Due Diligence: Importance, Tips & Strategies

What’s the cost of not being ready when a potential suitor comes a’ calling? Incalculable, if you talk to business owners whose transaction fell through because they weren’t prepared.

Instead, business owners should switch their focus to operating in a “Due Diligence Ready” state.

What is Due Diligence?

Due diligence involves developing a plan to intentionally and proactively address potential issues related to critical business, legal and operational information. Essentially, you’re getting your “house” in order to be in a position for a sale at any time.

Why is Due Diligence Important?

Whether you are in the selling mode or not, it’s just good business practice. When the time comes, potential buyers will ask hard questions and request information that supports the value of the business.

Time is money — acquiring companies want the information to be right the first time.

The more organized and prepared, the easier the due diligence process will be, and the more likely a company will be poised for a successful transaction.

10 Areas to Focus On to Best Prepare Your Company for Due Diligence Success

1. Accounting cleanup
2. Lender and investor agreements
3. Customer contingent liabilities
4. Contract database
5. Governance documents
6. Legal protection
7. Human resources
8. Information technology
9. Data room
10. Be prepared

1. Accounting cleanup

Acquirers expect 2 to 3 years of financial information: balance sheets, statements of operation and statements of cash flow, with general ledger accounts reconciled.

While audited financials may not be required, they will ease the concern of any buyer. Revenue recognition is often a significant issue, particularly if the acquirer is a public company.

A private company may be more lax, whereas auditors for a public company will expect all aspects of this to be thoroughly addressed.

2. Lender and investor agreements

Companies should maintain a current capitalization table or schedule of all stockholders and holders of agreements that offer a right to purchase equity.

This includes:

• Stock options
• Warrants
• Restricted stock
• Preferred stockholders
• Convertible note holders
• Anyone that’s been promised equity in a written and signed agreement

3. Customer contingent liabilities

Compile obligations the company has entered into in the ordinary course of doing business. This includes product/service warranty terms, rebates/discount and rights of return.

There are many nuances within that a buyer will consider for forecasting, contingencies, etc.

4. Contract database

Sellers should disclose any legal contract still in effect. This often becomes a fire drill that can be avoided by maintaining a contract database.

Many contracts have change of control requirements, termination clauses in case of control change, etc. There may also be commitments for product upgrades, etc. that are notable.

Active non-disclosure agreements or confidentiality agreements should also be housed here. And make sure all contracts have been signed by all parties to the agreement.

5. Governance documents

Company formation documents must be presented to potential buyers. Organizations should structure their legal entity in a manner to anticipate a transaction.

Sloppy governance documents often scare away a potential buyer, so maintain a disciplined approach around all governance meetings (board, committees, etc.) with a schedule following corporate document requirements and documented minutes.

6. Legal protection

Is the company’s intellectual property protected? Any proprietary IP will increase the value of a business but can diminish the value if the company doesn’t properly protect it.

Also, the company should have a full understanding of outstanding litigation and claims by third parties. Acquirers may use contingent liability scenarios to require an escrow of a portion of the sales proceeds until uncertainty of these issues is fully resolved.

7. Human resources

Companies should be diligent about keeping HR in compliance with the myriad of related rules and regulations.

Maintain a master employee database that includes all current and historical employees, along with agreements that are signed by all parties, including clearly defined terms regarding intellectual property ownership.

Additionally, maintaining the appropriate classification of employee status (contractor vs. W-2) is critical.

8. Information technology

Companies should have stringent IT policies and procedures around document retention, disaster recovery and other IT infrastructure systems.

This will demonstrate that the business has been careful about system access and loss of trade secrets and company data.

9. Data room

Once ready to “go on the market,” sellers should set up a virtual data room so potential buyers can access all the important information. This also enables the seller to track who is accessing which information for how long, etc.

There are several options to use such as DropBox, plus there are services that set up secure data rooms especially for acquisitions.

10. Be prepared

The Boy Scout motto applies to business too. To maximize success in business – especially for a sale, always “be prepared”.

Management who employ good business practices will increase the value of their businesses in the long run.

5 Due Diligence Activities For A Successful M&A Transaction

Why Operating in a Due Diligence Ready State is Vital

Remember, the cost of well executed due diligence far outweighs the costs related to a bad transaction.

Is your organization due diligence ready?

Our cross-functional team of professionals are well versed in the due diligence process and ready to help you succeed.