Business owners who have never sold a business before can find the buyer’s due diligence process to be overwhelming and frustrating. Having a better understanding of the process and together with the right team of advisors will help business owners prepare for the sale of their business, which will lead to an optimal outcome of completing the sale of the business at the highest price and on the best terms and conditions.
This article will help business owners:
- Understand the basics of due diligence in a divestiture process; and
- Provide actionable steps to prepare for sale.
What happens during due diligence?
During due diligence the buyers are provided access to detailed information about the seller’s company in all major operational and functional areas. The general areas of interest and type of information expected to be reviewed by the buyer and their advisors include:
- Financial Information –Financial statements, budgets, forecasts and details behind the balance sheet and income statement accounts
- Tax– Corporate income tax filings, HST/GST tax filings, notices, assessments etc.
- Legal and Corporate Records – Articles of incorporation, bylaws, minutes, shareholder registers
- Customer and Supplier Information – Volumes, business arrangements, key relationships
- Contracts – Customer, supplier, employee, IP, banking, insurance and all other contracts
- Human Resources – Contracts, compensation, length of service, benefits, bonuses
- Operations – Processes, equipment details, health and safety records and results
- Intellectual Property – Ownership, licensing, restrictions
- Regulatory Compliance and Permits – Government regulation and permit compliance
- Environmental – Air, water, ground environmental compliance, Phase I & II testing
- IT and Technology Infrastructure – Licensing compliance, security, functionality
- Real Estate – Ownership or lease details, zoning, land restrictions, environmental concerns
The due diligence process will delve into granular detail on each of the areas mentioned above. The buyer’s representatives are provided access to and copies of all information, reports and documents to allow them to carefully review and ask questions. Inevitably after reviewing the materials there are detailed and comprehensive questions that get asked with the expectation that the seller will provide further information as well as written or verbal responses to the queries. All of this is to help the buyer become very familiar with the business that they are intending on buying.
Action Item: Business owners need to consider the capabilities of their management information systems, to be knowledgeable on the reports that can be provided, where all the corporate information is located, what form it is in (paper copies, electronic copies) and who has access to the information to in order to prepare for due diligence.
Why does this happen?
The obvious answer is because the buyer wants to understand what they are purchasing. This is true but there is significantly more depth to the due diligence process and why it happens. The buyer wants to make sure they are making a good investment and by delving into the detailed information the buyers is, among other things:
- Understanding how the business generates its profits and cash flows and that there will be no material change post-closing,
- Verifying and confirming the contractual relationships they are assuming by becoming the owner,
- Verifying and understanding that there are no material unknown or undisclosed liabilities and
- Verifying and understanding that there will be no material changes that might occur in the business whether that is with respect to employees, customers, suppliers, regulatory etc.
Upon completion of the due diligence process the buyer will have a full and comprehensive understanding of the business that they are buying. This knowledge is used in three ways:
Corroborate assumptions made in formulating offer in order to commit to closing the deal
Typically, the buyers are provided preliminary information about the opportunity and are asked to make a bid or start negotiating the deal terms. The due diligence process affords the buyer the opportunity to corroborate the facts and statements the seller has made about the company up to that point of time and develop an understanding of the transition risks of purchasing the business. Ultimately the buyer will reach a decision that they are prepared to close the deal on the basis of their offer because the facts check out as expected and their underlying investment thesis and assumptions have held up through the knowledge learned in due diligence.
If the due diligence results in material surprises of fact it is highly likely that the buyer will want to re-negotiate the deal or will terminate its offer.
Develop integration plan
During due diligence the buyer will also be developing their own integration plan or post closing operating plan for the business. This could be in a variety of areas including operational, reporting, treasury and banking. The greater the confidence the buyer has in their integration plan and possible synergies the more comfortable they will be in committing to close the deal.
Legal documentation
Knowledge learned in due diligence is used in two ways with respect to the preparation and execution of legal purchase agreements. First it is used by the buyer to develop the specific representations and warranties that they want the seller to underwrite and represent to them. This is used to provide the buyer with a level of protection during the transfer of ownership risk. These representations and warranties are designed to make sure that the seller has disclosed to the buyer all of the pertinent facts about the business. The form and specifics of these are developed through the buyer’s better understanding of the business during due diligence.
Secondly, within the finalization of the purchase agreements the sellers are allowed to provide disclosures regarding the business and facts about the business to respond to the representations and warranties required by the buyer. A critical step is for the buyer to double check these disclosures against their findings during due diligence.
