A Look Under the Hood: Is Your Business Ready for a Buyer’s Due Diligence?
A Look Under the Hood: Is Your Business Ready for a Buyer’s Due Diligence?
October 19, 2018

You’ve started, grown, and now are looking to sell. When the exciting moment comes in your entrepreneurial journey to take steps toward offering your business for sale (or responding to a spontaneous offer), it’s important to be prepared. Understanding the process and the players can be the difference between a successful exit and a lost opportunity.

As early as possible, educate yourself and set the foundation for a successful sale. Prevent the death of your deal with the right preparation.

Setting the Foundation

Before even beginning the process of entertaining prospective buyers, there are steps to take as a business owner that will position you to obtain the maximum return with the least disruption. Here are a few examples:

Contract with Sale in Mind: Whether with landlords, employees, contractors, vendors or customers, keep in mind your goals and intent to sell and set the contracts up accordingly. For example, does your lease allow you to assign it to a buyer of substantially all of your company’s assets? Is the non-compete signed by your star salesman assignable? Will your customers with long-term contracts have an out upon sale because you need their consent to assign the contracts?

Keep your Financial House in Order: Simply put, sloppy financial records make buyers nervous and that devalues your company and will lead the Buyer to demand more protections in the form of hold-backs of the sale proceeds and indemnification obligations that can last for years. Make sure you have proper P&L, balance sheets and tax returns for the last 3 years. Are you in compliance with GAAP? How about detailed budgets? Do you know your COGS (cost of goods sold) and profit margins? It’s highly advantageous to have a financial team on your side from the beginning to keep the books clean and organized with your goal to sell in mind.

Understand How Your Company is Valued: If you listed your business for sale today, do you know what price you would ask for it? More importantly, do you understand the valuation method that led to that price, and whether it is the most common method for your goods or services? An experienced valuation expert and an M&A advisor can help you understand how your business is valued – and who will pay the most for it. As an example, a strategic buyer who can leverage your business as a footprint in a new geographic market and apply its economies of scale to your operations will typically pay more than a buyer who is new to the industry. Once you know your valuation metrics and your optimal buyer characteristics you can continue to grow and later package your business in the most desirable manner.

“Setting realistic valuation expectations and having a clear understanding of those factors that could adversely affect valuation will help you mitigate valuation risks and ultimately drive value,” commented Wendy Andrews-Fine, Vice President of Aberdeen Advisors, Inc. “Understanding the current market conditions and how those apply to your business will help you make better decisions.  Diversifying your customer base, improving your financial reporting integrity with GAAP-compliant financials and having a strong management team in place are key factors that will help you achieve your target valuation.”

The Acquisition Team

It’s important to include all key players in the acquisition process early and often. Choose a team that has experience with entrepreneurs and has completed acquisitions in the past. Your team should include:

  • Business Broker or M&A Advisor (i.e. mergers & acquisitions)
    • Find a broker/M&A firm that has some industry expertise and works in your range of value. If you’re selling a $50M tech company your broker is not the same person selling a $2M restaurant franchise
  • Attorney
    • As with brokers, you need to find an M&A business attorney with experience well-suited to your company, and that is adept at handling these kind of transactions – from due diligence to contract negotiations to closing deals
  • CPA
    • Obtaining sound tax and financial advice (before the deal is inked!) and having a CPA who is capable of effectively responding to due diligence inquiries is critical. Your current bookkeeper/CPA may not be the one to navigate you through the sale of your business. There are considerable tax strategies that can be deployed in a sale which can save hundreds of thousands – if not millions – of dollars.
  • Advisor/Coach
    • If you have a business advisor or coach, this is when you will need them the most. Selling your “baby” can be an emotional rollercoaster and many tough decisions have to be made along the way. For many business owners, their attorney or CPA has been their advisor/coach and can serve a dual role of professional advice and advisory support.
  • Key Executives
    • You will need to decide early on who to inform of your intentions to sell and who will be involved in the process. If employees discover that you are selling, they may get fearful and look for new employment. There is a lot of strategy around these choices.

Once you have your team, put together a communication plan and pre-schedule meetings out for three months. And remember to educate your team on your core values and what matters to you most: Is it the bottom line financial outcome of the sale? The legacy of what you built? Protecting employees? Being offered ongoing employment by the buyer? Cutting all ties at closing with an all-cash deal?

