What is Due Diligence?
What is Due Diligence?
May 20, 2019

For many clients looking to sell their company, due diligence appears to be the most daunting, confusing and challenging step of the process. Preparation well in advance of a transaction will ameliorate many of these anxieties and help the due diligence process run smoothly. Due diligence is simply the process a buyer uses to make sure that the business they’re buying is the business that they’ve been pitched in the investment banker’s or business broker’s marketing materials. Unless the buyer is an insider or has intimate knowledge of the company they’re buying, they will want to do more than just kick the tires. They will want to check the oil level, drain the oil, test it for impurities and then do the same for each system within the company. Some areas are more important than others. For retail companies, inventory levels and accounting are incredibly important. For software and technology companies, intellectual property issues such as patents, trade secrets, trademarks, cybersecurity, etc. are much more important.

Due diligence can create anxiety in business owners and distract them from running their business. That’s why we encourage our clients to speak with us at least a year or two in advance of their wanting to sell so that we can help them get prepared. The big areas of concern are 1) Organization Documents, 2) Financials, 3) Contracts and 4) Litigation/Other Liabilities.

  1. Organizational Documents

Organizational documents are a good starting point because they often are the easiest to clean up. One place we immediately assess is the capitalization table (cap table for short). Buyers like clean cap tables where voting control rests with a single owner or a small group of owners. We often encourage our clients to buy out small investors/owners well prior to a transaction so that there are fewer parties to cause drama and issues in the middle of a transaction. Or, in the event they won’t sell, then create a voting arrangement or update the organization documents to allow a single party to represent the other owners in negotiating and voting for a sales transaction. These are sometimes referred to as voting agreements or drag-along rights.

  1. Finances

Finances are another crucial piece of the due diligence puzzle and investing time and money into making sure they accurately reflect the company’s financial situation will save the seller time and money when it comes time to do a deal. Reviewed, and, even better, audited financials give buyers a higher level of confidence that the assets and business that they are purchasing is indeed what they’re told it is. Furthermore, if our client runs a significant amount of expenses through the company that are not essential to the company’s operations, then we encourage them to cease doing so as the fewer “addbacks” presented to a buyer, the higher the valuation you will receive. While the “addbacks” will be added to the company’s net income and EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) numbers, buyers don’t generally give full credit to such addbacks. Resolving those a few years before a transaction means that you’ll receive a higher valuation for your company without having to explain why the items are addbacks.

  1. Contracts

Contracts are a third area where we encourage our clients to work with us well in advance of the sale. See our earlier post HERE about one aspect we make sure to check, but verifying that contracts have a significant life span (in the event that they are favorable to the company), renegotiating unfavorable contracts, and ensuring assignability are all important tasks to do prior to starting the sales process. Spending time cleaning up your company’s contracts will reap significant dividends in time, money and stress when you do go to sell.

  1. Litigation/ Other Liabilities

A fourth area we work with our clients on to prepare for due diligence is litigation and other liabilities. Having an unresolved lawsuit, environmental claim, employment claim, intellectual property dispute, etc. can all be deal killers. Getting these items cleaned up and resolved earlier rather than letting them drag on can help create value at the deal table.

Due diligence does not have to be an overwhelming task. With proper preparation, it can be a minimally invasive part of the sales process that merely confirms the buyer’s assumptions about the company. If you are interested in selling your company or would like to speak with us about preparing your company for an eventual sale, then…

This blog was written by Hunter Business Law Attorney David Kronenfeld.

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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