7 Due Diligence Fundamentals You Must Know
People buy, sell, and merge businesses for many reasons. No matter the motivation, due diligence is key to a successful sale. An M&A Advisor and DealCoach can help guide you through the process.
Historic and Projected Financial Information
The seller must have prepared financial documents for the past three years. The buyer must review the company’s historical performance, and will need documentation to support it. The seller should provide financial documents about trends, spikes or decreases in revenue, cash flow, debt, assets and receivables, and other aspects of the business’s performance.
In addition to reviewing historical information, the buyer will need to evaluate projected future activity. This means checking to ensure financial projections are reasonable and rooted in fact. Buyers will want to know if the projected information is sound and believable, if the documents were succinct, how much working capital is available, and whether there are capital expenditures or other necessary investments that must take place.
Intellectual Property and Technological Developments
The seller should provide the buyer’s attorney with information about current and pending technical developments and intellectual property the company has. If there are pending trademarks or patent applications, the buyer must assess whether the appropriate registration has been completed. Materials used in marketing or technological advances require that the company has the appropriate ownership or license to prevent lawsuits.
Trade secrets are a key to many companies’ success. So you must ensure that these secrets are appropriately preserved, and that your company does not infringe upon other businesses’ secrets.
Revenue Streams and Customers
The seller needs a clear idea of the various streams of revenue the company has. This includes customers and their typical purchases. The buyers should also know how these customers, especially those in the top 20%, generate revenue.
Another consideration is how an ownership change will affect customer satisfaction. Will there be problems that could affect revenue? The seller should also provide details about any backlog of issues. Are there warranty problems? Many refunds or exchanges? The seller must have this information, and be prepared to tell the buyer why there were problems.
Contracts and Insurance
Due diligence should involve a review of insurance coverage and all active agreements and contracts. This should include outstanding loans, vendor contracts, partnerships and operating agreements, outstanding or potential settlements, equipment and vehicle leases, employment and independent contractor agreements, liability and worker’s comp insurance, IP insurance, vehicle insurance, health insurance, and umbrella policies.
Key Management and Staff
The buyer should look at staffing and management, including pending pay raises, profit distributions, equity shares, commissions, bonuses, 401(k)s, and other issues. This means a seller must be willing to open their complete human resource file.
A buyer will also want a detailed history of labor disputes. If there is a threat of any stop work, this may be a red flag. The buyer needs to look into issues that cause disgruntled employees.
Compliance and Legal Issues
Legal issues can be an expensive headache. These include pending or settled litigation and arbitration, as well as areas of exposure. Buyers will assess the potential effects of litigation, in addition to investigating threats and claims against the company. Being as forthcoming as possible can expedite the process.
Detailed due diligence can prevent serious future legal problems by exploring past, current, and potential legal threats. Matters in arbitration could potentially create issues for a new owner. And if sellers aren’t forthcoming, they could be sued for fraud.
Tax Issues
Tax due diligence offers an honest assessment of any potential tax issues. The process should include a review of five years of tax returns at the state, federal, and local levels. The buyer’s attorneys and accountants will look at net and operating losses. They will also want to investigate credit carryovers to ensure that a change in ownership won’t affect credit accounts.
Agreements, waivers, and other communications with the IRS are vital for the buyer to know about and comprehend. Settlement agreements can also affect a sale.
By Brad Kirkpatrick In Acquisition Strategies, Exit Strategies