From Contract to Close: What happens during due diligence?

|Advisor Corner

You just signed a Letter of Intent with a buyer. Congratulations – you’re under contract! Now the fun starts. You heard about “the diligence process” from your friends who recently sold their businesses, and it sounds time-consuming and invasive, to say the least. What can you expect over the next 60-90 days before closing?

First of all, each transaction is different. Diligence does not look the same from one company to the next, even across similar industries or similar companies. Despite the unique facets of every transaction, there are some standard practices you can anticipate during diligence.

Due Diligence. Once the Letter of Intent (LOI) is fully executed, the due diligence process starts. The LOI typically outlines a target diligence period (usually 60-90 days, but sometimes longer).

During diligence, buyers examine the ins and outs of your company to understand the unique make up of your business. In order to identify and minimize areas of liability, buyers review every area from financials and insurance, to equipment and real estate. Depending on the buyer, this review can be done by their team internally or they will hire third-party advisors to perform detailed, professional reviews. There will be detailed request lists and often onsite visits to the operation to complete the full analysis. Below are five common areas buyers dig into during diligence.

  1. Financial/Tax – Most buyers hire an outside accounting firm to do a professional review of your financials and compile a report, called a Quality of Earnings, to verify your numbers are what you say they are and identify any process that is not GAAP-compliant. There will also be a tax analysis to confirm tax practices and the jurisdictions where you pay taxes (property, payroll, sales and use, etc.).
  2. Environmental – There is typically some level of environmental review of your facility, called a Phase I, to confirm any unknown environmental concerns at the facility. This is especially important if your business handles any kind of hazardous materials like chemicals, explosives, flammable solids or liquids, toxins, etc.
  3. Equipment – Equipment appraisals are relevant if your company owns a significant amount of expensive, capital equipment critical to business operations. Buyers want to affirm the value of any large assets on your balance sheet and might bring in an outside party to perform an appraisal of your equipment.
  4. Insurance – To ensure proper insurance coverage is in place, buyers hire outside insurance advisors to review current policies, verify they are current, and identify whether there are potential cost-savings post-closing.
  5. Employees/Benefits – The buyer works to validate a good, stable workforce will convey and there are not any underlying labor issues (workplace/harassment complaints, employees are eligible to work in the U.S., significant employee turnover, etc.). In addition, a review of current benefits and any potential cost savings will be completed.

Legal. After diligence is well underway and the buyer has some assurance in the results of the financial review and other critical issues, they prompt their attorneys to begin drafting legal documents. It’s to the benefit of both sides to get preliminary feedback on some of the main diligence areas. No one wants to run up a large legal bill without some preliminary legwork completed and validated on the merits of the business. Specific legal documents vary based on deal structure, terms, industry, etc. but there are a few staples that you’ll see on most transactions:

  1. Purchase Agreement (PA) – The largest document outlining all the details of the sale, the purchase agreement is the first to get drafted. The buyer’s legal team typically drafts the first draft, which gets redlined back and forth until closing. The PA includes provisions around working capital, purchase price allocation, indemnification, reps and warranties of the seller and the buyer, and more, all of which must be agreed upon before closing.
  2. Employment Agreement / Consulting Agreement – After closing, the seller is expected to support some level of transition – whether long-term employment or a short-term consulting period. This document outlines the terms and timeline of your employment/consulting arrangement, how you’ll get paid and receive benefits, etc. These items are negotiated during diligence. There is always a non-compete provision included – no buyer wants to buy a business and then have the seller turn around and become a competitor after closing. The buyer may also require that certain key personnel execute an employment agreement to confirm the business will continue on and everyone isn’t jumping ship with the seller.
  3. Disclosure Schedules. Attached to the purchase agreement, the disclosure schedules outline information referenced within the main document along with any exceptions to the representation. These include representations around contracts, financials, assets, liabilities and more. After diligence, these can feel like a lot of duplicate work, but they are key in confirming what the seller has represented about their business.
  4. Seller Note, Earn-out Agreement – If there is a seller note or earn-out provision in the LOI, these are often documented in separate documents at closing. The seller note details the terms of repayment and security of the note. The earn-out agreement outlines contingent payment terms when the company hits pre-determined metrics after the sale is complete.
  5. Ancillary Docs – Many other “smaller” documents circulate back and forth in the final weeks before closing.

While diligence is performed and legal documents are drafted, the buyer must also secure financing with their lender. This may require follow up diligence requests and a review of the material legal docs prior to closing.

At the same time, buyer and seller collectively identify an integration plan to transition IT, human resources (payroll, employment agreements, medical benefits, insurance) and finances (bank accounts, credit cards), and determine the best approach to communicate the sale to customers and employees.

Bottom line: there’s a lot going on. While selling your company is a very exciting time, the process can be overwhelming. If you’re ready to sell your business, consider engaging a top-notch M&A firm to support you through this extensive process. We do this all day, every day and love to help business owners, like you, close on the transaction you want.

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