Selling Your Business: A Guide to the Due Diligence Process

When selling a business, you have to make it through a few stages before the deal is complete and you get paid. Usually, the process starts with both sides signing a letter of intent (LOI) or a similar memorandum of understanding that says you want to sell your business and the buyer wants to purchase it.

The LOI shows that both sides are serious, but you still have some details to work out before any money is exchanged. Before purchasing a business, any conscientious buyer will want to know as much about the company as possible so that they're fully aware of any outstanding or potential liabilities. To properly assess a business's value and to decide whether it's worth going through with the purchase, the buyer will need to conduct what's called a "due diligence investigation."

Table of Contents

• What Is Due Diligence?
• How Do You Prepare for the Due Diligence Process?
• How Do You Navigate the Due Diligence Process?
• Talk to a Business Attorney

What Is Due Diligence?

Due diligence is the process by which the buyer requests from the seller any documents, data, and other information about the company the buyer wishes to purchase. The buyer then reviews the information and documents to identify any potential liabilities or roadblocks that could affect the transaction.

The results of the due diligence process can cause the buyer to react in a variety of ways, from demanding a reduction of the purchase price to terminating the transaction altogether. For example, if, during the due diligence process, the buyer finds out that the seller has made some bad investments, the buyer might change their mind and decide not to purchase the business.

Typically, in the due diligence process, the buyer will send the seller a list of documents and information that they would like to look over. Once they receive the list, the seller will work to provide the buyer with all the requested information.

The due diligence process is generally the most time-consuming and burdensome part of the purchase process. To make it out on the other end, you'll need to know how to prepare yourself, what to expect, and how to protect your company.

How Do You Prepare for the Due Diligence Process?

You'll need to take some steps to prepare yourself for the due diligence process. Learn what the buyer expects from you and prepare yourself and your team for the project ahead.

Find Out What Information Your Company Will Be Expected to Provide

The first thing you need to know is what kind of information the buyer wants to review. The most cautious purchaser will want to see everything. However, depending on the particular nature of your business, other purchasers might only be focused on specific areas.

For example, if you own a technology company, then the buyer might be primarily focused on your intellectual property (IP) ownership and applications, IP licenses, employee assignments of proprietary rights, and so on. If, on the other hand, your business is uniquely prone to environmental concerns, then the primary focus of the buyer's diligence review might be environmental reports and certifications. The information you'll be expected to provide depends on the buyer's specific concerns.

The Due Diligence Checklist

Generally, you should prepare for the following types of due diligence:

• Financial due diligence. The buyer will likely want to review your company's financial statements, cash flow, revenue trends, assets and liabilities, tax statements, and general ledgers. They'll also want to know about any outstanding debts and liabilities as well as financial projections to assess the financial health of your company and determine its value.
• Legal due diligence. You'll probably be expected to provide your company's organizational and corporate documents, such as your articles of incorporation, bylaws, operating agreements, and stockholders' agreements. The buyer will likely want a record of your company's property, including real estate, personal, and intellectual property. You'll also probably need to provide copies of any current contracts and agreements with suppliers, customers, and employees. Finally, you'll likely need to disclose whether your company is part of any lawsuits or has any legal or compliance issues.
• Operational due diligence. The buyer will probably want to examine your business operations and processes. Be prepared to provide information about your business's marketing and sales strategies, inventory management, supply chain, production methods, IT systems, cybersecurity, and management team.
• Human resources (HR) due diligence. Be prepared to provide employment records, such as employment contracts, benefits and compensation packages, workforce demographics, and turnover rates. You'll also need to have your HR policies and procedures ready. Be prepared to disclose any potential or current labor disputes or claims.
• Industry-specific due diligence. Your business might face specific scrutiny based on your industry. You'll probably need to show compliance with industry regulations and government requirements. You might need to provide copies of permits, registrations, and licenses.
• Other due diligence. The buyer might also want to see your insurance policies and any settled or outstanding claims. You might also need to answer questions about your company's culture, reputation, and publicity.

In any case, the buyer should provide you with a list (the due diligence request list) of all categories of documentation and information they want to review. You should emphasize to the buyer that the initial list provided should be as comprehensive as possible. Providing a complete list up front can help limit or avoid incremental, supplemental requests that could weigh down the process.

Establish a Due Diligence Contact Person

You should designate one or multiple people to be due diligence contacts for the buyer. Designating a specific contact person will allow for the due diligence process to be better organized, more efficient, and less frustrating for all parties involved.

A due diligence contact could be:

• you
• general counsel
• the chief operating officer
• the chief financial officer, or
• anyone else you would deem best suited to manage the process.

