What happens during the due diligence phase of the sale of a business?

What happens during the due diligence phase of the sale of a business?

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If you’re getting ready for a business sale, due diligence will be on your to-do list. This crucial step will get you the value you have been offered by a buyer. It also makes the overall journey easier – a win-win situation.

However, if this is your first sale, you might not know how to get started or what’s included in the process. Due diligence involves checking the risk in your business from the buyer’s perspective. The goal is to assess and validate your claims, ensuring that your business is ready for sale.

Though due diligence may sound confusing, it doesn’t have to be. There are simple steps to take to prepare your business information for your buyer. It’s good to start this process early, as you’ll have more time to rectify any issues before the exit date. The bonus is the assurance you get from knowing that your business affairs are in order.

Are you gearing up to complete due diligence? Don’t leave this process until the final moments. We’ve created a complete guide to help you prepare for a satisfying sale and a free PDF Selling A Business Checklist to ensure you stay on track. Keep reading to learn more. 

What is due diligence?

Due diligence refers to steps business buyers and sellers take before entering a sale contract. This involves investigating assets, commercial potential, and liabilities. Owners will have to warranty certain aspects of the business sale and the due diligence process gives certainty and definition to those. For buyers, it offers reassurance that the business is robust and has been presented to them accurately. 

You should conduct due diligence in a systematic fashion. This way it covers all potential issues and allows you to mitigate risk pre-sale. Risk mitigation leads to a better sale outcome. So, completing due diligence early provides you with more time to fix issues before the sale.

Due diligence occurs in various scenarios dependent on each business. These might include background checks on employees, product manufacturers, and a company’s finances. This is all about the buyer checking that the business they are about to inherit is exactly as has been described.

To make sure the investigation is successful, it’s helpful to reassess your goals. Like any project, the aim can get diffused along the way. The level of detail required in your due diligence should reflect the size and nature of the business sale. 

Expecting a small family-run manufacturing business to present the same level of due diligence as Rolls Royce is not viable. Remind yourself of the goal to keep on track. You don’t want the checks to take longer than needed but they do need to be fit for purpose.

The role of legal documents and contracts in due diligence

Due diligence encompasses many aspects of the sale. An essential section of due diligence is legal due diligence. All owners must review legal documents and any contracts in the process.

This isn’t just for the buyer, though. Reviewing legal documents benefits both the buyer and the seller. Here, you can identify any legal risks and ensure a beneficial exit for yourself.

But what types of documents should you check in legal due diligence?

Standard documents in this step of the sale process include customer contracts, supplier contracts and any past or pending lawsuits. These allow you to assess any legal issues before you hand over your business. Other standard legal documents include intellectual property details, trademarks and copyright registrations. These are important as you can protect your intangible assets before an exit.

Legal due diligence also reviews any property leases, tax documents, and warranties. In some cases, you may even need to examine environmental laws or licensing. If your business manufactures cask ales, are your premises correctly licenced to operate as a brewery? If you offer financial services, are you correctly qualified and registered to do so? 

As a business owner, you’ll be looking at due diligence from the sell-side. Though a buyer needs due diligence to affirm any risks, this process benefits you too. Due diligence can help to identify and rectify any gaps in your business such as not holding the legal title of your company domain name. 

Starting your due diligence process early is key. If 90% of your sales come through your website, yet you don’t own the legal title to the domain, your sale could collapse. Preparing your due diligence ahead of coming to market means your buyer may not know there was ever an issue. You’ll experience a smooth sale which is more likely to complete.

A buyer will use legal due diligence to understand your company and its operations. They will also look for security for their future ownership. No one wants to accidentally pay more for a business that isn’t protected and can be easily hijacked by competitors. And if you think that’s not likely, big brand names that forgot to auto-renew their domains include Yorkshire Bank, Dallas Cowboys and even Microsoft. All have had to re-purchase them at an inflated price.

Woman organizing legal documents and contracts for due diligence

So, legal due diligence should be at the top of your list. For you, the exit process is more organised and less stressful the earlier you start checking and gathering this information together.. For the buyer, they’ll feel more comfortable going ahead with the purchase.

Reviewing employee records as part of due diligence

Legal framework isn’t the only aspect of pre-sale due diligence. Employee records and information are also included in this review.

In your due diligence report, you also need to disclose employee contracts. It’s also advisable to include employee records, pay information, and length of service too.

Potential buyers will want to know about employees as this can flag any potential issues or risks. Employees are essential to your profits. But, a buyer will want to check whether your employees are valuable assets or liabilities. This protects the company’s future and informs them of the business framework.

