What’s Due Diligence?

Trust, but Verify
due diligence

Business Law Firm

The due diligence stage can appear to be a daunting task for a prospective buyer of a business. Imagine you’ve put yourself in a position to finally invest in that company you’ve been researching. How do you know the claims made by the seller are legitimate? What steps do you need to take to protect your investment? Where do you start?

Ronald Reagan once said of treaty compliance by our Soviet adversaries, “Trust, but verify.” Due diligence is like that. It’s the process a buyer uses to verify the details of the business they’re about to purchase. No disrespect to the seller, of course. As simple as that concept seems, it can be a confusing time. Preparation in advance of the transaction can reduce the possibility of issues arising at the time of sale and ensure that the process runs well.

Imagine you’re Ronald Reagan. Are you going to take the Soviets at their word? Or are you going to want to see actual evidence that they’re complying? Spy photos are only the beginning. You’ll want to parachute into their missile silos and have a bowl of borscht with someone named Boris. Stroll Red Square and take photos of the Kremlin. Take shots of warm vodka with Sergei ask to see the disassembled nukes.  You get the point.

Every system within the company must be analyzed to painstaking detail. Depending on the nature of the business, you may want to divert extra attention to specific areas: retail companies may require a closer look at inventory and accounting practices; software companies may need an in-depth review of intellectual property; manufacturing businesses may require you to review quality control reports. Despite these variations, there are four categories where due diligence reviews can have the biggest impact: organizational documents, financials, contracts and litigation.

1. Organizational Documents

Previously, we’ve spoken about how important the organizational documents are for your business. They create the legal framework for how your entity is governed, and you shouldn’t skip this step of the process (or download a template). The larger the organization grows, the more is at stake.

Starting here in our due diligence analysis is a good idea because problems with organizational documents are relatively easy to resolve. For example, if you have a disorganized or ineffectual capitalization table with conflicting voting rights and various overlapping claims as to the ownership of the business, you’ve got a problem on your hands. Typically, a buyer will want to see a capitalization table where voting control is clean and concise; resting with a single owner or group of owners. One way to do this is to consolidate the ownership of the business by encouraging smaller players to sell their shares in advance of the sale of the company. Fewer members results in fewer voices at the table, which is a good thing for the buyer. You want as much consensus as possible from stakeholders during the sale process. If they don’t want to sell, that’s okay too. You may be able to update the voting rules or allow proxy voting. A voting agreement can accomplish this easily. Assuming the organization’s analysis satisfies us, we move on to the next phase: finances.

2. Finances

At this step, we’ll almost always bring in a financial expert such as a CPA to help us analyze the financials of the company. This step cannot be rushed and often takes a considerable amount of time to pour over years upon years of financial statements. Doing this step correctly ensures the buy that all of the financial claims made by the seller are backed up by hard evidence. If you want the highest level of analysis, an audit can be a great way to produce additional confidence in the buyer that the assets and liabilities of the business are as claimed. During this step, we also counsel sellers to minimize the amount of expenses that are passing through the business which are not essential to the operations of the company. Reducing the level of expenses will result in a better EBITDA (earnings before interest, taxes, and depreciation). Showing lower expenses over the course of several years will help you show better numbers to a prospective buyer and increase the likelihood of a sale. After finances, we move on to contracts.

3. Contracts

Contracts are the lifeblood of your business. They govern the agreements you have with suppliers, merchants, even employees. Taking time at this step in the due diligence process is important because unfavorable contracts can cause a long-term headache for a new buyer. Having contracts that benefit the company, or work to the company’s advantage are beneficial. Conversely, contracts which are disadvantageous should be exited as quickly as possible before sale. Moreover, the ability to assign a contract to a new owner is important because you want to establish continuity of operations so as to not cause a disruption. Sellers can benefit immensely from contractual due diligence, and therefore, we advise this is done with enough time to do it the right way.

4. Litigation

Liabilities can come in many forms, the most common of which is pending litigation which threatens the livelihood of the business. If you’re buying a business which is also facing a class-action lawsuit, of course that changes the calculus of the transaction significantly, if indeed you decide to proceed. Lawsuits come in various forms, but we’ve seen ones in the areas of employment, class action, intellectual property, and contract disputes. The due diligence phase will attempt to alleviate this liability by accelerating these cases as much as possible.

Trust, but Verify

Due diligence review is a time-consuming process that ultimately exists for the protection of both the buyer and the seller. It benefits the buyer by verifying the seller’s claims, and it benefits the seller by bolstering his claims and clearing up any confusion or misconceptions about the nature of the business. While it may induce discomfort given its seemingly unending nature, it is an important piece of the puzzle in selling a business and should not be overlooked. 

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