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Selling Your Business?  You Need to Ace Due Diligence First

Picture this: 

You’ve received an offer from a potential purchaser to buy your business.  They’ve sent you a letter of intent and you’re floored by the offer.  The purchase price is substantially higher than you were expecting.  You’re trying to be calm, but you can’t help picturing the closing table and signing on the dotted line.  But not so fast . . . . 

You see this language in the offer letter:

“A binding agreement will arise only after we [the prospective Buyer] complete due diligence with satisfactory results . . . “

You think to yourself, “Sounds like boilerplate legalese.  Nothing that should dampen my excitement.  Or is it?”

The Small Language Taketh Away

To the untrained eye, this “subject to due diligence” language may seem innocuous.  You may think that with a signed letter of intent, the deal is as good as done.  Don’t be fooled. 

This language is a savvy buyer’s escape hatch to pull the entire deal from under you or substantially change the terms to your detriment.  If you, the seller, are not adequately prepared for what can often be an arduous and demanding due diligence process, those favorable terms, including the impressive purchase price offer, could disintegrate before your eyes.

As a seller, your preparedness for the due diligence process can significantly impact not only the valuation of your company but also the terms of the deal and even its ultimate success.  Having your financial, legal, and tax situations in order is critical.  Failing to do so can result in a reduced purchase price, unfavorable terms, or the buyer walking away from the deal altogether.

Why Due Diligence is Critical

Due diligence is the process through which a potential buyer thoroughly examines all aspects of a seller’s company before finalizing an acquisition. Due diligence can be daunting, but it can make or break the deal.  The process ensures that the buyer fully understands what they are purchasing and identifies risks or liabilities. For sellers, this means the buyer (or, most likely, the buyer’s attorneys) will make repeated requests for information and documents about all aspects of your business.  For sellers, it can feel like a prolonged invasive exam that seemingly never ends.  But it’s necessary for you to comply, and for the buyer to be satisfied with what they see, for the deal to go through. 

Due diligence encompasses a variety of areas of a business.  Although there can be many sub-areas, we’ll focus on three common key due diligence areas: financial, tax, and legal.

Financial Due Diligence

One of the first areas buyers scrutinize is your financial records. They will want to see accurate, up-to-date financial statements, including balance sheets, income statements, and cash flow statements.  If a buyer finds any of the following problems in their investigation, they’ll likely consider it a serious red flag:

  • Inconsistent financial statements:  If your company has discrepancies between reported figures in different financial statements or between historical and interim statements, this can raise a buyer’s doubts about the accuracy and reliability of your company’s financial data. 

  • Declining Revenue or Profit Margins: If your company has a downward trend in revenue or profit margins without a clear and justifiable reason, it may indicate to a buyer that your company has unfavorable underlying business issues. 

  • High Customer Concentration: Does a significant portion of your company’s revenue come from only a few customers?  Buyers will likely be concerned about the impact if these key customers are lost. 

Further, if your financial records are disorganized or incomplete, the buyer might perceive higher risks, leading to a lower offer or more stringent terms.  In worst-case scenarios, significant financial irregularities can cause buyers to lose confidence entirely and walk away from the deal. Ensuring that your financial house is in order is crucial.   Closely-related but just as important, your tax compliance must also be in good condition.

Tax Due Diligence

Buyers will scrutinize your tax returns, filings, and any correspondence with tax authorities. Below are a few tax due diligence red flags that can impede a successful deal:

  • Unfiled or Late Tax Returns:  Any instances of where your company has unfiled or late returns can raise serious buyer concerns.  This indicates to a buyer that you may have potential noncompliance that could result in significant penalties or interest.

  • Outstanding Tax Liabilities:  If your company has significant unpaid tax liabilities or ongoing disputes with tax authorities, this will likely be a serious issue for a buyer.   

  • Inconsistent Tax Reporting: If a buyer finds discrepancies between your company’s tax returns and financial statements or inconsistent reporting of income and expenses, this will likely raise buyer’s doubts about the accuracy and reliability of your tax records.

Unresolved tax issues or liabilities risk success of the deal going through. It is essential to have a clear tax strategy and ensure that all your tax obligations are up-to-date and accurately reported.  In alignment with the importance of financial and tax due diligence, your legal compliance and documentation must also be in order.

Legal Due Diligence

Buyers will review your company’s legal documentation, including contracts, licenses, intellectual property, and any pending litigation.   Buyers will also examine your corporate structure and governance documents.  Here is a non-exhaustive list of some of the legal due diligence red flags to a potential buyer:

  • Poor Corporate Governance:  If your company has inadequate or outdated corporate governance documents, this can indicate to a buyer that your company has a lack of proper oversight and control.  Buyers need assurance that your company is well-managed and compliant with governance standards.

  • Contractual Discrepancies:  Do you have inconsistent or missing contracts, particularly with key customers or suppliers?  If so, buyers will likely be concerned about the stability of revenue streams and operational continuity.

  • Unresolved Litigation:  If your company has ongoing or threatened litigation, this can be a significant red flag to buyers.  Buyers do not want to buy a lawsuit and they are wary of potential legal liabilities that could arise from unresolved disputes.

These are just a sample of some due diligence items to watch out for.  Ensuring that all your legal documentation is in order and that your company is compliant with all relevant laws and regulations can instill confidence in a buyer.

The Consequences of Poor Preparation

If you are not thoroughly prepared for due diligence, your deal is at risk.  Buyers may lower their purchase price offer, offer less favorable terms than initially outlined in their offer letter, or even terminate the deal.  

What can you do to give yourself the best outlook for a successful transaction?

Work with Experienced Advisers

To maximize your chances of a successful deal, it is crucial to work with advisers experienced in mergers and acquisitions (M&A). The right advisers can help you get your financial, legal, and tax situations in order, ensuring you present your company in the best possible light to prospective buyers.

Do you have the right lawyer for your transaction?  The sale of your business is one of, if not the, biggest transactions of your life.  This is no time to choose a generalist business lawyer.  There are particulars about M&A transactions that only experienced M&A lawyers will catch.  Work with a skilled M&A law firm, like Garza Law, to successfully navigate the complexities of your deal.

If you need more customized support, set up a call with us here.

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