Due Diligence 101
The Anatomy of a Deal Newsletter September 25, 2020
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
- Effective due diligence processes can often make the difference between a successful deal, and a deal that eventually falls apart.
- Buyers should assemble the right team, coordinate focused document requests among their advisors, and have justification for those requests.
- Sellers should incorporate due diligence and documentation into daily operations, be acutely aware of their weaknesses, and learn to love the process.
You’re back?!? I thought for sure the tax article would scare you away for good. Well, if that didn’t do it, maybe an entire article dedicated to due diligence will.
Ah, yes. Due diligence. The land where many deals go to die. The place where the excitement of the deal turns into the drudgery of non-stop document requests, conference calls, and disclosure schedules.
SELLER: After five weeks, I finally completed everything on your 20-page due diligence list. When do we close?
BUYER: Great! Those were just the financial diligence requests. Our lawyers will be sending you their request list shortly, and we’ll also have separate request lists from our HR, environmental, IT, and tax teams coming as well. We’ll also have some follow-up questions and requests on everything you’ve provided. And then, we’ll also need you to prepare several hundred pages of disclosure schedules.
SELLER: [Hangs up and begins sobbing uncontrollably]
No one likes due diligence. But it’s incredibly important and often means the difference between a successful deal and a dead deal. A smart approach to due diligence—from both the buyer and the seller—can make this process more productive and (at least somewhat) less painful.
1. Assemble the right team.
For buyers, due diligence is a team sport. In a given transaction, the buyer will need some (or all) of the following types of experts on the team: (1) financial advisors, (2) accountants with various specialties, (3) lawyers with various specialties, (4) environmental consultants, (5) surveyors, (6) title searchers, (7) public records researchers, (8) HR consultants, (9) benefits consultants, (10) insurance advisors, (11) IT/data security consultants, and (12) an integration team. In cross-border deals, you may need translators and local advisors, too.
Due diligence is complicated…and expensive, unfortunately. But, if you’re serious about doing the deal, you need to have the right team in place from the start. Having an organized approach, open lines of communication among the team and clear expectations for who does what will save you time, money, and frustration. Experienced buyers are good at managing the team, particularly when the same team is accustomed to working together. Buyers who are newer to the process may want to tap one of their advisors to manage the diligence team.
In addition to making the process cleaner, cheaper and easier for you, an organized and thoughtful approach to due diligence will minimize deal fatigue for everyone.
2. Coordinate requests among your team.
I’ve had many calls from exasperated (and angry) sellers who are beside themselves because the buyer repeatedly asks for the same crap (they usually choose a different word than “crap”). In reality, it’s not that the buyer is asking for the same thing over and over again, it’s that the buyer’s diligence team is not communicating with one another. For example, the buyer’s financial advisor, accounting firm, and law firm may all have the same requests relating to the target’s tax returns. While they all have a legitimate reason for requesting this information, it’s beyond frustrating for the seller.
Yeah, it’s annoying. But just tell the seller to suck it up, right? I wouldn’t recommend that approach. As in any relationship, there’s a finite amount of social capital between the buyer and the seller. A disorganized and exhausting due diligence process erodes trust with the seller and discourages cooperation. Without cooperation from the seller, the deal becomes exponentially more difficult and costly—or dies entirely.
A more coordinated approach between the buyer’s advisors would allow the advisors to still get all of the information they need without inundating and frustrating the seller. The information the seller provides to anyone on the diligence team then gets posted to an “electronic data room” that gives everyone who needs it access to the same documents and information.
3. Know why you’re asking for something.
Another call I get frequently from sellers goes something like this: “Why the hell do they care about that?” Usually, it’s reasonably apparent to those of us who do this every day, but it’s much less apparent to sellers who are fatigued and confused. That frustration reaches a boiling point when the seller asks the buyer the same question and the buyer shrugs and says simply, “I don’t know.”
There should be a reason for every request. Buyers—and their advisors—should be prepared to justify their requests. That’s why one-size-fits-all due diligence requests are often unhelpful. Before asking a seller to respond, buyers and their advisors should think about what really matters for this particular transaction and tailor their requests accordingly.
1. Make due diligence part of your daily operating strategy.
The best due diligence strategy for sellers is to operate your business every day like you’re getting ready for a deal. Adopting—and then following—standard operating procedures that address common areas of buyer concern will make your due diligence examination a (relative) breeze.
