World Class Mergers & Acquisitions  |  For Companies $5 Million to $100 Million in Revenue

What to Expect from the Due Diligence Process

By: James Darnell, KLH Capital

As with many things in life, expectations are key to having a successful outcome to the diligence phase of selling your business. The more you understand of the due diligence process — and match your expectations accordingly — the more you can prepare, the easier the process will be, and the most likely you will be to achieve the best outcome.

One of the most critical parts to preparing for the due diligence process is to understand the perspective of the buyer. Since investors are responsible for being wise stewards of their capital, they need to learn about every facet of your business and leave no stone unturned. They are trusted with the money of larger LP investors and they cannot be frivolous with that responsibility.

As a result, it is important to remember that the due diligence process is not personal. Investors are simply trying to best understand your business and, since you have run your business for years and accumulated years of knowledge and understanding, you are the best resource for them.

Generally, given the many stages that have already passed in the deal process, the investors will likely know a lot about the financials of your company, its performance, its history, and its structure. The diligence process will help confirm that information. If serious information discrepancies emerge, it can be a deal killer.

However, the deal professionals will also use the diligence time to learn new information. This will likely include more information on how to grow your business, possible new products and services, the landscape for potential acquisitions or add-ons, etc.

The Actual Diligence Process:

The diligence process, which can take anywhere from 3 – 6 months, will be led by the investor and supported in large part by a variety of experts employed on behalf of the investors — namely lawyers, accountants, consultants, and other service providers. They will be looking into five major parts of your company: overall business, accounting, legal, IT, and environmental.

Focus A: Business Due Diligence

In this phase of the due diligence process, investors want to understand i) the sustainability of the company’s revenue and cash flow and ii) the prospects of growing your business. To uncover these data, the diligence team will request a number of meetings and phone calls with you to extract all the wisdom you have built over the years of running the company. You should expect questions on nearly every aspect of your business, including: products & services, pricing, supplier relationships, operations, accounting, HR, IT systems, etc.

Once investors have a better understanding of your business, they will likely begin investigating the broader industry. The PE firm will likely hire third-party researchers to perform studies on your industry and customers to understand the most important market dynamics. Understanding this broader market picture helps investors understand the growth potential of the business and the landscape of products, services, and competition already present in the space.

The last major part of the business due diligence will focus on your customers. It is very common for investors to request calls or meetings with your top customers so that they can make sure the customer is comfortable with the transaction, better understand how the customer views your products/services, and make sure the customer will still want to do business with you after the deal closes.

Focus B: Accounting Due Diligence

After analyzing your business and broader industry, investors will begin reviewing your financial performance. This step is mostly confirmatory due diligence — making sure what you told them is the truth.

The review will not be as detailed or as in-depth as an audit, but is typically referred to as a “Quality of Earnings” report. In this report, accountants will help the investors understand your primary accounting policies, your compliance with GAAP, and any modifications to the financials that need to be made to become GAAP-compliant.

You should expect the investors to be very involved in this phase of the process. They will want to understand the economics of your business works — how delivering your products/services gets translated into EBITDA and cash flow.

Practically speaking, this stage of the process will require a great deal of data collection. To make the process as easy as possible, you should be prepared for your CFO/controller/CPA to be significantly involved in these discussions so they can help collect and prepare the requested information. Once the data is collected, accountants will likely be on site for about a week to review the information and ask questions. Although this may seem like a while, this is one of the most critical parts of the diligence process.

Focus C: Legal Due Diligence

In addition to the financial review of your company, investors will need to take a look into the legal side of the business. A group of lawyers will review all material contracts (i.e. suppliers, customers, service providers) to understand any terms or conditions that would result in liability going forward or any material change in the business.

Additionally, they will review leases to make sure the company will continue to have access to the needed facilities and confirm the terms of the lease are “market.” Other items to be reviewed include any current or prior litigation, the corporate books to make sure that there is clear title to the stock/assets of the company and all paperwork is in order.

Focus D: IT Due Diligence

The fourth key area of due diligence is information technology (IT). Like most of the other phases, the investor will bring in third-party consultants to review the posture of your current IT networks.

These consultants will help the investor understand the importance of technology to the running of your business, your historical spending on technology, the future expectations for IT budget, and any risks in IT infrastructure that could prove harmful for the business (i.e. cyber risks, disaster recovery, down time, etc.).

Focus E: Environmental Due Diligence

The last major area of due diligence is a review of the environmental risks associated with your business. While the importance and rigor of this diligence will vary based on your industry, consultants will review all publicly available information in Phase I of the transaction.

The goal of the review is to understand any environmental liability that may be associated with the business or potential for liability in the future. To uncover these issues, the consultants will perform detailed onsite inspections and will review any prior claims and/or issues.

These are the five core areas of the due diligence process to expect from every buyer in a transaction. There is no way around it. The due diligence process is hard work and will require extra effort on part of team that already has a business to run.

The best strategy to ensure success is to know what to expect, have the right attitude, and bring the right people onto your transaction team. If you do that, you’ll have a successful transaction that accomplishes the goals and objectives that you originally set out to achieve.