What is Due Diligence…
Nobody undertakes the buying or selling of a business lightly, so to find out as much as possible about their potential purchase, a buyer will perform extensive research, known as a due diligence process. This will help them to decide whether or not to go ahead with the purchase, and if so, what level of price they should offer.
There are several reasons why due diligence is undertaken:
The first is simple commercial sense. Committing a large amount of money to acquiring or merging with an unknown company would clearly be far too great a risk, so the more information that can be gathered, the more that risk can be assessed and reduced. Setting a price for a purchase can be a difficult decision to make, based on several factors, so the more information the buyer has, the more confident he or she can be in a proposal.
The second is as “cover” for the decision to be made. The more a purchaser can demonstrate to their managers, financiers and/or shareholders that they went through a due diligence process designed to uncover all aspects of the target company’s operations, the more they can show that the decision was a sound one, especially in cases where there might be commercial difficulties later on.
The third reason is for legal and regulatory compliance. Commercial law in all developed countries requires that shareholders’ funds are protected as far as possible by the process of due diligence, and buyers must follow certain minimum processes to ensure compliance with the legal requirements.
In his book “Due Diligence, a Strategic and Financial Approach”, Luis Gillman sets out nine key aspects of good practice for due diligence when considering buying a business:
- Compatibility audit – in which the researcher should explore how well the organisation’s operations are compatible with the buyer’s own company
- Financial audit – during which a detailed review will look at all aspects of the target company’s financial position, including looking at published and unpublished accounting information
- Macro-environment audit – reviewing the position of the target company in its market, and the prospects for future profits in that sector
- Legal/environmental audit – due diligence to ensure that there are no “nasty surprises” regarding potential lawsuits or environmental concerns once a sale is made
- Marketing audit – examining the strength of the target’s ability to sell its products and services
- Production audit – looking at the quality and quantity of goods and services produced, and how they serve customers
- Management audit – reviewing the strengths and weaknesses of the current management structure (bearing in mind that this may well change if a purchase is made)
- Information systems audit – to ensure that the company is maximising use of technology, or identifying areas where improvements could be made
- Reconciliation audit – bringing all of the above audits together to complete the due diligence process, to make a final decision as to whether the vendor and the purchaser are a “good fit” and whether ultimately, there will be added value to an acquisition.
A buyer will probably only follow all of the above processes in cases of large and complex mergers and acquisitions, and it may be enough for more straightforward business processes that the due diligence process covers only some of them.
Usually, the buyer will rely heavily on the advice of advisors when going through the due diligence process, and this work forms a large part of the expertise of commercial lawyers, accountants, bankers, brokers and other financial advisors.
Due Diligence Performed on You (the Seller)
As a business owner looking to sell your company, you will need to provide as much information as the potential purchaser needs to complete the due diligence process to their own satisfaction. The usual concerns you will have about keeping information confidential do need to be set aside to a certain extent, because a buyer can’t be expected to make a decision based on a partial picture. To protect yourself, it is normal business practice to get your lawyer to draw up a due diligence confidentiality agreement for buyers to sign, preventing them from copying or sharing the information you provide – and crucially, to prevent them from taking action upon it should they decide not to go ahead with the purchase.
It’s a good idea to ask your lawyer or accountant to give you an idea of exactly which documents the buyer is likely to want to see, before the due diligence process begins, so that you’re prepared with all the information. This should help to speed up the process and prevent delays caused by requests for missing information during due diligence. (Check out our Store to find resources that can help you with Due Diligence)
Due Diligence You Perform on the Buyer
Similarly, you will want to perform some due diligence yourself as a vendor. Due diligence is, to some extent, a two-way street, and although you wouldn’t need to go through as much detail as the buyer, you should ask your advisors for help to ensure that the buyer at least has the means to pay the asking price. If the purchase involved the offer of their own shares as well as cash, then of course you would need to do more work to ensure that they were really worth the amount that the buyer claimed.
Joanna Miller helps business owners navigate their way through the start to finish process of selling a business. Her specialty is helping owners understand how to prepare and make the most of their business sale process to maximise their company’s value. To understand how you can sell your business quickly for the highest sales price, purchase her book, “How To Sell A Business: The #1 guide to maximising your company value and achieving a quick business sale”