Due Diligence When Buying a Business

Many people misunderstand the true meaning of due diligence. To the misinformed, it is the time when a buyer can check out a company’s financials. However, it goes way beyond that. It is the stage of the business-buying process when a buyer can really dig into the guts of a business and analyze every aspect of it.

One of the major hurdles buyers face, is the time allocated to complete this critical step. From the buyer’s point, they want the most time possible. After all, this is usually the the first time they really gain access to the business, and can peel back the layers.

On the other hand, this is when the seller knows that any possible problems can surface so they want to negotiate the shortest period possible.

I have seen some seller counter offers pushing for a five day due diligence period. That is completely ridiculous. Yes, it is true, that the analysis of the financials may only take a few days, but what about the assets, legal issues, contracts, customer review, understanding the systems, the marketing, the internal processes, the competition, the industry analysis, and on and on the list goes?

Of course if you are looking at a two-person pizza joint, much of these disciplines d not apply. But in any reasonably sized business, there is a whole lot more that just the numbers to consider.

Buyers must beware of some contracts floating around the business brokerage community with the caveat that if the financials are within five percent of what has been represented, then the financial review is deemed to be satisfactory. That is complete nonsense! What if the percentage holds true, but the buyer discovers that one client represents fifty percent of the revenue? Or, what if a business that relies on location, and major road construction is slated that will render the business inaccessible for six months? Or, what if the business is in a plaza that relies on one anchor tenant for traffic, and they are rumored to be in financial trouble? I can give you a thousand other examples, but the lesson is the same – you cannot possibly tie the due diligence solely to the numbers, or have clauses that defy logic.

I have personally sold nine companies that I owned and perhaps my philosophy is different. However, I have always told the buyers to take as much time as they need to conduct their review (of course within reason). My thinking was that if I found a qualified buyer, and was satisfied with the deal, I wanted to get the deal closed. The only way to do so was to allow them to eliminate any concerns. I never held back any information; I disclosed all possible issues before they uncovered them, and so an element of trust was established. Further, when the buyer and seller trust one another, and the buyers wants to buy, and the seller wants to sell, they cannot be stopped from getting a deal done. In other words, they will find a work-around to every reasonable issue.

I have always found it interesting that in large transactions, and not necessarily complex ones, a thirty to sixty day due diligence period is standard, and sometimes more. Interestingly enough, larger deals are not necessarily more complex. In fact, they are often simpler because the parties are usually far more experienced than most small business buyers and sellers. Yet, in the larger deals, all sides understand, and agree to, a due diligence stage that will allow the buyers ample to time to conduct a thorough review.

Here’s the big difference: in smaller deals, buyers go into due diligence expecting to find problems. Often, they are looking for a reason not to do the deal but it is almost always due to the fact they have not received enough data yet to satisfy the most basis buyer concerns. Conversely, sellers are worried the buyers will find issues and back out. In the larger deals, when the buyers get to the stage of “formalized” due diligence, they are fully intent on getting the deal done. Leading up to that point, the sellers have disclosed ample documentation for the buyers to compile their initial research.

In smaller deals, the parties can be less sophisticated; it may be the first transaction for both the buyer and the seller. If the buyer has not done enough initial work, or is not adequately prepared, they go into due diligence with way too many areas to investigate. Then, if they’re bullied into a short review period, it is almost certain the deal will never get done. It is probably why half of the deals that get to due diligence never close.

There are several lessons here for all parties to consider.

For the buyer:

• Don’t be bullied into an unreasonable due diligence time frame.
• Don’t allow any clauses that could come back to haunt you like the five-percent rule noted above.
• Preparation is critical. No matter how long you have, time moves quickly, so make certain you are well-organized before you begin.
• As soon as a business is of interest, you must start investigating the industry, competition, market, location and anything else you can do on your own.
• Do not start the clock until the seller has provided the documents required. Naturally, you may need additional data once you begin, but the core list should all be in place first.

For the seller:

• Get your house in order. Your goal is the finish line so help the buyer reach it.

• If your books and records are a mess, be prepared for a messy deal.
• Understand that the buyer’s future is at stake. They will be cautious; you would be as well in their shoes.
• If your business has any hidden issues, drag them out and display them to the buyer. You can always resolve challenges that you put on the table. But, if you sweep them under the rug, when they surface, and they will, you will lose all credibility, and often the buyer along with it.
• Stay involved in the process. Be helpful. It is also the time for you to measure up the buyer, especially if you are financing the deal After all, you want them to be successful and the more sophisticated, articulate and detailed the buyer is during this stage, the more comfort you will gain with their business acumen.

I have long believed that if two sides can reach an agreement, then barring any catastrophic and previously undisclosed issue, the deal should get done. Deals fall apart because the buyer can’t pull the trigger. Often, it is a result of them not having enough time to thoroughly investigate the business so they cannot gain comfort and move forward with the transaction.

It is true that time usually kills all deals, but a lack of it will almost always make the buyer uncertain. It is difficult enough for buyers to find a good business, and sellers to find a good buyer so when that does happen, both sides need to recognize they share the same goal and must work together to achieve it.

If you want a 200-point due diligence checklist and strategy guide, it is included with our program How To Buy A Good Business At A Great Price or, you can purchase it on its own. To order your copy click here

Comments

[website business]

Richard, timely article for me personally as I was just reviewing two LOI's that came today. Both had the same issue in common that I was not terribly excited about and that was the due diligence period and proposed close. In both cases they ask for exclusivity for 30 days to do due diligence and then an additional 30 - 45 days to close.
Although I agree with you about providing comfort and enough time to a buyer, most of the internet deals I am selling are not as complex as a brick and mortar business and can be investigated pretty thoroughly and quickly in a remote fashion - over the internet. For larger e-commerce deals buyers typically need to meet the seller on premise and see the operation and feel the products. The other thing is the deal is off the table for other possible suitors for a longer period which does pose potential problems if the deal falls through after a month and the other buyers find another deal! After reading your article I think I am going to take a more tempered stance and allow for a longer DD period if required and agreeable by my clients and place an "on or before" clause in there so it can close quicker if possible.
good timely advice as usual.

David Fairley
www.websiteproperties.com

[Kipp Krukowski]

Richard, You bring up some very good points that both buyers and sellers need to consider from each other’s perspective. Having been involved in the successful transactions of over 60 businesses, I have seen much of what you have written about firsthand. I think the point that you bring up that has come true time and time again is that when the buyer and seller trust one another, and the buyers wants to buy, and the seller wants to sell, they cannot be stopped from getting a deal done. As I am sure you have seen from your experience, each deal is unique and it requires flexibility on both ends to get to the closing table. If both parties are honest and fair the transaction should be a win-win for both parties.
I also agree in the statement that smaller deals are not necessarily easier than larger deals. Educated buyers and sellers in the business buying / selling process improve the chances of a transaction.

Kipp A. Krukowski, MBA
Certified Business Intermediary
Certified Exit Planning Advisor
Confidential Business Sale, Inc.
216-739-0272
www.ConfidentialBusinessSale.com

[Miriam]

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Miriam

http://www.craigslistguide.info