Pre-Sale Due Diligence – The Critical Process of Dealing with the “Skeletons in the Closet” Before Entertaining a Sale

​Sellers routinely underestimate what it takes to convince a buyer to close on a deal.  They also often tend to mistakenly withhold information that they deem to be immaterial, only to find that when it emerges during due diligence, it threatens the deal or the potential buyer tries to renegotiate the initial offer.

Potential buyers of a business view investment risk and opportunities from a completely different frame of reference than the seller.  They worry that they will pay too much, or even more so, that the business may not perform as expected once they become the owners (and hence, they paid too much).

The seller, on the other hand, is already intimately familiar with the business and understands its customers, its suppliers, employee matters, etc. and the business risk and opportunities associated with each.  Transferring that deeper understanding of the real risk and opportunities from the seller to the buyer is ultimately the overriding purpose of the due diligence process. Sellers must look at the business from the viewpoint of a buyer and try to anticipate how buyers will perceive risk and opportunities with a healthy dose of skepticism.  Simply put, buyers will believe what the seller can prove and be skeptical of what they can’t.

Undertaking a comprehensive “Pre-Sale” due diligence process will go a long way in preparing the business for a smooth sale when it is time to sell.  By “Pre-Sale” due diligence, we mean a comprehensive investigation or review of all aspects of the business, either through the utilization of internal resources or by an outside advisor, to identify, document, and ultimately correct issues that will be inevitably uncovered by a potential buyer.

So how do you begin the process?  The first step is to compile a due diligence list and populate it.  Buyers expect to review almost everything today electronically, so start by building a directory on your server or online.  It should be organized by major sections, such as “Financial”, “Operations”, “Sales and Marketing”, “Legal” etc. with subdirectories for each major section.
  
Once the information readily available has been uploaded, gaps and shortcomings will start to emerge. Are your operating procedures up to date and documented properly?  Have changes been made to your performance management program that is not fully reflected in your latest employee manual?  Employee matters are a critical part of the due diligence process by buyers.  Are there restrictions to assignment clauses in important supplier agreements?  Are there inter-company or related-party transactions and relationships that are not documented with formal contracts and are they at market rates?

Revenue quality (sales that are, profitable, sustainable, and predictable) is one of the most important aspects explored extensively by potential buyers early in the due diligence process.  Sellers should be able to aggregate and segregate sales and margins by customer, customer type, region, salesperson, location, product, product line, etc.  Sophisticated business analytics capabilities will go a long way in helping a buyer assess risks and opportunities, as will a comprehensive, up-to-date, written business plan, complete with embedded strategic planning and implementation processes.

Having audited statements will help ensure that the firm’s accounting practices are up to date and the internal controls are up to industry standards.  An audit will help build a buyer’s level of confidence in the financials, but some may require a “Quality of Earnings” (QofE) review.  A QofE will help a buyer determine maintainable earnings by adjusting for one-time/non-recurring expenses and sales, owner-benefits, inter-company and related-shareholder transactions, etc.  For companies that have a lot of potential adjustments, undertaking a QofE by the seller before going to market may be advisable.

Organizing and compiling the information a buyer will need to review will give you a “running start” when you hire an advisor to assist you in the sale, or when you begin discussions with potential buyer candidates.  It will also get your potential buyer to “yes” or “no” a lot faster if you’re prepared.  Drawn-out extensive discussions and “bit by bit” information flow usually leads to a monumental waste of time for all involved.

The reality is that buyers will eventually uncover any “skeletons in the closet”, so it is always best to identify and correct them on your terms and well before you get into detailed negotiations with a potential buyer.

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