The lower middle market is seeing a growing trend toward pre-due diligence. Traditionally, when you take your company to market, you work with interested buyers, negotiate to a signed letter of intent, and then work with the buyer’s team through due diligence. At that point the buyer is looking for potential liabilities and risks and verifying the quality of earnings.
But now, more sellers are bringing in a pre-due-diligence team before they go to market. It’s like getting an inspection on your house before you sell, only more intensive. You and your advisers are viewing your business through an objective lens, looking for any concerns that could lower your value or sidetrack a potential sale.
You may say to yourself, “There’s no way I would invest all that time and money only to go through it all again in due diligence,” but there are several reasons sellers are taking this extra step:
The pre-due diligence process is time consuming to be sure, but you can take it in steps, working at a pace that makes sense for you and your team. By contrast, a buyer-driven due-diligence process will be a time-intensive data dump. You’ll be spending hours responding to requests for information, providing explanations and digging up old documents that were filed away years ago.
A traditional due-diligence process typically occurs under significant time pressures. You’ll feel pressed to respond quickly, possibly even uploading documents before you’ve had a chance to fully review and vet them yourself.
By taking time to complete a pre-due diligence process, you’ll be the one to discover those potential road blocks and red flags that could dissuade a buyer from purchasing your business.
Control the narrative:
After your pre-due-diligence team brings issues to your attention, you decide whether to address these concerns before going to market. If you decide not to remedy an issue, you can raise it to the buyer in a proactive, transparent way. Either way, you control the timeline and the messaging.
On the other hand, if the buyer uncovers surprises, you’re forced into a reactive position. It doesn’t matter if the error was intentional or not — it may be that not all key employees have a signed non-compete agreement or a contract has mistakenly gone out of date — you’ll be on the defensive and the buyer could ask to renegotiate the deal.
Optimize the financials:
During pre-due-diligence, you may discover there are certain tax issues or financial reporting considerations that you’d be better off addressing in advance. For example, how you manage your working capital can mean the difference of hundreds of thousands of dollars in a sale.
Your advisers will also review quality of earnings as seen from a possible buyer’s perspective. Different from an audit, a quality-of- earnings analysis places a greater focus on things such as sustainability, future economic earning power, cash flow and the validity of any adjustments that have been made to the financials.
Shore up your contracts:
Many of the business owners I work with still operate on relationships and handshake agreements, but what works just fine in day-to-day operations can limit your value in a sale. In pre-due diligence, you’ll review all your third-party contracts to ensure they’re up-to-date and transferrable.
With pre-due diligence, you’ll get a comprehensive picture of any weaknesses and warts, so you can mitigate those issues before going to market. The better you prepare, the better your final outcome. We’ve had several buyers tell us that if someone does pre-due diligence and verifies their quality of earnings up front, they will typically pay at least half a multiple more.
Remember, less risk and uncertainty for a buyer, the higher the purchase price for the seller. Pre-due diligence is part of getting your business ready to sell, just like sprucing up the facility and clearing out excess inventory. It’s an investment, but one that will pay off in the long run.
You only sell your business once, and it’s to your advantage to be as prepared as possible.
Scott Bushkie is principal of Cornerstone Business Services.