What To Expect During Due Diligence

What To Expect During Due Diligence

A deal team enganged in buy-side due diligence with a seller who knew exactly what to expect from the process.

Key Takeaways For Seller's Approaching Due Diligence:

This guide aims to prepare sellers for the formal due diligence process they will go through during the process of selling their business. Here are some things to cover before we get started:

  • The concepts in this guide are discussed in more detail, with more context in our free eBook Due Diligence: A Seller's Perspective. We recommend you read this resource for a more comprehensive understanding of due diligence and what to expect.
  • Here, we aim to focus on what sellers can expect from due diligence, if you are not familiar with what due diligence is or how the M&A process works, we recommend the above resource as a primer to this guide.

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What Can Sellers Expect From Due Diligence?

First, while the formal due diligence process will begin after we have a signed letter of intent, it's important for business owners to understand that the buyer's due diligence actually begins with the very first document, call, or meeting that a buyer has with the seller or their representatives.

From the perspective of the buyer, conducting due diligence involves gathering sufficient information to assess the value of the business while weighing both the already identified as well as potential unknown risks that may be involved.

Professional buyers have become increasingly sophisticated in how they go about conducting due diligence. In the aftermath of the financial crisis, the due diligence process has become an even more critical aspect of deal-making. Buyers are now placing a heightened emphasis on uncovering non-traditional risks and liabilities through more comprehensive examination.

It's important for business owners to understand the buyer's perspective during due diligence. You know far more about your business than the buyer does and they're aiming to address this fundamental asymmetry so that they can mitigate as much of their risk as possible.

Naturally, some parts of the due diligence process are structured; and some parts are more fluid.

In this section, we'll help you to understand what to expect from this part of the process. We'll look at:

  • A realistic timeframe for due diligence.
  • Expectations regarding the buyer’s due diligence priorities.
  • Who needs to be involved during due diligence.
  • What the buyer will need to begin their due diligence.

What Is A Realistic Time Frame For Due Diligence?

Now that we've seen how due diligence fits into the M&A process, we'll look at what business owners can expect from a time frame standpoint and we'll briefly discuss why.

Generally, in the lower middle market, M&A deals take nine to twelve months to complete. The infographic below gives a breakdown of a typical sell-side M&A deal in a Gantt chart.

A Gantt chart showing a typical M&A process timeline in the lower-middle market.

While the ability to get a deal done quickly and efficiently is certainly valuable, there is a cost to rushing the process. Good deals take time. However, you as the business owner would probably prefer to get a deal done in nine months as opposed to twelve. Here, we'll look at the three most time-consuming phases of the process so that you can understand where this time goes.

Note that there are multiple things happening at different stages of the process. We'll look at the process in a slightly different light by grouping a few phases together.

Generally, these three areas take the longest time:

  • Preparing the business for sale.
  • Marketing the deal and negotiating the winning letter of intent.
  • The due diligence process and closing.

It should also be noted that the timeframe for completing a deal could be deliberately sped up or slowed down. We'll look at four factors that often influence the lifespan of a lower-middle market deal.

  • The seller's sense of urgency regarding an exit.
  • The size and complexity of the deal.
  • The M&A advisor's ability to drive the process forward.
  • The buyer's motivations for doing the deal.

Seller's Sense of Urgency - Naturally, the seller's motivations for selling will factor into the time it will take to complete a deal. If the seller needs to sell as quickly as possible, then the deal could be deliberately rushed. However, this is generally not a good thing. If the deal is rushed, then it's likely the purchase price will suffer, unless great care is taken.

Deal Size & Complexity - The size and complexity of the deal will also factor into how long it takes to close. Some things that increase the complexity are the size of the business, the complexity of the cap tables, regulatory issues, and the need for extreme confidentiality surrounding intellectual property or ingredients. While this isn't an exhaustive list, generally selling smaller businesses with simpler ownership structures without regulatory restrictions or the need for extreme confidentiality measures will speed up the time it takes to get a deal done.

M&A Advisor's Skill - M&A advisors provide value throughout the process, but one of the biggest ways they deliver value is through their ability to drive the closing process forward. Time is the biggest killer of deals and deal fatigue sets in during a prolonged due diligence process. Business owners want an advisor who can drive the deal forward.

