Due Diligence is a Burden but it’s a Business Seller’s Best Friend…..

Due diligence is a necessary stage in a successful M&A process. Although wrongly, most sellers would just as soon skip this stressful step if they could. Unfortunately, due diligence is only getting more onerous and more important. In the wake of the recent economic downturn, business buyers and their lenders are focused on risk like never before. They are using due diligence to head off negative surprises, such as undisclosed liabilities, pending litigation, environmental issues or customer concentration concerns. Sellers today, therefore, should be prepared to provide a serious buyer with everything from extensive financial records to long term strategic plans, to detailed lists of tangible and intangible assets. It is a good idea for business owners to include the inevitable Due Diligence issues in a well thought out Exit Plan or Exit Strategy. Sellers also should expect the due diligence period to last longer than it might have only a few years ago — potentially delaying the deal’s close.

A thorough due diligence is a seller’s best insurance against a claim from the buyer after closing the sale. Good words for sellers to remember during due diligence…disclose, disclose, disclose!

Although the collapse of the financial markets in 2008 has fueled a more cautious attitude among buyers and lenders, ramped-up due diligence has been a long time coming. Implementation of the Sarbanes-Oxley Act of 2002 (SOX) was a turning point. SOX rules require public companies to assume greater responsibility for accurate financial reporting and fraud prevention — including those of the companies they acquired. Private company buyers and Private Equity Groups are embracing the intent of SOX to reduce their risks if they intend to one day take the business public.

Some experts estimate that the average length of the due diligence process now is months longer when compared with an average of three- four months in the mid-2000s. Several factors, of course, determine the length of this stage, including the size of participating companies, their industry, whether the seller is financially distressed and whether the buyer is public or private.

In this environment, buyers likely will solicit input during the due diligence stage from, among others, risk management, forensic accounting, human resources and information technology experts. Further, it’s not uncommon for a buyer to request a second or even third go-round on a target’s financial statements, especially if the Seller’s financials are not audited by a respected CPA firm.

Ready for inspection

Although you can’t and probably shouldn’t limit the buyer’s due diligence process, thorough preparation the seller can reduce the time it takes and the disruption to the organization. Start preparing for due diligence before you have a deal on the table, it will strengthen your bargaining position. Assemble a due diligence team with representatives from every relevant department to be overseen by your CFO and you M&A advisor. The team should divide potentially large data production tasks among themselves and regularly report on their progress to the rest of the group. If you don’t have the staff to spare or in-house expertise to prepare for due diligence, hire a third-party consultant to spearhead this important effort.

Today most professional M&A Advisors will have electronic data rooms where the parties can upload due diligence materials for all to see. An additional benefit is that these data rooms can track who has looked at and downloaded what documents.

Your CFO also should prepare for the types of queries that risk-averse buyers are likely to make about your financials. For example:

• What is your debt, when does it mature and what are its terms?
• Are you or your company guaranteeing any debt for which you’re not the principal holder?
• What’s the nature of all your debt you use for financing (for example, mezzanine, vendor terms, floor plans, etc)?
• What leases or mortgages do you hold?
• What’s your break-even sales mark, with or without debt servicing?
• What are your primary markets? Product lines? Geography? Industries?
• How have your earnings fared during the market downturn?

As with all facets of the due diligence process, it’s essential that your company provide candid answers and full disclosures. Any potentially damaging piece of information will come out eventually. If it isn’t revealed until after the deal closes, you could face legal and financial repercussions.