By: Steven M. Bush, J.D.
What is Due Diligence?
Most people would not want to buy a used car or a house without having a mechanic or inspector look for problems that could affect safety, longevity, and future value. If, after your inspection, you still decided to move forward with your purchase, knowing about the actual and potential problems may affect the price you’d be willing to pay.
A similar inspection process, called “due diligence,” applies to the sale and purchase of a business. A buyer will try to gain a complete understanding of the business, which involves more than “kicking the tires.” The potential buyer will try to discover any problems, including the potential for problems to arise in the future, because they affect the business’s value.
What happens when a buyer finds problems? There are many answers to this question, none of which are good for the seller. At the end of the day, due diligence is about defining the boundaries and magnitude of risk that might keep the buyer from fully realizing his or her plans for the business. If there’s substantial risk, there may be no deal or the buyer may reduce the purchase price.
The Typical Approach to Due Diligence
Most transaction advisors recommend that sellers go through “pre-transaction” due diligence before going to market. By working to spot problems before trying to sell, you can correct the issues you find on your schedule. When you and your team fix potential problems before negotiating with a buyer, the likelihood of closing the deal on your terms increases, and the time and expense of the transaction can be significantly reduced.
Doing this work before you go to market will help you keep the sale on track while the buyer is conducting his or her own due diligence. Not only will you be organized before the transaction, you will also have a better chance of staying organized throughout the negotiation and closing process. This will improve your ability to protect your confidential information, to appear open and accommodating, and to hold onto any highly sensitive information until your mileposts have been reached. Most importantly, you will have the best chance to avoid disrupting your business.
Add Value by Taking Problem-Solving to a Higher Level
“Cleaning up the messes” before going to market will make the negotiation and closing easier and smoother, but it probably will not increase the value of your business. Is it possible to add value while, at the same time, taking care of problems? Yes, and it takes only the added steps of creating, improving, and memorializing your processes while doing your pre-market due diligence.
Here’s an Example.
Imagine that one of your sales representatives quit on Friday. On the following Monday, your former employee has started a competing company with offices across the street. During the normal pre-market due diligence process, your advisors would probably recommend having your remaining sales representatives sign non-competition agreements; even having all of your employees sign non-competition agreements.
How could you increase the value of your business while dealing with this problem? First, you might try to create written procedures and checklists to memorialize your hiring process. You would want to make sure, for example, that your process includes a check of whether applicants are subject to any non-competition or non-solicitation agreements with their current or prior employers. You would also want to analyze whether a new hire will have access to your confidential trade secrets and information. If so, part of your hiring process would include confidentiality and non-disclosure agreements and, in the right circumstances, non-competition and non-solicitation agreements that would be enforceable in court, if needed.
The benefits of taking your pre-market due diligence to this level are two-fold. First, you will create processes where none currently exist, and you will formalize and improve any processes you already have in place. Second, as you apply this approach to all other parts of your business, you will be creating an “owner’s manual” for your business. The creation and improvement of your business processes, coupled with your version of “How to Run My Business for Dummies,” increase the value and marketability of your business.
You and your advisors can further leverage your pre-market due diligence by creating a due diligence “war room” as you complete each process. If you use a physical location for your war room, it will contain file cabinets that hold copies of the documents and information that a buyer may want to examine. If you use a “virtual war room,” the information will be stored electronically in a password accessible format.
Regardless of the approach you choose, when the time comes to play host to a buyer’s due diligence team, you’ll be glad you did your homework early. Not only will the sales process be smoother and less disruptive, you’ll probably put more in your pocket at the closing table, too.
Steve emphasizes business startups, commercial transactions, and real estate. He graduated from the University of Denver College of Law and finished his undergraduate career by graduating with magna cum laude honors. He has practiced law in a variety of settings, including government, private practice, and corporate positions. Immediately prior to opening his current practice, Steve started and operated the Denver “Mr. Handyman” franchise and was awarded the Franchisee of the Year and Top Performer awards for the entire worldwide system. Steve sold his business in August of 2003 and now focuses his efforts on helping his clients effectively develop and execute plans for their businesses. Steve has been a contributor to professional and business magazines, and is a frequent speaker at business and professional seminars.
(originally published in the April 2012 eNewsletter)