When a business owner decides to go to market and to sell their business, they want to fully maximize the value of their business. One of the best ways to accomplish this is by presenting the cleanest and most comprehensive package to prospective buyers. One item that many business owners fail to do as they prepare for a potential sale is conduct a comprehensive due diligence review of the business. This failure is due to a couple of factors – sellers fail to appreciate the level of detail required by buyers in connection with a sale transaction and do not want to spend the time and money to take on this work until they know they have a buyer in hand. Unfortunately, avoiding the work associated with this review often results in increased time spent addressing issues that will arise when the buyer is doing its due diligence. Having the buyer raise issues that could have been addressed delays transactions (“time kills all deals”) and gives the buyer bargaining power.
We encourage our sellers to think about the pre-transaction diligence process as an investment in their business that will help them achieve a successful sale transaction. If a business owner goes to market without conducting pre-transaction due diligence, there will more than likely be due diligence items that a potential buyer will view as red flags. A buyer will often require that these issues be rectified prior to closing a deal. Buyers may still be willing to transact but at a lesser valuation due to the risk of these flagged items to the potential buyer. Conversely, if a business owner invests in pre-transaction due diligence and irons out any potential flagged due diligence items before going to market, the lack of flagged due diligence will likely instill confidence in the buyer and result in a greater valuation of the business. For example, if a business owner invests in pre-transaction due diligence and presents a comprehensive and clean business package to potential buyers, the business valuation may increase by an additional 0.5x or 1x EBITDA multiple. To summarize, the business owner’s investment in pre-transaction due diligence can have a direct correlation to a greater valuation of the business and, at a minimum, avoid renegotiating terms with the buyer or delaying a closing, which in and of itself carries risk.
The three pre-transaction due diligence items we urge our business owner clients to address before going to market are (i) legal due diligence, (ii) financial due diligence, and (iii) tax due diligence.
Legal due diligence: Legal due diligence involves: (i) making sure there is a comprehensive and accurate capitalization table that evidences the ownership of the company since its inception. If there are any gaps in ownership record keeping, we work with our client to close those gaps by documenting the missing corporate records to the extent possible and explaining any gaps that cannot be documented; (ii) reviewing the corporate records to make sure that (a) the business has adopted bylaws or an operating agreement (you would be surprised how often these documents are missing even in a company with multiple owners), (b) it is clear who the directors, officers, or managers of the business are and have been, and (c) the business has documented appropriate authority either by meeting minutes or written consents for all major events that occurred in the business’ history – e.g. any change in the company’s federal tax status, purchases of other business or the purchase and sale of real estate, or the issuance or redemption of any equity, the merger with any subsidiary, or the recapitalization of the business.
Financial due diligence: Financial due diligence focuses on ensuring that the financial statements are consistently prepared throughout the business’ history, determining whether the business has any abnormal accounting procedures, and if possible, if the business is not GAAP compliant, the business’ exceptions to GAAP. In pre-transaction financial due diligence for middle market companies, it is now standard to obtain a pre-transaction quality of earnings. A quality of earnings is a report that examines the quality and sustainability of the business’ earnings – essentially a deep dive into the business’ financial statements to assess how earnings are generated, identify any red flags or unusual trends, and determine if the reported earnings are likely to be recurring and sustainable. Having this information before identifying a buyer results in a high degree of confidence in the company’s EBITDA calculation and streamlines the buyer’s validation of the metrics underlying the business’ enterprise value.
Tax due diligence: Tax due diligence focuses on the business’ federal and state tax filings and returns. If the business is an S Corporation, we need to ensure (i) that the business properly elected to be an S Corporation and its corporate records – e.g. operating agreement or bylaws – were updated to reflect this election and (ii) that the business maintained its S Corporation election since its election (i.e. it has not taken any actions that could invalidate this election such as the issuance of equity to a non-eligible shareholder). Regarding state tax returns, we need to ensure that the business has filed, or files, all tax required state tax returns – for example, (a) has the business filed employment tax returns in all states where it has employees, including all remote employees, and (b) has the business filed all state and local tax returns in states where the business earns income.
In closing, although pre-transaction due diligence involves time and expense, business owners should view it as an investment that will undoubtedly facilitate closing a transaction on the best terms and an expedited timeline once it goes to market.