A buyer will be looking for a business with the potential to grow, and employees are essential to growth. After all, due diligence ensures the company is ready for a takeover.

Again, completing due diligence early will put you in good stead. If any issues occur, you can mitigate their risk and fix them before the sale. Potential issues happen, but don’t let them affect your sale value.

Intellectual property checks when doing due diligence

Do you have intellectual property that needs protecting?

Alongside legal and employee checks, you might need to complete intellectual property checks. This is a detailed review of your ownership of the intangible assets and their quality. The outcome of this review will identify the value of the property. It can also identify any risks that might occur in the transfer, such as rights reverting to the individual staff members, rather than the organisation they were employed by, if the company is sold. 

Intellectual property due diligence checks have become a standard step in a business sale. They also occur in mergers, dissolution, and when licensing any intellectual property rights.

During an intellectual property check, three main steps occur. You’ll need to gather all relevant intellectual property documents and contracts. Next, check through all the content, ensuring each receives a thorough review. Finally, you can assemble a report which shows the analysis and validity of the property.

The outcome of an intellectual property report will confirm the validity of assets. It can also highlight any issues, allowing you to resolve them. Due diligence might highlight areas that need further examination. So, be aware that you might need to re-check aspects.

Working with a professional can make the intellectual property path easier. Some experienced solicitors might charge higher fees, it’s worth it for the efficiency. Peace of mind is priceless.

The initial stage of the due diligence process

Is it time to start your due diligence process?

The initial step is an important one. You want to stay organised and thorough from the start. Set the tone for the check by taking the process slow from the outset.

When you’re ready, the first step is to create a due diligence hypothesis. A hypothesis is a proposed explanation and an investigation starting point. While this might sound strange, business exits don’t use complicated hypotheses. Often, they sound like ‘The valuation submitted by the company is correct’. The buying company will then prove or disprove the statement with due diligence.

Once the first step is completed, the companies can move on and start the investigation.

The detailed stages of the due diligence process

Due diligence isn’t complete after one stage. There are many elements to consider throughout this complex investigation.

But, these details don’t come without challenges. Many businesses face tedious waiting processes and poor communication. This is why it’s important not to leave the process until the last moment. If a buyer asks for a stock list and you regularly update yours or operate an electronic POS system of some sort, you can provide it straight away. 

If you are still using manual stock sheets and there are boxes of components in the back of the store which have been there for decades because they are hard to access, producing an accurate list will take some time. Delays such as this eat away at the trust a buyer has in your business and doubts will start to creep in. 

Of course, a business exit isn’t a quick process. However, starting the details and organisation early will help you in the long term and make your business much more streamlined to run whilst you do own it. 

Also, you’ll need to work with professionals for specific jobs to avoid a lack of expertise. For example, an intellectual property expert will help you in detailed areas, but you’ll also need to consider costs.

Ensure you take time to delve into the details of each element. The more thorough you can be, the better. Make sure each aspect is clear and ready to present to your business. High-value exits rely on the details.

Seven elements of the due diligence process when selling your business

Is it time for you to start the process? If you’re planning your due diligence, there are seven elements you should know.

These elements are what a buyer will want to look at. So, when planning your framework, make sure you include these.

The more time you take to check and fix any issues, the higher your likelihood to complete a sale will be. Remember, buyers won’t pay premium prices for businesses with unresolved issues.

Here are the top elements you should note when performing due diligence.

1. Financial

Financial records are usually the first element a buyer will want to explore. Since they’re planning on taking over your company, everything needs to be transparent. This includes your books and other financial documents.

To ensure your finances are up to date, there are specific areas to examine. These include balance sheets, income statements, invoices, and payables. Having systematic recording and filing processes in place will save you time in running your business and demonstrate trustworthiness to a buyer who will want to follow a customer journey through your records from purchase order, through delivery note, invoicing, payment and to bank reconciliation. 

It’s helpful to work with an external accountant ahead of the sale. An accountant can review or audit your files, making the process faster. If you haven’t worked with an accounting team, you should also ask one to review your past books. This will ensure that all historical records are good to go too.

An accountant can review or audit your files for due diligence

2. Legal

Legal contracts are a vital element of business. These frameworks define boundaries and keep your professional relationships organised. From suppliers to employees, contracts are essential for everyone.

When buyers enter a new company, they need to understand contracts and relationships. Long-term contracts and leases are the most important. Long contracts can determine terms for the next decade, directly affecting the future of the business.

In legal due diligence, it’s important to look for ‘assignability clauses’. These allow you to assign your new buyer to the contract without permission from the other party. If the other party has the right to refuse, these contracts can become worthless. This can even bring the sale to a halt. So, make sure you check everything and reach out for legal advice if needed.

