Curious about the definition of due diligence and why it’s relevant in the acquisition of a business? You’re in the right place.
Every day, we work with clients who have never bought or sold a business before. Since most will only go through the process once in their lifetime, the details can seem daunting.
A common question that comes up when talking to buyers and sellers of businesses is: “What does due diligence mean?”
In this post, I'll define due diligence when buying or selling a business and cover:
- The purpose of due diligence
- How long does due diligence take?
- How do you perform due diligence?
- What happens when due diligence expires?
- Is due diligence only financial?
This article is not intended to provide legal and/or tax advice. Every business transaction is unique, and buyers and sellers should always consult with the appropriate professionals (attorneys and accountants) when considering a business acquisition/sale.
Due Diligence Definition
Due diligence is simply the investigation of a potential investment. Typically, it starts after an offer is agreed upon by both buyer and seller.
The purpose of due diligence is to confirm the accuracy of the information presented (usually by the seller).
One of the most important goals of a buyer is to confirm the cash flow being represented by the seller. The buyer wants to make sure the company has positive cash flows so they can pay their debt service and make a good return on their investment.
MIDSTREET TIPDue diligence should also be performed by the seller or their representative. Depending on deal structure, it's important to make sure the buyer has good credit, background in the industry, and sufficient assets to complete a transaction. Doing this early in the process helps the seller mitigate confidentiality risk.
How Long Does Due Diligence Take?
Typically, the due diligence period will last for 45-180 days, depending on the sophistication of the buyer and complexity of the deal.
With more complicated deals, it could last six to nine months. Brutal!
That said, it's important to remember the due diligence period is negotiable. A buyer may ask for a longer period, but a seller always has the right to negotiate the time period down.
MIDSTREET TIPA buyer and seller agreeing to an offer is a great sign of progress in a deal, but it usually means they're only halfway to the day of closing.
For an individual buyer of a MidStreet-size ($1M-$25M in revenue) company, due diligence usually lasts 45-60 days.
NOTEIndividual buyers are typically high net worth individuals with a significant amount of cash (and/or total assets) to use in part with an SBA 7(A) loan.
How Do You Perform Due Diligence?
Due diligence can be as simple as a “book check” of a business or as complicated as a full group of attorneys and consultants analyzing a company.
Typically, private equity or strategic buyers of businesses will perform a “Quality of Earnings” analysis.
NOTEA Quality of Earnings analysis (also known as a "Q of E") is an analysis of the company performed by accounting and legal professionals on the financial, legal, and operational aspects of a business. It can be painful for buyer and seller.
Don’t send a pre-made due diligence checklist from the internet to the seller!
As a buyer, doing so is a huge mistake – trust me.
There’s nothing wrong with using a list off of the internet as a starting point, but every business is unique.
We always ask buyers to sit down and think through what things they really want or need to know.
We've seen some crazy lists with hundreds of items that don't even apply to the business being purchased. It's important for a buyer to remember, while trying to make sure you're comfortable with the company, you don’t want to overwhelm the seller with requests that are not relevant. If you do, you risk alienating the seller or losing their trust.
For example, when creating a due diligence list for a manufacturing company, learning about their real estate property tax history likely wouldn’t be nearly as important as learning more about how often they purchase new equipment.
MIDSTREET TIPPrioritize due diligence requests in order of importance.
For MidStreet companies (businesses doing $1M-$25M in revenue), common due diligence items include:
- Financial statements (3 years of income statements, 3 years of tax returns, and a recent balance sheet)
- Incorporation documents from the target business
- Equipment list
- UCC filings
- Vehicle and trailer titles
- Customer concentration information
- Accounts Payable and Accounts Receivable Aging reports
- Real estate leases
- Condition of the assets
- Customer contracts
After due diligence is completed, the buyer and seller will likely work together in training & consultation for at least a couple of months.
The buyer’s goal should be to ask them as few questions as possible that satisfy their comfortability with the acquisition.
Even though an item is on a list, that doesn’t mean you should ask the seller for it.
If the buyer cannot get comfortable with a transaction and doesn't feel trusting of the seller, consider abandoning the deal.
MIDSTREET TIPFor individual buyers, remember, your professional advisors are not buying a business, you are. If you get to the point where you're comfortable proceeding with the deal and start to feel like your attorneys are slowing down a transaction unnecessarily, you might have to assert your role in the transaction. Remember, there may come a point where if you push too hard on the seller, you could blow up a deal. You could lose a great business by pushing too hard on something that isn't actually too much of an issue.
What Happens When Due Diligence Expires?
The letter of intent or "LOI" (also known as the offer) typically includes a due diligence clause, which sets the terms for the parties involved, the buyer’s rights during the investigation, how long due diligence lasts, and what happens after it ends.
This is what’s known as the due diligence contingency. If the buyer isn't happy with what they find during the due diligence period, they have the right to withdraw from the contract. The deposit, if any, is usually returned to the buyer.
To summarize, once due diligence is over, the buyer has three options:
- Continue forward and close the deal
- Back out of the transaction
- "Re-Trade,” or renegotiate the purchase price
Can You Negotiate During Due Diligence?
Re-Trading is the act of renegotiating the price of the business after initially agreeing to purchase at a higher price.
In my opinion, re-trading is only fair play if you find something that actually affects the value originally offered on the business.
MIDSTREET TIPA "Re-trade" occurs after the Seller and investor have already agreed to the terms of a Letter of Intent. As a negotiation tactic, some investors may attempt to use items uncovered during due diligence to change the terms of the deal.
Is Due Diligence Only Financial?
Most people think due diligence just means reviewing the financial aspects of the company.
While assessing the financial health of the company is one of the most important items to review, due diligence is a very broad term.
You can perform many types of it, including due diligence for real estate, legal due diligence, and more. It’s important to go beyond the numbers.
See the graphic I made below for types of due diligence:
Financial Due Diligence
Financial due diligence is an analysis of the target company’s financial records.
Understanding the financials of the business helps the investor better understand valuation and determine potential risks.
What financial documents should the investor collect?
- Revenue, profit, and growth trends
- Short and long-term debts of the company
- Income Statements (AKA Profit and Loss Statements, or P&Ls), balance sheets
Legal Due Diligence
Legal due diligence is important to perform to verify the legal structure of the company.
Here are some things to consider for legal due diligence:
- Customer reviews of the seller
- The customer base
- Contracts (if applicable)
NOTECorporate Finance Institute has a great guide on the different types of due diligence that exist.
Understand The Due Diligence Process in a Business Acquisition
In mergers and acquisitions transactions, due diligence can be lengthy, complicated, and require significant effort from all parties.
The goal of the due diligence process is to get the buyer to a position in which they trust (and confirm) what is being represented by the seller.
If the buyer asks the right questions with a good team of advisors around them, the buyer and seller should both feel positively about the acquisition process.