Are your organizational documents and cap table up-to-date? If not, do it now!
Do you have signed copies of all of your contracts at your fingertips? If not, do it now!
Do you have sales tax exemption certificates with each of your non-retail customers? If not, do it now!
I highly recommend that all companies—but especially those who are actively thinking about an eventual sale—go through their own “sell-side” due diligence process before there’s even a buyer on the scene. That sounds painful, but doing it now makes sure you’re ready when the buyer starts asking. The same social capital in the buyer-seller relationship we talked about above applies here. A buyer is not only gathering facts about the business, it’s also judging the seller’s competence, attention to detail, and business acumen.
In many cases, a pre-transaction due diligence review can directly impact the dollars the seller eventually receives in the transaction. Locking down contractual relationships with key customers may become important to ensuring that the buyer is able to achieve the value it intends to receive in the deal. Putting in place appropriate incentive programs and restrictive covenants with your key employees can ensure that your valuable talent remains committed to the business through a sale (more on this next month!). Protecting your intellectual property assets can directly put money in your pocket at sale.
And once you learn the lessons going through this process the first time, it’s pretty easy to build these habits into your daily operations. You’ll be glad you did.
2. Find the skeletons before someone else does.
Every business has them. In most cases, they can be dealt with. So what should you do about these possible issues?
- A. Hide them and hope the buyer doesn’t find out. Move to Moldova immediately after the closing and change your name.
- B. Let the buyer find them. The buyer will be pleased because it got its money’s worth from all of those expensive advisors it’s paying.
- C. Find them proactively before the transaction, and then develop a strategy for addressing any issues and disclosing them strategically to the eventual buyer.
If you chose C., you passed this month’s Anatomy of a Deal pop quiz!
The best thing to do is to find potential problems before they become real problems. In most cases, you can implement solutions and show the buyer what you’ve done to find and fix the issue.
Even if you can’t fix the issue, you’ll be better off disclosing the issue in a proactive manner. While it’s counterintuitive and nerve-wracking, sellers are better off disclosing issues themselves. Doing so builds trust with the buyer and allows the seller to control the narrative. If, instead, the buyer finds the problem itself and the seller is shocked to learn about it, the buyer will immediately start wondering what other scary surprises might await the buyer after the deal closes.
3. Believe it or not, disclosure schedules are your friend.
The first deal I ever was involved with almost died because the seller simply wanted nothing to do with the disclosure schedules. In honor of that experience—and countless others that have played out over the years—here’s the Anatomy of a Deal’s “Top 10 Reasons Why Disclosure Schedules Suck:”
- They take so much work to complete.
- I already gave all of this stuff to the buyer!
- I have better things to do.
- They’re often the primary thing holding up the closing.
- They lead to more questions from the buyer.
- I have to talk to other people who may not know about the deal.
- It seems like a total waste of time.
- The buyer knows more than I do about the business at this point.
- They cost a lot to complete.
- Did I mention they take a lot of work?
I get it. Schedules aren’t fun. But they are really important…especially for sellers. Why? Because if you properly disclose things in the disclosure schedules, you can oftentimes stop the buyer from making a post-closing claim based on the issues you’ve disclosed. Sellers want to be sure that they both get their money and keep their money. Schedules are an important part of keeping your money.
“But I already told the buyer!” Great! The disclosure schedules are the only way to get credit for what you’ve already told them. If it’s not in writing, then it’s just as if you didn’t tell the buyer anything. If you’ve already disclosed it to the buyer, why not make sure you get some protection for doing so?
“But it’s stuff I don’t want to disclose.” These are exactly the things you should disclose. The disclosure schedules provide a good vehicle for disclosing these issues strategically.
“But I don’t want to do them!” I know. But by spending the time to complete disclosure schedules thoughtfully, you’re actually buying yourself protection against post-closing risks. It’s absolutely worth your time and attention to prepare complete and accurate schedules. If you’re going to do the deal, you might as well do it right.
Due diligence is all about avoiding surprises. Buyers don’t like ugly surprises after closing. Sellers don’t like surprises that threaten their money. A smart diligence strategy for buyers and sellers will help you complete your deal smoother, faster and cheaper…and greatly increase your chances of a successful deal.
Next Month: Restrictive Covenants
Read last month’s piece: M+A Tax 101