3. Customers

Business sales can affect customer relationships. Sometimes customers will break away when a company changes hands. While this isn’t always the case, it does happen.

Your buyer will want to know if the major customers will continue with business post-sale. A buyer will rarely want to complete a sale if there aren’t any customers to trade with. Luckily, there are some ways around this.

Conducting regular customer satisfaction surveys combined with a defined complaint and suggestions system for them to access if required helps to build a more secure relationship between them and the business. It also helps a buyer assess the loyalty of those customers and their likelihood to stay loyal post sale. 

Either way, customers are a must-discuss topic when selling.

4. Employees

Employee checks are an emerging area of due diligence reviews. This allows the next buyer to see what the employees think about the company.

A business which gathers feedback in an annual employee survey will be able to demonstrate how satisfied staff are to work for the business. This is an indication that they will remain after the business is sold, which gives the buyer stability and customers continuity as to who they are dealing with on a day to day basis. 

The other side of employment is the legal rights to raise a claim against an employer. In many cases of unfair dismissal these have to be brought within 3 months of employment being terminated, but for claims relating to unsafe working environments (think asbestos claims where unsafe working conditions weren’t identified for decades) there is no timeframe. Having records on file which confirm the actions of the company in a variety of circumstances are vital.

5. Inventory

Inventory due diligence will look different for each business. For some, this aspect will be part of the company’s financial process. But, for distributors or manufacturers, it will need its own in-depth check. A detailed check occurs when inventory is a large part of the business value.

The main risk due diligence looks for is slow-moving or obsolete stock. Stock (whether parts or completed goods ready for sale) is an asset and part of the value a buyer is paying for your business. If some of that stock is obsolete and has no hope of being turned back into cash, buyers won’t pay for it. Think about an electronics manufacturer who is holding a large number of VHS video machines ready for sale. Realistically, who will buy them in the streaming age? 

If you know you have current inventory sitting around, don’t worry. Removing your stock before the due diligence process won’t affect your sale price. Just ensure that you liquidate obsolete inventory/stock/products before the buyer completes a check. It might be selling component parts on sites like Ebay or scrapping others, but get them turned into cash or written off the stock value and out of the warehouse.

Remember, nobody wants to inherit old clutter. 

6. Reputation

Reputation might not be the first element you associate with due diligence. Yet, your company’s market reputation will affect the value of your sale.

But, how do you measure reputation? In the modern world, social media apps and online reviews can tell you a lot about a company. These areas can determine what customers think about your business. It also signified which communities your business is most prevalent in.

It can also be helpful to compare your company to competitors. See how you measure up against others in the online world.

Many employees and customers also complete reputation due diligence on companies. This usually occurs when they’re considering buying or working with them. In fact, likely, you’ve also completed these checks too.

Reputational damage, particularly through social media accounts, is increasingly becoming the target of hackers so your due diligence should also demonstrate effective password controls and third party authentication protocols. 

7. Culture

Finally, culture is another crucial element to assess. Did you know cultural mismatches are a prominent cause of acquisition failures? Working culture matters more than many expect.

How much does your buyer know about your company’s working culture? If they operate in a different manner to you, it might cause friction when they take over causing employees to leave.

Two different working cultures aren’t always incompatible. There are even instances where a new culture re-vitalises and re-vamps the business.

However, different cultures do heighten the risk of the sale. This increases the chance of misunderstandings. So, if your buyer wants to investigate your culture, understand that it might be for the best.

Cultural diversity and different working cultures should be considered for due diligence

Final Thoughts

Due diligence isn’t everyone’s favourite sale step, yet this necessary evil will help you achieve the price you deserve. Anything a buyer uncovers which is detrimental to their successful takeover of your business usually results in a revised, lower offer price.

Achieving a smooth exit and a high-value price are the priorities for most sellers. Therefore, sellers should prioritise due diligence, as well as a comprehensive exit strategy. Many aspects need to come together for a smooth sale, so don’t miss any out.

Many sellers find that curated checklists are the best route to a high-value sale. If you’re in need of a solution, Uscita can help. Our free Selling A Business Checklist PDF is here to make sure you don’t miss a step. This checklist provides guidance and advice to businesses in all niches. Plus, we formulated the contents from years of experience in the industry.

If you’re preparing for a business exit or considering your options, we’re here to help. Uscita is a business broker that will guide you every step of the way. Whether you’re interested in a free business valuation or achieving your true value, our services are ready.

When you’re ready to work with an expert, get in touch with us here to learn more.

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