The contact person has a big responsibility that involves coordinating with the buyer, people within your company, and outside agencies. Their responsiveness to the buyer and the buyer's legal team might be critical in determining the outcome of the sale. So, you should choose someone who's trustworthy, efficient, and responsible.

Assemble a Team of Advisors

The due diligence process is a large undertaking that involves a lot of moving parts. It's a good idea to prepare yourself for the task ahead by putting together a team of experienced people. Your team could include lawyers, accountants, HR professionals, valuation experts, and other business consultants.

You should hire a team that can help you:

• gather and prepare documents
• respond to buyer requests
• fix any issues that come up during the process, and
• advise you on your company's best interests.

For example, you might want to hire an accountant to organize and prepare your financial documents before you turn them over to the buyer. In addition, an HR professional can help you determine what employee information you can legally share.

Protect Your Company's Information

During the due diligence process, you'll be giving the buyer access to sensitive company data. The buyer will likely have access to trade secrets and other proprietary and confidential information.

Trade secrets could include:

• customer lists
• marketing strategies
• manufacturing techniques
• product designs
• computer algorithms
• business plans, and
• production methods.

To protect your company information, you should have the buyer sign a nondisclosure agreement (NDA)—sometimes called a "confidentiality agreement.". By signing an NDA, the buyer promises not to share any of your company information without proper authorization. NDAs are common for business purchases so it's reasonable to have your buyer sign one.

Fix Any Known Issues Before the Due Diligence Process Begins

If you know of any gaps in your business's profile or any shortcomings or issues, fix them now. The sooner you address these problems, the better the outcome. For example, if you're behind on taxes, pay them and any resulting penalties so that you don't have any delinquencies on your account. If there's a discrepancy in your general ledger, investigate it. You'll want to know whether the discrepancy is just a clerical error or a sign of a larger problem.

You should address these problems before the due diligence process begins. If the buyer discovers the issue during their review, they'll likely want you to resolve the matter anyway, and you'll have to follow up with the buyer on your progress and resolution.

An existing issue could also prompt the buyer to demand a lower purchase price to account for the liability. But if you fix the problem before the due diligence process begins—depending on the problem—you might not have to inform the buyer that there was ever an issue.

How Do You Navigate the Due Diligence Process?

Once the due diligence process has begun, you'll need to know how to respond. Just like the rest of the purchase process, it's a negotiation. You should give the buyer the information they need to make an informed decision, but the amount of information you give and how you deliver it is negotiable.

Negotiate the Documents Your Business Will Provide

Once you've received the due diligence request list, your company's department managers should carefully review it so that they can point out any requests that might be overly burdensome or impossible to provide. These managers should also be able to give you immediate feedback regarding any items that can be summarily answered with "none" or "not applicable."

Any requests that are too difficult to meet should be negotiated with the buyer as soon as possible. Open negotiations can help manage expectations from the start.

For example, suppose the nature of your business requires all directors, officers, employees, contractors, and other representatives to sign a boilerplate NDA. In that case, these NDAs could number in the hundreds, if not the thousands. If the terms of these NDAs don't materially differ from one another, then it's likely that you can negotiate up front with the buyer to either provide a handful of sample NDAs or your company's standard form.

Be Thorough In Your Response

You should be as thorough as possible in your response to the initial due diligence request list. Providing a complete and clear answer can minimize subsequent requests. It'll also reduce any leverage that the buyer would otherwise gain if a potential liability were to be revealed later in the negotiating process.

For example, suppose Lex Corp. wants to buy Kent Systems for $5 million. But the day before the deal closes, Kent Systems reveals to Lex Corp. that it has overdue taxes totaling $200,000. Now aware of this tax liability, Lex Corp. has much more leverage to demand a $200,000 or more reduction in the purchase price, or else threaten to delay or cancel the closing.

Keep Records of All Information Provided

Your company's diligence contact should use the buyer's due diligence request list as a guide for not only categorizing and providing the documents requested but also for keeping track of what materials have already been delivered. One of the most frustrating things for a seller is to have a purchaser make repeated requests for information that the seller is confident they have already provided.

It's also a good idea to keep a record of the information provided for security reasons. Your company information is valuable and you should know who has access to which information. If the deal falls through and your proprietary information is leaked, you'll have a record of who had access to that data.

Talk to a Business Attorney

The due diligence process can be taxing. You're tasked with gathering and sharing your company's information in the hopes that you can sell your business for a good price. The process can take months and there are many opportunities for obstacles that can stall, or even worse, cancel the deal altogether. If you're up to the task and have experience selling businesses, you can probably navigate the process on your own.

But if you don't have experience selling businesses, you should talk to a business attorney that does. A lawyer can help you negotiate what documents you should provide and what the time frame for the due diligence process should be. They can also help you prepare an NDA to protect your company's confidential information and assess potential risks throughout the process.