What is Due Diligence and What Does it Entail?

Dbusiness due diligenceue diligence is an investigation of a business or person prior to signing a contract.  More specific to a business sale, business due diligence is the process of verifying the representations made in the CIM and other marketing materials provided to the potential acquirer by the seller.  For example, in a CIM it may say that the seller’s customer contracts have an average life of three years and that no single customer accounts for more than 5% of revenues.

The potential acquirer will extend an expression of interest based, in part, on this information (remember, while the CIM highlights all the facts that drive sustainable value – it still holds back competitive sensitive information).  Business due diligence is the act of examining and verifying all of the signed and valid customer contracts and, in this example, confirming that customer contracts do, in fact, have an average life of three years and that no single customer does account for more than 5% of revenues.

Due Diligence Process Checklist

A seller should always keep due diligence in mind when thinking about the sale of their business.   We typically provide sellers with a due diligence checklist early in the process so that they can take the first several months of the process to get organized and assemble the documents.  The  documents required for due diligence include all material signed contracts such as customer contracts, banking agreements, funding contracts, shareholder agreements, employment contracts, as well as resumes, benefit commitments, internal financial statements, receivables/payables aging schedules, capital acquisition and depreciation schedules, tax records, asset listings, articles of incorporation, the minute book, and perhaps software architecture documents, product road-maps, environmental assessments, historical board presentations, and ultimately customer and bank reference calls.  These are just a few of the items typically included but, generally speaking, it consists of everything material to the well being of the company.  Clients provide us with these documents and we scan them and selectively, and in stages, make them available in a virtual data room to be shared with relevant parties.

The Due diligence process generally happens in phases

Some due diligence is performed before exclusivity (i.e. a signed LOI) and most after.  The first phase of due diligence is business due diligence; this is where the acquirer’s executive and accounting teams figure out exactly how the revenue streams and products of the acquirer and target complement each other in order to determine how much they can pay for the target while meeting their own ROI targets.  This phase can include third party contractors to perform such things as Quality of Earnings Reports  or technology audits.

Legal due diligence occurs during the exclusivity period and will include title searches and other searches to ascertain the target company is a valid company, owning the assets that it purports to own and operating within the regulations of the jurisdiction and that no lawsuits or claims are outstanding.  Once a certain amount of due diligence is completed parties typically initiate work on the purchase and sale agreement.  Sixty to ninety days is a typical time-frame from signing an LOI to closing the acquisition of a straight forward private company.

Reps and Warranties

Finally, after due diligence the seller will still be asked to represent that they did not withhold any information, such as knowledge of potential lawsuits, in a purchase and sale agreement.  In “What Does a CIM Include and How Do You Position It?”, we noted that a CIM must not over-promise or leave less than flattering facts out because it forms the basis of an expression of interest that may turn into an LOI and, ultimately a purchase and sale agreement.  Due diligence will make the CIM seem like  a light read.

Recommended Further Reading

For more on reps and warranties, see: Reps and Warranties: Common Issues and Resolutions

For more on the sale process, see: The Sale Process