The Buyer's Deal Motivations - Additionally, we have to consider the buyer's strategic rationale for wanting to do a deal. This strategic rationale will impact the priorities they have for due diligence, which will translate to the complexity of the negotiations and the formal due diligence process.

Understanding The Buyer's Due DIligence Priorities:

As a seller, you should understand the strategic rationale behind why prospective buyers want to do a deal. A good M&A advisor understands M&A strategy and will thoroughly vet their motivations for you. As we've just mentioned, buyers will have different due diligence priorities based on their intentions for the deal.

To learn more about M&A strategy, we recommend our article: Types Of Mergers & Acquisitions.

Normally, in the letter of intent, the buyer will give a list of due diligence priorities and ask for a period of exclusivity in which to conduct this due diligence. It's in your best interest to understand their motivations for doing a deal before the buyer creates this list. In M&A, you will greatly increase the probability of closing a good deal when you take the time and make the effort to make sure everyone is on the same page, moving forward.

Who Needs To Be On Your Due Diligence Team?

Selling a business is a complicated process. Here, we'll look at who you will need to have on your deal team in order to get the best end result possible. Just like when you are hiring and building a sales team, the people you hire will make all the difference.

Sell-Side M&A Advisor - Hiring a competent sell-side M&A advisor is the best place to start. Your M&A advisor will play the "quarterback" role on your deal team. They will be your primary point of contact and they will operate as an intermediary between you and the buyer. This means they will take an enormous load of work off of your back and they will give you third-party negotiating leverage.

They will be responsible for:

  • Advising you on pre-transaction exit planning designed to maximize value,
  • Conducting a market-based valuation of your business,
  • Preparing your marketing materials (ie. teaser CIM, etc.),
  • Building the buyers list,
  • Structuring the auction and running the bid process,
  • Negotiating the winning letter of intent,
  • Driving the closing process forward,
  • Negotiating the definitive purchase agreement that closes the deal.

Getting this piece of the puzzle right is one of the most important parts for sellers. If you're contemplating selling, we recommend that you hire an M&A advisor as early on in the process as you can. They can drive value through exit planning if they have time.

You should read our free eBook: “The Ultimate Guide To Choosing The Best M&A Advisor” to help you get started. You can get your free copy here:

Your Accountant - Your accountant will be an invaluable resource to you throughout this process. To begin with, they will assist you at the very beginning in preparing your initial financial statements. These statements are part of what your M&A advisor will use when they conduct a market-based valuation of your business. Your accountant will also serve as an excellent resource during due diligence and they will assist in matters related to deal structure, purchase price allocation, and more. Finally, they will work with you post-closing and will assist you in filing your taxes when due.

Your Lawyer - Your lawyer will also be an invaluable resource during this process. Initially, they will help you in drafting an NDA specific to your business and confidentiality needs. This is what prospective buyers will sign if they like how your business is presented in the teaser, in exchange for the confidential information memorandum (CIM). Your lawyer will also assist in negotiating the LOI, which will include some fully-binding aspects and some non-binding aspects. Finally, they will assist in the negotiation and language of the definitive purchase agreement contract. They will be largely responsible for negotiating the representations and warranties and indemnification aspects of this contract. We will cover these more below.

Third-Party Accounting Firm - In addition, to your accountant, you will want to hire a separate accounting firm to conduct sell-side due diligence of your business. This is a preemptive measure. Sell-side due diligence, when conducted by an unbiased third party, will uncover much of what a buyer's team would, and it will give your M&A advisor more ammunition in negotiating the final contract.

As we will see in the next section of this guide, the financial due diligence that a buyer will conduct can open the negotiations up to potential reductions in the purchase price. Hiring a third-party firm to conduct sell-side due diligence (preemptively) will drastically mitigate this. Some business owners choose to go above and beyond with sell-side due diligence, hiring several different consultants to conduct due diligence in different areas. In the majority of lower-middle market deals this is actually overkill (in most cases) and business owners can save themselves some money by understanding which areas to focus on in sell-side due diligence.

The majority of sell-side due diligence is about getting a qualified third-party accounting firm to come in and conduct a sell-side quality of earnings review as well as an assessment of "normal" working capital. These are normally the two most heavily negotiated points that will impact the purchase price and we want to get out ahead of these.

