Even though that broker did most of the heavy lifting, there was one piece of the acquisition Frigerio found rather tedious: due diligence.
“The due diligence process, in particular, wasn’t fun,” Frigerio said. “But luckily the buyer was a very nice guy and tried to make everything as easy as possible.”
Due diligence, whereby a buyer who has expressed intent to purchase a business closely examines the state of the company and its corresponding valuation, is an essential — and often dreaded — part of the acquisition process.
For first-time sellers in particular, going through the due diligence process can be an adjustment, said Bob Greisman, fractional CFO and M&A advisor at RKG Business Growth Advisors.
“The first mindset to get used to is having someone looking over your shoulder and in other places as well,” he said. “Psychologically, you have to be prepared for that and not take it personally. Be open and transparent.”
What is due diligence?
Buyers undertake due diligence to investigate the health of the business and identify any risks prior to purchase.
When due diligence begins, you’ve likely already signed a Letter of Intent (LOI) and shared some details about the business. Through the due diligence process, the buyer will dig deeper to ensure the company is operating as you’ve promised and that it’s worth the value you mutually agreed upon in the LOI.
For sellers, the process is an opportunity to provide up-to-date, accurate information and transparency to ensure that the transaction progresses smoothly.
“If someone is selling a house, they prepare it, stage it, clean it up. And if the washing machine is broken, they fix it,” he said. “For a business, if your financials are done on pen and paper, put them in Excel, preferably into Quickbooks, and prepare everything.”
Being ready for due diligence means preparing for it in advance. Prospective buyers typically send over a document checklist, which can act as a road map for how the due diligence process is likely to proceed. For sellers, this involves ensuring that all documents are ready and easily accessible, perhaps in a designated data room, ideally well before a proposed buyer is ready to look at them.
“There were lots of things that I learned that I had not done as well as I should have,” said Anna Maste, who sold Boondockers Welcome, a community for RVers, for 7 figures in 2021. For example, she wished she had gotten ironclad IP (intellectual property) contracts from freelance graphic designers. “[And] there were lots of things that I had made efforts to fix up in the previous 2 years — accounting practices, internal record keeping — that I was very glad I’d done, as it made my life a lot easier,” she said.
Buyers will usually have an adviser to represent them, and these advisers will often bring their own questions. Sellers, especially those with more complicated businesses, may also want to have advisors on hand as support, Beylin said.
In an ideal world, he said, to prepare for a smooth due diligence process and transaction, sellers should consider retaining an advisor, such as a broker or an M&A advisor, a year or two before they list a business for sale.
What to expect from the due diligence process
Due diligence is a way for both the buyer and seller to ensure that their expectations are aligned. It can last anywhere from a few days for small companies to months for larger ones.
In most cases, it has three separate components, according to Nate Ginsburg, the chief executive and owner of Centurica, a provider of buy-side due diligence services for web-based businesses that he acquired in May 2022.
- Financial due diligence is the process of making sure all the numbers are accurate, complete and available.
- Operational due diligence assesses the team operating a business and provides a closer look at standard operating procedures.
- Commercial due diligence, often seen as the icing on the cake for smaller acquisitions, allows the buyer to get a sense of the future trajectory of the business, including the competitive landscape, sales pipeline and marketing strategies.
Let’s look at each type and what it requires.
Tips for preparing for financial due diligence
“Financials are the one where most small businesses mess up,” Ginsburg said. “Not due to lack of effort, but because the financials are tricky and most entrepreneurs are not accountants.”
How you present those financial records is also important, according to Greisman; while some financial records are clean and well organized, others can resemble a shoebox filing system, where it’s hard to find the information you need. Although the latter set-up might work for the seller, it isn’t likely to provide the visibility that a third party would want, he said.
Making sure financial information is accurate and in order is crucial because failure to do so could potentially affect the final sales price of the business, Beylin and Ginsburg said. This is particularly important during initial negotiations, prior to the issuing of a Letter of Intent (LOI), which typically includes the sale price.
Although mistakes are common, the sooner you clean up your financial records, the more likely you are to notice any discrepancies before negotiating with buyers. It’s often worth hiring a financial consultant or bookkeeper to look over documents before you set out to find a buyer.
As a seller, you should review not only historical financial statements, but cash flows, income taxes and sales taxes; in some cases, Greisman said, sellers discover during the due diligence process that they owe unpaid taxes in particular states where they do business.
“Don’t do [accounting] on the cheap – you are going to pay for it at some point,” Ginsburg said. “Get it right beforehand, even if it costs more initially. It is better to do it right the first time.”
In addition to having documents ready before they are requested, take the time to vet them to ensure they will present the business in the best light possible, Beylin said.
The importance of preparing for operational due diligence
In the case of operational due diligence, take time to organize access to the tools used for the business, including standard operating procedures (SOPs). You should gather everything from existing contracts with customers and vendors to insurance policies, pricing, employment manuals, operational documentation and log-ins.
Familiarizing buyers with these tools is vital to the sale, because ultimately they’re evaluating whether the business will be transferable and sustainable under new management.
Operational due diligence is often more complicated to prepare for than financial due diligence, Greisman said, and depending on the complexity of the business, buyers may send in a different team of advisers for this stage.
All of these pieces can help a buyer get a better handle on the business they’re about to purchase. Every company has its own way of doing things, the “secret sauce” that helps them provide unique value in some way. The question is, have you documented how you do those things? And trained your team to do them consistently?
“The concept is that the company has systems and processes, and the buyer will be looking to understand them and see how other people understand them,” he said. “The worst case scenario is that it’s all in the owner’s head.”
Greisman cited the example of one client, a business with 1,000 employees, in which the person responsible for renewing the company’s web domain left, and no one had access to that person’s email. These are the situations you want to avoid ahead of an acquisition.
Finally, what to expect from commercial due diligence
Commercial due diligence is more crucial for sellers of bigger and more complex businesses, especially those over $1 million in valuation.
While commercial due diligence is often a less high-profile aspect of the process, it can nonetheless have an impact on the completion of the sale.
“It’s the future vision, the story of the business, looking at the next five-year plan or project launch trajectory,” Ginsburg said. “That can also impact the valuation and narration around the exit.”
When due diligence leads to renegotiations
In general, smaller businesses tend to be held to less strenuous standards of due diligence. Expectations will be lower for a $200,000 website than a business worth $5 million.
But here’s something to watch out for: the due diligence process can sometimes be the catalyst for renegotiating the sales price.
This is more likely to happen with smaller companies, Greisman and Ginsburg said. While it could sometimes represent a bargaining tactic, that’s not always the case; it might also be a result of the buyer getting full access to the internal workings of the business for the first time.
The buyer might also try to renegotiate if they’re able to poke holes in the financial records you’ve provided. That’s why you want your books to be clean from the get-go, so the expectations you set ahead of due diligence are exactly what the buyers find when they dig deeper.
“Be open-minded and don’t take it personally,” Greisman said. “That’s hard for owners to do.”
We’re reporters, not lawyers. If you need help with a legal matter, please hire a lawyer. The information contained in this piece is provided for informational purposes only, and should not be construed as legal advice.