Twenty percent of engaged couples break it off before the wedding. At least that’s what I heard and I thought the number was low. Sure, the proposal and engagement parties are pure bliss and filled with anticipation of walking the aisle, but not long after, some might start to see yellow or red flags. Maybe the fiancés’ true colors reveal themselves under the pressure of planning a wedding, maybe it’s discovered that with the marriage comes loads of debt, maybe you meet the in-laws (and it ain’t so good), or maybe there’s simply cold feet.
Due diligence is like the season between the accepted proposal and the “I do.” When that letter of intent is signed, everyone’s on cloud nine and an inexperienced seller can feel like the hard work is over, that it’s downhill from there. The experienced buyer has a different perspective. They’re like a groom or bride with 100 marriages under their belt. They’ve had good unions and they’ve had bad unions and they are all the wiser for it. Hopefully you’ve picked a good partner who’ll do it nicely, but they will probe (and hire a whole team of people to probe) to make sure they are entering into what is expected to be a solid union. Oh, and they never walk the aisle without an airtight prenuptial agreement (i.e., purchase agreement). We advised one seller last year where the buyer had a due diligence team of more than 50 people, and the initial due diligence request was a book. Seller beware, and get ready for an uphill climb.
There are typically six major diligence categories, including Financial/Tax, Legal, HR Benefits, Insurance, IT Systems, and Environmental. Not all categories are created equal. As you can imagine for most businesses, Accounting/Tax due diligence is the most intense with Legal due diligence a close second.
Financial/Tax Due Diligence – Sellers should expect to have the most work, questions, and deepest dive from the financial due diligence team. Sophisticated buyers always hire a third-party advisor to investigate the seller’s company and to produce a quality of earnings report. The buyer’s advisor will provide a list of questions, and typically, the advisor will schedule and attend a site visit to ask probing questions related to the financial trends and accounting processes. The seller’s CFO/controller, tax professional and CEO are normally in attendance. The areas of particular focus are TTM (Trailing Twelve Month) or valuation period EBITDA, addbacks and adjustments, GAAP and non-GAAP comparisons, working capital, accounting systems and processes, and tax implications of the deal structure. After this site visit and close examination of the financial results and processes, the advisor will produce a quality of earnings report. This report is often the gating factor for legal and the overall deal moving forward.
Legal Due Diligence – Buyers will of course have transaction lawyers representing them in this process, as should sellers. The initial legal requests are typically very straightforward, tying back to discrete legal documents such as articles of incorporation, operating agreements, amendments, board minutes, etc. They will of course investigate to see if the seller has any existing legal issues, such as IP ownership/protection, outstanding lawsuits, problems with the IRS, etc. The buyer’s legal team will provide a draft purchase agreement once the buyer has received all third-party advisor diligence reports and findings. At that point, some of the topics or terms addressed in greater detail are working capital, escrow, indemnification, reps and warranties and tax structure.
IT Systems Due Diligence – The level of probing for IT systems in due diligence varies. The more dependent a company is on IT systems, the deeper the probe. This is especially true for software companies where the buyer will want to carefully examine and understand the existing code. In this process, typically another outside party will review the overall technology infrastructure, which involves networks, operating systems, purchased software, accounting/ERP systems, industry/operational packaged software systems and other proprietary/custom packages.
HR Benefits Due Diligence – The buyer wants to understand what employee benefits the seller provides so they can better know how to transition these benefits to the seller’s employees post transaction. This is more collaborative than other parts of due diligence, and many times the buyer, because they are larger, have better benefits than the seller. Key employees will be addressed individually, but most all non-compete and employment agreement issues will be dealt with as part of the legal process.
Insurance Due Diligence – Buyers will want to determine if the seller has adequate insurance coverage. This will include inquiry into insurance amounts, terms, quality and types. Buyers’ insurance advisors ensure the that the benefits of insurance policies are properly transferred, design runoff or tail coverage, structure coverage to match the terms of the transactional documents, assess pending claims, and evaluate whether potential claims have been properly reported.
Environmental Due Diligence – For most sellers, environmental due diligence is a non-issue. The big exception is for companies handling and mixing chemicals or waste. Action taken by the buyer in this process is typically seeking information about the seller’s site or sites, and coordinating visits. Based on the utilization, purpose or historical use of each site, the buyer may choose to perform a Phase I Environmental Review. If the review comes back clean, this is most likely the extent of this due diligence. If the Phase I uncovers unexpected issues, further measures will be taken, such as a Phase II Environment Review or exploring the costs of remediation.
Negative or unexpected findings in any category of due diligence may cause the buyer to walk away from or renegotiate the deal. This is why it is extremely important for a seller to 1) represent the business properly prior to entering into a letter of intent, 2) properly negotiate a letter of intent to address the hot-button issues, 3) manage the due diligence process in an organized and professional manner, and 4) obtain advisors to help manage and represent the seller as issues arise.
About Founders Investment Banking
Founders Investment Banking (Founders) is a merger, acquisition & strategic advisory firm serving middle-market companies. Founders’ focus is on oil and gas, industrials, software, internet, digital media and healthcare companies located nationwide, as well as companies based in the Southeast across a variety of industries. Founders’ skilled professionals, proven expertise and process-based solutions help companies access growth capital, make acquisitions, and/or prepare for and execute liquidity events to achieve specific financial goals. In order to assist Founders Investment Banking with securities related transactions certain Principals are registered investment banking agents of M&A Securities Group, Inc., member FINRA/SiPC. M&A Securities Group and Founders are not affiliated entities. For more information, visit www.foundersib.com.