The Acquisition Process

With the foundation set and team in place, the acquisition process has six main components with much to consider and plan out with your team. It’s important to set expectations of your involvement and intent early, avoid any litigation, and be ready to walk away if the deal isn’t what you were expecting.

  1. Buyer finds youOnce a buyer is interested, don’t jump into anything until you know your buyer (and its lender – SBA, P/E, public/private, or bank). Is it a competitor? Does it appear to be a good fit, and able to do the transaction? How is its reputation? You need to do due diligence on your buyer too, especially if you’re likely to be employed by the buyer and subject to an earn-out after closing.
  2. Letter of Intent, Term SheetThe LOI/Term Sheet presents the initial offer… It’s important to get an attorney involved before the LOI/Term Sheet is signed to ensure it’s a reasonable offer, clearly articulated and does not contain deal breakers. While the LOI/Term Sheet is typically non-binding, changing material terms after this stage can lead to ill-will and blow a deal.
  3. Asset Purchase AgreementMost buyers prefer to purchase a company’s assets, not its stock; this is primarily to limit liability from past acts. An asset purchase agreement outlines all of the terms of the purchase. For example, it will identify what assets are being purchased, which liabilities are being assumed, the purchase price, the payment schedule, the parties’ representations and warranties, and details such as holdbacks, earn-outs and restrictive covenants.
  4. Due DiligenceThe process of due diligence can be a time-consuming burden on an operating business, and if not done well by the Seller can result in devaluing of the business and less favorable deal terms. To make it efficient and effective, start as early as possible to organize information in digital folders labeled with typical due diligence categories. Categories of important information include but are not limited to:
    • Financial Statements
    • Contracts
    • Equipment/Inventory
    • Intellectual Property
    • Leases/Real Estate
    • Employment and Contractor Agreements
    • Permits/Licensing/Compliance

    Make sure you are in control of who accesses these folders and that confidential information the Buyer should not yet see is redacted (examples are customer names and social security numbers of employees). This is the time to review your records; you don’t want to have your prospective buyer point out that some of your contracts are unexecuted or expired!

  5. FinancingUnless Buyer has cash, there will be a contingency for Buyer to obtain financing, whether from a bank, private equity engagement or some other source. The lender will also be conducting their own due diligence, of Buyer and Seller, and may be the cause of a failed deal.
  6. ClosingAssuming due diligence does not uncover any major issues that result in termination of the contract, the final contract is executed.
  7. Post-ClosingAs the deal closes, management teams work together to execute on the transition of the companies including employees, customers, assets and more.

Protecting Yourself from Potential Risks

With so much important information at play, there are key questions to consider and decide on with your acquisition team to reduce your risk in the acquisition process.
Protecting Confidential Information

  • Assess the risk: Existing competitor? Prospective competitor?
  • Nondisclosure Agreement (remember: confidentiality agreements do not delete knowledge from the brain so be strategic about what information to disclose, and when)
  • Should disclosures be mutual?
  • Who should know about the potential sale, and when?

Questions to consider early:

  • Will you give Buyer an exclusivity period during which you will not solicit or entertain other offers?
  • Are all the owners on the same page? If not, can the majority owners “drag along” the minority?
  • What is the minimum you can accept as a sale price – Net!
  • Will you agree to have some of the purchase price be in the form of an earn out
  • Will you accept Seller financing?
  • Will you stay on as an employee, or contractor?
  • Will you agree to a noncompete?
  • What are the values that drive your decisions in this process?
    • protecting employees?
    • protecting customers?
    • protecting the brand (legacy)?
    • maximum price?
    • free at last (v. ongoing employment)

Are you Ready?

If you are looking for guidance on the sale of your business – or if you are looking to buy a business – get in touch with our mergers and acquisitions team at Hunter Business Law. We can assess your readiness, help you prepare, bring together an experienced team and guide you every step of the way.

DISCLAIMER: This blog is for educational purposes only and does not offer nor substitute legal advice. Additionally, this blog does not establish an attorney-client relationship and is not for advertising or solicitation purposes. Any of the content contained herein shall not be used to make any decision without first consulting an attorney. The hiring of an attorney is an important decision not to be based on advertisements, or blogs. Hunter Business Law expressly disclaims any and all liability in regard to any actions, or lack thereof, based on any contents of this blog.

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