Like the men and women on Naked & Afraid, business owners who are not prepared or not well represented during the due diligence phase of selling their business may feel very exposed.
“Naked and Afraid” is an American reality television series that airs on the Discovery Channel. Each week two survivalists–a man and a woman–meet for the first time and must survive in the wilderness naked for 21 days. After they meet they must find and/or produce water, food, shelter, and clothing to survive.
Like these survivalists, business owners, who are not prepared or are not well represented during the due diligence phase of selling their business may feel exposed. It is during this due diligence phase of the sale that the seller opens the kimono and allows the buyer access to the operations of the company.
The business owner understands that the buyer needs to meticulously scrutinize their business during the due diligence stage, to fully understand its operations and to discover any problems, issues or threats that might impact the agreed to price within the Letter of Intent. If the owner is not prepared for the rigors of the due diligence, they will likely experience undue stress and potentially diminish their chances of securing a premium price for their life’s work.
As an investment banker, I have helped many business owners prepare for the due diligence process. To avoid feeling naked and afraid, and to ensure that the due diligence process runs smoothly, business owners need to focus on three key areas before the sale:
1) Financial records
Numbers, statements, reviews! The more complete, and verifiable a business’s financial statements are before the sale begins, the more confidence the buyer will have during due diligence. A comprehensive audit of your financial statements by a recognized accounting firm is a recommended strategy in advance of due diligence. Ideally the accounting firm will audit company records for the last three years. If time and expenses are factors, financials can instead be simply reviewed. Other important financial check marks owners should execute before the sale include:
- Reconcile financial statements to bank account statements every month.
- Establish security measures to prevent internal fraud.
- Recognize revenue and expenses in a GAAP-compliant manner.
- Determine what amount of expenses are potential “add-backs.”
- Reconcile actual inventory to financial statement inventory.
- Ensure depreciation schedules and inventory book values are MACRS-compliant.
- Identify any “off-balance-sheet liabilities” that would concern potential buyers.
2) Systems, people and operations
A key issue a seasoned buyer must address as part of their due diligence process is whether the company is sustainable “as is” or will it require the investment of a lot of time and capital in order to improve it to meet the buyer’s standards. The buyer needs to be confident that the company can maintain or exceed its current performance after the deal closes, especially once the current owner is no longer involved in daily management. The future success of the business cannot be overly dependent upon you. Pre-sale operational checks should focus on the following areas:
- Establish a management hierarchy that will sustain the business after the founder/owner leaves the company.
- Create a proven hiring and training process to facilitate growth.
- Document fraud-proof systems for accounting and finance.
- Document established systems used for engineering, product development, production and quality control.
- Establish a firm pricing list/methodology that does not rely upon what is “in the owner’s head.”
- Ensure that key management and sales roles are distributed between several individuals and not tied to one key executive whose departure could devastate future performance.
- Define specific marketing, sales and promotion systems for diversification of your customer base.
3) Legal, regulatory and patents
The fewer outstanding or potential legal issues that may arise from regulatory compliance and patent protection, the more confident the buyer will feel before the sale. Pre-sale legal reviews should focus on the following areas:
- If possible, settle all outstanding lawsuits in a fair and equitable manner.
- Use arbitration as an option to expedite the legal process if necessary.
- Determine the long-term impact of protracted litigation on company performance.
- Ensure full compliance with ADA, EPA/Superfund, ERISA, and other industry specific regulations.
- Ensure patents, copyrights, trademarks and other proprietary information are finalized for key products and/or systems in order to sustain the company’s established competitive advantage after the sale.
Owners who have not fully addressed these important issues before the sale may feel naked and afraid during the process because they are not adequately prepared or do not fully understand why the issues are important to the buyer. Owners who work with an experienced investment banker will receive guidance in all of these critical areas. If the owner understands and prepares for the due diligence process, he or she will not feel intimidated by what occurs. It will also facilitate the sales process and make it more likely that the transaction will be completed.