This article originally appeared in the November 9, 2018 issue of The Daily Pitch.
Everybody knows what due diligence is, right? Probably so, but maybe it’s best to start with a definition. Here’s one I like from Wikipedia:
Due diligence is an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations.
I like this definition because in addition to contracts, it includes acts with a certain standard of care. We are used to thinking about due diligence in the context of sales agreements, typically contracts related to business transfers. But as we can see, the spirit of due diligence reaches deeper in order to address actions or activities requiring investigation prior to accepting responsibility or a fiduciary duty. These are actions requiring probity which imply a conscious commitment to truth and accuracy.
So, let’s look at due diligence remembering that its purpose is more than just a test confirming that you won’t get ripped off on a business deal. Due diligence is the opportunity to understand and embrace accountability as we commit to certain acts or decisions prior to judgement, acceptance and commitment. It is a process committed to honesty, openness and thoroughness. With this in mind and since every business owner will likely be confronted at some point with circumstances requiring due diligence, let’s explore the process as it relates to the sale of a business.
Generally, it’s buyers that engage in due diligence—they want to know what they are getting. This is a simple enough concept. Asking the key questions and investigating the right issues will provide answers and comfort to a buyer. But I might argue that it’s the sellers who perhaps should spend more time with diligence. According to our definition, sellers are contemplating an act which implies a certain standard of care. Are they taking the steps necessary to maximize a transaction? Have they identified and addressed the issues that a buyer will be concerned about before negotiating the deal? It can be useful to think of due diligence like a test. As a seller, can your business withstand the scrutiny of a professional review and analysis? Wouldn’t it be easier if you knew what the issues might be; any test is easier if you can prepare up front. And for the buyer due diligence is a thorough exam, insuring that the business is in fact as valuable as the seller purports it to be. Due diligence is a tool to maximize value creation and facilitate smooth transitions.
Implied in our discussion is the fact that for due diligence to be successful, it needs to be performed by individuals who are trained professionals. A neutral third-party is able to recognize and digest information, review relevant data and communicate accurate findings. Oftentimes this means industry experts, but not always. Experienced functional experts, usually in finance and accounting, can provide the type of professional scrutiny and analysis that the due diligence process requires. But due diligence is not mediation! Usually, each party to a transaction will engage professionals on their own behalf. A seller may engage a professional to perform due diligence before a transaction is entered into preparing a company for sale and a buyer may engage a professional to perform due diligence during a transaction.
How does the rubber meet the road? For example, Investor Ted is considering an acquisition of Company ABC. Ted knows that ABC is a retailer and that as a private investor, he is not an industry expert. Ted engages a professional to provide the diligence. The professional has the advantage of being an independent third party, as well as a highly-trained functional expert. Knowing his business, our professional sends out a document request list to the managers at ABC. Request lists provide a map for how the process will work. The investigation will be thorough! But the owners of ABC are prepared, having performed their own due diligence. Below is a summary list which offers a glimpse of what will be investigated, a complete copy is appended to the article.
Due Diligence Checklist for Business Owners
- Financial Information
- Financial Statements
- Cap Structure
- Other info
- Products and Development
- Customer Information
- Strategic Partners
- Significant Relationships
- Supplier List
- Marketing, Sales and Distribution
- Customer Base
- New Business
- Workforce Productivity
- Research and Development
- Product Pipeline
- Management and Personnel
- Org Charts
- Leadership Summaries
- Incentive Plans
- Employee Turnover
- Legal and Related
- Pending Lawsuits
- Environmental Issues
- Patent Matters
- Insurance Matters
- Material Contracts
- Regulatory Matters
If nothing else, this list should leave you with an appreciation for how detailed and thorough a sales process is likely to be. There’s a lot of room for gotcha’s, that’s for sure. For the seller this means that your own due diligence needs to match these aspects to prepare the business for sale. For a buyer, this list details the type and depth of information you will insist on having as you make your purchase decision.
In practice, no seller can be expected to know everything that a buyer will ask. No buyer will know enough to ask all the questions they should. That is why third-party professionals should be engaged. In the case of the seller, a professional is engaged for sell-side assistance to help the owner prepare their business for sale. The professional guides a process of identifying and detailing deficiencies that the business may have, which could be exploited by a buyer. Usually these same professionals have the experience and skill to help resolve the problems.
A buyer typically engages a professional to provide due diligence to confirm what they’re buying, this professional is not usually fixing problems. The due diligence professional creates value by safeguarding a buyer from mistakes and sometimes through helping to negotiate price reductions related to their findings. By using professionals this way, both buyer and seller are able to protect their interests and facilitate the successful completion of a business transition.
For small business, which is characterized by owner/operators, due diligence is very relevant process. Although to a seller due diligence can feel like unwarranted scrutiny, private company transactions require a mechanism to transfer knowledge and value. Due diligence has nothing to do with the personal side of a business transition. It is related completely to the value proposition and more specifically to transferable entity value.
Transferrable entity value describes the value developed and maintained by current ownership, which can be transferred and replicated by subsequent owners. Any asset’s value hinges on a buyer’s ability to realize it. Small businesses often rely on the business owner (who is often the operator) to generate results. In these situations, systems and processes must be identified and developed in order to create value which can be transferred. A lack of these systems and processes represents opportunity lost and lower valuations for the transaction.
Due diligence is a valuable tool to create value on both sides of a transaction. For the seller, since transferrable entity value is the by-product of improved systems and processes, it can be developed. Seller’s due diligence is a big undertaking, particularly for a small business, but it is a necessary step in any transition. For the buyer, due diligence is an insurance policy against catastrophic oversight and it is also a tool to help match the purchase price with value received. The smart small business owner is wise to recognize the value of due diligence and commit to the process.
Edward Webb is a partner in BPM’s Advisory Practice Group. He leads the Firm’s Corporate Finance Practice and has over 30 years of experience advising businesses of all sizes through difficult situations. Edward can be contacted at [email protected].