Do Your Diligence: Part II

Editor’s Note: This article is the second in a two-part series that outlines why a due diligence review is important when purchasing or selling a business and how to prepare for the review.

When you are preparing to sell your business, you should have an independent reviewer look at your company to ensure that you are prepared for the due diligence review (DDR) that will be conducted on behalf of the purchaser.

Many potential sales of businesses fall through or are renegotiated when the DDR reveals undisclosed information, and the closing can be delayed while these issues are resolved.

“In the ongoing day-to-day running of a business, many potential obstacles may have been accepted by the current owners and are not top-of-mind, but will likely be discovered in the DDR process. The seller can obtain a much better outcome by determining the likely issues and strategizing and preparing for a smoother DDR,” explained James Phillipson, a founding principal of Mastermind Solutions.

Information Gathering

A large amount of documentation, both hard copy and electronic, is required for a DDR, regardless of the size of the business. Murphy’s law dictates that a DDR will interfere with month-end, quarter-end, year-end, budget preparation, and vacations, for example. Preparing in advance by anticipating what will be required will help facilitate a smooth process with a minimum of delays. The management team should assemble a data room or space for all the documents that are likely to be required by the DDR.

In preparation for annual financial statements, many midsized businesses allow for the accounting processes to stop short of the adjustments that will be provided by the external accountant. If these entries include a routine “cleanup,” this can delay the DDR because the reviewers calculate the true results and cash flows. The pre-DDR identifies the adjustments and implements processes to ensure that they become part of the routine accounting to avoid delaying the DDR.

In addition, the DDR consultant will report back to their client -- the potential purchaser -- on all that they discover, so it makes sense to be prepared. In my discussion with Phillipson, he stated that “in many midsized businesses, three factors often have not kept pace with the growth of the business: descriptions of responsibilities, approach to documentation, and processes.”

These will reflect on the quality of management.

A pre-DDR identifies many areas of weakness and gives the seller an opportunity to take steps to remedy the issues so that they will be moot during the DDR.  The quality of management, processes, and controls inevitably influences how readily documentation is available at the outset, how the issues that arise and requests for additional documentation are dealt with, and the perspective gained in reviewing the material provided. Having this documentation speeds up the DDR and reduces the risk of the issues giving rise to renegotiation of the purchase price.

Of course, issues will always arise in a DDR; in fact, there may be many. How the seller responds can have a material impact on the results.

Preparation for a DDR reduces the risk of the review process continuing for a long period of time, which has a much larger impact on the seller than on the purchaser. It is common for the seller and its staff to allow the day-to-day operation of the business to slip. They might be demotivated when they anticipate a change in management and staffing, and they probably are overworked or feel scrutinized because they attend to the many issues that arise.

As the time for a DDR extends from a few weeks to a few months, the reviewer maintains a vigilant eye on the key performance indicators of the business. Slipping indicators provide fodder for the purchaser to renegotiate the purchase price to reflect those lower results and the increased risk to the purchaser.

Mark Borkowski is president of Mercantile Mergers & Acquisitions Corporation, mark@mercantilema.com, www.mercantilemergersacquisitions.com.