What a Buyer Looks for During Due Diligence

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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If you're considering selling your business — even a few years down the road — it's important to know what potential buyers will look for during the due diligence process. While "due diligence" can be used to describe several different investigations that anyone party to a contract might carry out before signing that contract, in the case of a buyer considering taking over a business, the due diligence process is usually focused on making sure that the business is exactly what the seller promises. That can mean looking at inventory, accounting records, and much more.

The Questions That Come Up During Due Diligence

Kumi Bradshaw's job with Asgill Post is to value companies, as well as provide advice during the business acquisition and sales process. He has been through the due diligence process many times with different clients, to the point it has become a routine process for him. As a business owner, there are some specific topics you should expect to discuss as you go through the due diligence process, Bradshaw says. He points out a variety of questions you will almost always be asked, pointing out that buyers consider cash flow one of the most important factors during due diligence:

• How much cash does the business generate? How does it generate cash? Is there documented proof of the seller's statements? Invoices, bank statements etc... Due diligence will go beyond the review of a Quickbooks file or standard financial statements.
   
• Does the business allow customers to pay on account? How are receivables collected and what are the terms? Are there significant outstanding receivables?
   
• What are the expenses like? What is the mix between fixed and variable expenses? As a rule of thumb, a business with a higher concentration of variable expenses versus fixed expenses will require a lower level of sales to break even.
   
• What is the burn rate? How much cash does the business need for operating expenses to be paid on a monthly basis? How much working capital is currently available to pay for this? This will influence the amount of financing required by the buyer.

During due diligence, your business can be in for scrutiny in every department. Expect to start with the most basic documents that make up your company, like the articles of incorporation for the business. You'll be expected to provide lists of all physical assets, as well as information on any intellectual property — including legal issues surrounding that property. Even your employees are in for close examination: just about every document in your human resources files will likely be reviewed.

The Problems Due Diligence Finds

The point of completing the due diligence process is to reassure buyers that they are getting exactly what they expect when they take over a business and that they can repeat the successes of the current owner. Bradshaw has seen more than a few problems show up during the due diligence process — problems that the current owner may not have even considered.

I have seen a seller with a business generating over 5 million a year in sales. There was next to no documentation. Price lists were kept in the seller's head, financial records consisted solely of the proverbial cardboard box full of bank statements. Our responsibility was to assist with buy-side due diligence and the buyer ended up closing the transaction, but because of concern about the records, the buyer ended up paying over $500,000 less than he might have been willing to pay.

Many of these problems come from the same source, according to Bradshaw. He says:

By far, the number one challenge that I have seen arise during the due diligence process has to do with transparency or lack thereof... this can be intentional, where a seller may not be 'telling the full story' or unintentional where a seller just does not have appropriate systems or has not been sufficiently organized as they been more focused on 'working in the business' than 'working on the business.'

It's important to limit the number of surprises that pop up during due diligence to the extent you can. That can mean bringing in an outside expert to go through your files with a fine-tooth comb before you even start looking for a buyer. With such an approach, you can resolve potential problems before the person you're trying to sell your business to can take a look at them. You'll still likely need to disclose that there were issues, but if they're already resolved, they won't be a barrier to sale.

Making the Due Diligence Process Smoother

Whether or not you're planning to sell your business any time soon, investing some time to "work on" your business, rather than in it, can be a wise decision. Bradshaw suggests starting with putting your financial affairs in order: everything should be on paper that an outside expert could easily review. That includes loans, taxes and other financial responsibilities. Bradshaw also suggests having financial statements prepared. At the minimum, having a balance sheet and profit and loss statements are important. Having historical profit and loss statements, as well as a budget and a forecast, can provide the information necessary to smoothly navigate the due diligence process.

Another issue that can significantly slow down the due diligence process is if you have mixed personal and business funds. It's crucial to separate your finances from those of your business, even if it makes your day-to-day money management more complex. Other issues can also arise from an overlap between personal and business matters. If there is a legal issue, for instance, it is important to resolve it before trying to sell your business.

Lastly, Bradshaw suggests organizing your business so that you don't have to pay so much attention to it during the due diligence process.

Have strong systems and management in place to keep the business running on an even keel. The due diligence process can be distracting and time-consuming. You don't want to lose profits, revenue, customers in the meantime.