Action item: Business owners need to prepare for due diligence by making sure they remember everything about their business that they have forgotten or have key managers involved and ensure that all critical contracts, licenses, reports, data and facts about the business are available for due diligence. It is critically important that:
- The buyer is made aware of all material facts, opportunities and risks about the business before they finalize their bid in order to ensure there will be no surprises during due diligence. Material negative surprises lead to buyers re-negotiating the deals or walking away.
- The seller and its deal team of investment bankers, accountants and lawyers are knowledgeable about all material facts about the business to make sure that the appropriate disclosures are made in the legal agreements.
Preparation by the seller, and their advisors, to ensure that all critical and material information on all aspects of the business is available will help the buyer efficiently and effectively get through due diligence.
Who is involved?
It is not uncommon for the buyers to have deal teams of 50+ people involved in the due diligence process. This likely includes key members of the buyers’ management team and functional business leaders and a host of outside professionals and advisors including investment bankers, lawyers, accountants, bankers, environmental specialists, real estate specialists and IP specialists amongst others. This is obviously situationally specific, however whether you are dealing with a larger company or private equity group as your buyer there will be many people involved, each with their own domain expertise and focus.
This results in an interesting dilemma for business owners. Who should be involved and who has the knowledge to be able to provide the required information and respond to the relevant queries from all these different people on the buyers’ due diligence team. Many times, business owners don’t want their employees, including management, to know they are selling and try to get through due diligence without them. Depending on the level and depth of knowledge that the business owner has about every detail of their business this is more or less practical. Due diligence is comprehensive, and it is important to be able to not only provide detailed information for the due diligence process but also be able to provide clear explanations to any query brought forward by the buyer.
Action Item: Business owners need to make sure that they either have a full or complete knowledge of all aspects of their business or ensure that they have key managers involved in the process. At a minimum it is recommend that business owners include not only their outside professionals but also their President/CEO and CFO/VP finance or controller. For larger companies, including the rest of the c-suite and certain key managers, such as the manager of HR, will ensure a smooth and successful process.
When does this happen?
Due diligence is a gradual process that starts with a controlled release of overview information about an opportunity to interested parties and ends with corroborative and final due diligence by one final bidder who has won the competitive action process. CCC’s competitive auction process is designed to drive competitive tension between bidders to maximize the price on the best terms and conditions all while protecting the confidential nature of information and ensure that due diligence will result in deal closings.
It is critical that there are no negative findings during the final corroborative due diligence stage and therefore the release of information is critical. General information and general due diligence occurs early on when many possible buyers are engaged. More sensitive and critical information is only released to the limited number of parties who are in the competitive auction negotiating the letter of intent. This information is again controlled. Only after a letter of intent is signed back does the buyer gain access to all corporate information. Typically, the buyer is given 60-90 days to complete their due diligence. Significant frustration can occur for the buyer if the business is not ready for the due diligence process. Therefore, preparation is critical.
Action Item: It is important for business owners and their companies to make all relevant information available for due diligence and that they are able to respond to queries throughout due diligence. Lengthy delays will result in higher transaction costs and potentially risk that the buyer gets too frustrated, loses confidence in the seller’s business, and walks away.
Where does this happen?
Gone are the days when due diligence teams sit in the offices and boardrooms of the seller reviewing paper documents. Due diligence processes have evolved whereby today much can be completed in a discrete and remote manner. CCC hosts secure electronic data rooms which act as a depository of all corporate information. Individuals on the buyers deal team are provided login details to these secure data rooms where they can access key corporate documents. This reduces the onsite due diligence visits and helps ensure confidentiality of the sale process.
Action item: Business owners should prepare prior to the sale process to make sure all corporate information, contracts, licenses, agreements are available, duly executed and in good form and are available in electronic form to facilitate the due diligence process via electronic data rooms. Preparation will reduce delays, confusion, and frustration when the due diligence process begins.
Conclusion
Getting through due diligence during the sale of a business is a very detailed, complex and comprehensive process. Business owners are well advised to hire an experienced investment banker to help manage the sale process on their behalf. Being prepared, having the corporate matters well organized, information readily available and having the right staff and advisor resources available will drive the successful sale of the business with optimal value and minimal disruption to the daily operations.
The team at CCC Investment banking would be happy to further discuss the sale process and how our investment banking services will ensure a smooth and successful sale of your business.
Rob Bird
Managing Director, Toronto
Rob joined CCC in 1997. He has been in corporate finance for over 25 years and has been involved in more than 100 successful transactions. Rob has advised clients on acquisitions, divestitures, private equity recapitalizations, intellectual property licensing, and financings, including senior debt, subordinated debt and equity financings.
