs, and the buyer’s team, which may include their lawyers, tax experts, finance professionals, etc.

The due diligence process typically begins after you’ve accepted an initial offer. Here are a few things you can expect during the process:

1. Information requests. Buyers will request a detailed list of documents and data. Be prepared to respond promptly and thoroughly. A slow response could signal disorganization.
2. On-Site visits. Buyers may visit your premises to inspect operations, meet with employees, and evaluate assets. This is your opportunity to showcase the business.
3. Follow-Up questions. Be ready to provide additional information or clarification as buyers analyze the data.
4. Negotiations. Findings from due diligence may lead to negotiations on the purchase price or terms of the agreement.

During the process, I recommend that you:

1. Be transparent. Hiding things can damage trust and derail the sale. Disclose problems upfront and show what you have done about them.
2. Get professional support. Work with experts, including accountants, lawyers, and business brokers, to navigate the process. Yes, it costs to hire them, but their expertise can help you avoid costly mistakes.
3. Stay positive. A smooth due diligence process reflects well on you and your business. Approach it as an opportunity to showcase your achievements and build trust. Buyers typically value sellers who show confidence (without coming across as arrogant) and approach the process with a cooperative attitude.

Components of Due Diligence

Financial Due Diligence

1. Work closely with an accountant to ensure your financial statements (profit and loss statements, balance sheets, and cash flow statements) are accurate and up to date. Ensure your books comply with Generally Accepted Accounting Principles (GAAP). GAAP-compliant books reflect professionalism and inspire confidence in buyers.
2. Provide accurate and realistic financial projections to highlight the future growth potential of your business.
3. Demonstrate good accounting practices and internal controls to reassure buyers of your business’s integrity.
4. Prepare a quality of earnings report to give buyers insight into your business's normal/ recurring revenue and profitability.
5. Adjusted EBITDA often should be prepared if needed to present a clear picture of your business’s true growth and profitability.
6. Have a clear understanding of your working capital and monitor recent changes. Fluctuations in working capital can significantly impact the sale process.
7. Pay close attention to revenue recognition practices for various reason, including the impact on potential earnouts.
8. Evaluate employee compensation, including tax obligations, benefit plans, and bonus structures.
9. Review compensation plans and their relevance to strategic buyers. Comprehensive plans that align with business objectives add to your company’s value.
10. Employment expenses should be carefully prepared and reviewed: Employer tax; benefit plans; bonus plan; key employee comp; vacation and sick; employee agreements; stock options plans; severance

Tax Due Diligence

1. Ensure tax returns are readily available for review. Show compliance with local, state, and federal tax laws. A clean tax record reflects operational integrity and reliability.
2. Understand whether the sale involves stock or assets, which impacts various tax implications. Clearly outline the structure to avoid misunderstandings.
3. Review any outstanding tax liabilities or disputes that could pose risks to buyers. Resolve these issues beforehand to streamline the transaction process.
4. Account for operations in multiple states or countries, including state-specific income and sales tax obligations.
5. If applicable, ensure sales tax compliance by reviewing records thoroughly.
6. Address any tax notices or unresolved inquiries from tax agencies.
7. If applicable, highlight eligibility for tax credits, such as R&D tax credits.
8. Clearly separate business and personal expenses to avoid confusion.

Legal Due Diligence

1. Work with a lawyer to review and ensure that major contracts, leases, licenses, and permits are up to date and compliant.
2. Protect intellectual property rights, including trademarks and patents.
3. Address pending litigation or legal disputes transparently.
4. Show your compliance with local, state, and federal regulations.
5. Evaluate compliance with environmental laws, particularly if your business operates in a regulated sector.
6. Review employment law compliance, including employee agreements and policies.
7. Verify real estate ownership or leasing arrangements, if applicable.
8. Ensure compliance with industry-specific laws and standards. Buyers in regulated sectors prioritize businesses with a proven track record of compliance.
9. Review corporate governance documents such as shareholder agreements, articles of incorporation, and bylaws.
10. Check for any liens or encumbrances on assets. Address these issues to avoid complications during the transaction process.
11. Review key employee agreements, including stock option plans, non-compete clauses, and severance packages.
12. Be prepared to discuss employee-related litigation, if any. Addressing these things transparently is super important.

Customer and Market Due Diligence

1. Provide detailed customer data, including client contracts and retention rates. Strong customer loyalty is a compelling selling point for buyers.
2. Showcase marketing and sales strategies to show how revenue is generated. Buyers want assurance that revenue streams are sustainable.
3. Highlight adaptability to market trends and industry changes. Buyers value businesses that are prepared to navigate market challenges.

Human Resources Due Diligence

1. Examine employee contracts, benefits, and compensation structures. A stable and satisfied workforce adds significant value to your business.
2. Review the organizational structure and identify key personnel.
3. Assess employee turnover rates and workplace culture.
4. Ensure compliance with labor laws to avoid potential liabilities.

Operational Due Diligence

1. Streamline operations to address inefficiencies and showcase well-maintained equipment. Buyers value businesses that require minimal immediate intervention.
2. Analyze key processes and workflows to show operational efficiency.
3. Review supplier and vendor agreements to ensure stability. Strong relationships with suppliers add to your business’s value proposition.
4. Evaluate inventory levels, equipment, and assets to verify their condition.
5. Highlight technology and systems in use. Modern tools signal a forward-thinking business.

Industry-Specific Due Diligence

Different industries have unique regulatory requirements and operational issues that require special attention during due diligence. For instance, businesses in highly regulated sectors like healthcare or finance must prove compliance with industry-specific laws and standards. Buyers of manufacturing companies will likely focus on things like supply chain and equipment maintenance records to assess operational sustainability.

Going through industry specifics is beyond the scope of this article.

In conclusion, understanding and preparing for due diligence can position your business for a successful sale and achieve the best possible outcome for all parties involved.