Business Transaction Basics: It’s All About Due Diligence

You’ve been talking to buyers for months and have a letter of intent (LOI) in hand. So, what comes next? The answer is due diligence, and it is exactly what it sounds like. Even though your company is hopefully in sound financial and operational condition, before taking on tens of millions of dollars in new assets, buyers will undergo a thorough check to understand exactly what they are purchasing. Here’s what you need to know about due diligence to make the process as smooth as possible.

What are buyers looking for?

In short, anything and everything – good or bad. Positive information adds leverage to the deal’s valuation and helps the seller maximize value. Negative information will incur adjustments that lower the overall value, and in some rare cases can jeopardize a deal.

Generally buyers dive into the following categories:

• Legal: Buyers analyze a company’s entire legal history, from articles of incorporation and bylaws to historical and pending litigation. They are also interested in trade secrets and IP protection, board meetings and employee agreements.
• Operational: Buyers will take a broad look at the operational mechanism from beginning to end. This includes quality control, the state of equipment, subcontractor and vendor usage and any risk concentrations. After COVID-19, buyers have sharpened their eye on the supply chain and insurance coverage.
• Environmental: For manufacturing M&A, best practice is generally for buyers to undergo a stage one study of every site to identify contamination.
• Regulatory: In more highly regulated industries such as medical equipment, buyers will ensure companies are compliant. Large regulatory issues have the potential to derail agreements.
• IT: Buyers will examine a company’s IT assets, cybersecurity infrastructure, prior security incidents and system compatibility.
• Customers: Buyers will analyze consumer sentiment towards the company and the diversity of the customer base, both of which help determine the company’s overall viability.

What data do they need?

Sellers should prepare to hand over 3-5 years of financial documents to potential buyers during the due diligence process. The big points that will be pulled out will be:

• Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): Buyers will confirm financial information for 3+ years, including cash flow and inventory.
• Debt: Buyers want to have a broad understanding of the overall debt burdens of the company. This includes lines of credit, long term notes, liabilities and customer deposits. Debt definitions can vary, and fluctuate the deal by millions of dollars depending on classifications and adjustments.
• Working capital: Buyers want to make sure they will not have to inject substantial capital after an acquisition, and that the company will sustain itself over time.
• Tax exposures: Determining total tax burdens can be one of the most difficult pieces of due diligence, with buyers doing a thorough analysis of tax history in every possible jurisdiction. The bigger the footprint of the company, the more comprehensive the analysis.

Getting to an LOI can be a heavy lift, but there are plenty more hurdles to jump over before a transaction is complete. Due diligence is one of the most difficult and having the right team in place will make sure that you answer every question and retain as much value in the sale as possible.