What Does The Buyer Need To Start Their Due Diligence Process?

Before we dive into the particulars of this process, we want to briefly go over some things the buyer will need in order to start their due diligence process. Keep in mind that the buyer will almost certainly hire outside consultants to help them with their investigation. The due diligence process is time-consuming, stressful, and tedious—and it's in everyone's best interest to get the process moving as efficiently as possible.

This is not designed to be an exhaustive list, but buyers will want to have these things before they get started:

  • Working Group List
  • Document Request List
  • Data Room Access

Working Group List

First, the buyer should produce a working group list. Buyers normally hire outside consultants to help them conduct due diligence. They will normally hire different firms for different functions. These may include firms that specialize in financial and tax due diligence, IT due diligence, HR due diligence, and business due diligence. These firms will have multiple people involved at different stages, working on different things. Beginning the process with a working group list is a wonderful way to help ensure everything goes as smoothly as possible. Additionally, this helps to maintain confidentiality and to ensure everyone has signed the required documents in order to begin.

The due diligence process is stressful, chaotic, and often drawn out. Having clarity on who is doing what (and when) greatly improves work efficiency, reduces redundant communication, helps everyone stay on schedule, and makes sure that what needs to get done actually does.

Additionally, it is usually the job of the sell-side M&A advisor to establish a "pace" for the deal and for communication. Working group lists help facilitate this as well and translate to faster, more efficient work.

Document Request List

In addition to a working group list, the buyer will need several documents in order to begin their formal due diligence. Here, we'll go over some documents that the buyer will almost certainly need to have in order to get started. This is not intended to be an exhaustive list but is probably all the buyer will need to get started in most circumstances.

Acquisition Strategy/Target Search Criteria - It's important for the buyer to go over their acquisition strategy and search criteria again before starting due diligence. If they are a financial buyer, they will almost certainly have an investment thesis. The consultants assisting the buyer in conducting due diligence should have access to a copy of this thesis, as well as the buyer's search criteria. This is crucial because they need to comprehend the buyer's strategic rationale for the deal before they can certify that the seller's business aligns with these expectations.

Target Company Background Information - The buyer's due diligence team should also make sure to have any background information the buyer has assimilated about the target business. This should include industry or market research and should also include a list of the working assumptions they are making about the seller's business that they need to confirm. Their working assumptions may include their list of synergies they are expecting, value drivers, opportunities, issues, and risks they perceive. They should have a list of their non-negotiables as well, so this can be confirmed.

Confidential Information Memorandum (CIM) - The CIM is another important document for the buyer's due diligence team to have. The CIM is where most of the background information the buyer has comes from. This is how the seller has represented their business during the bid process and negotiations, and the buyer will want to make it a point to confirm that the information in the CIM is correct.

Letter of Intent (LOI) - Additionally, the buyer's due diligence team should have a signed copy of the letter of intent. The LOI is important because it summarizes the key points of the deal that have been negotiated up until this point. The buyer will want to make sure that they can confirm the terms laid out in the LOI make sense. The LOI includes a lot of valuable information such as the period of exclusivity the buyer and seller have agreed to for due diligence. The due diligence team will need to work inside of this time frame or the seller will have the ability to shop for other competing offers. In the LOI, the buyer has also made a list of key items they intend to dig into during due diligence.

Additional Information - Furthermore, the buyer's due diligence team will need to know whether the target company is private or public, this is a cross-border transaction, and they will need to have information regarding tax jurisdictions, carve-out, regulatory issues, privacy issues, and other complexities.

Data Room Access

Finally, the buyer will need access to the seller's secure data room. This data room will be used to house confidential information and for the buyer and seller to share access to various documents throughout due diligence. This data room will need to be secure, with protected access, ensuring that confidential documents aren't unintentionally disseminated. Normally, the seller's M&A advisor hosts the secure data room and manages the documents inside, as well as the flow and control of information.

Below is a list of some typical data requested in lower-middle market deals:

  • Monthly trial balances and reporting packages
  • Revenue by customer, product channel, and geography
  • Accounts receivable and payable agings
  • Inventory aging or listing on balance sheet end dates
  • Calculations of reserves (with roll-forwards)
  • Details for other current assets and liabilities
  • Historical capex and fixed asset detail

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