Exit Strategies: A Three-Part Series

Part Three: Giving Diligence Its Due

In this article series, Harris Williams Managing Director Bill Watkins, the firm’s specialist in advising family-owned businesses, shares his insights on preparing to sell your business.

The initial article covered five key issues that have the potential to disrupt a transaction and how to address them. Part two provided a checklist of nine critical things owners must do to prepare to sell before that day comes. Part three addresses three principal areas of due diligence, and outlines the information to organize in advance of this important step in the sales process. 

The Power of Focus

Due diligence is a simple concept: Make sure you’re truly getting what you’ve been promised.

In that simplicity is the challenge. As a business seller, how can you possibly prepare in advance for the potential slew of questions and data requests you’ll be faced with? How can you know which areas will attract the scrutiny of your buyer? How can you address all of these questions while running your business and managing a complex sale process that likely will involve more than one potential buyer?

Experience is the answer. Through years of experience helping a wide variety of companies go to market, Watkins has a keen sense of which areas tend to be the focus of the due diligence process: those related to the business and its operations, to financial results and to fundamental legal points. By preparing documentation in advance to address common concerns in these three areas, business owners, with the support of their advisors, can more readily handle the lion’s share of due diligence inquiries without substantial additional effort, freeing them up to run the business and maintain its performance during the process, which is essential to a successful outcome. 

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Thorough and well-organized due diligence information helps ensure a smooth transaction by providing complete transparency for buyer and seller. Buyers want to validate that what they believe to be true about the company is in fact true, as well as protect their capital by ensuring they are putting it to its best use. Sellers want to smooth the process and maintain momentum. The more prepared the seller is with comprehensive information that supports its business story, the better the process will be for all parties. 

While due diligence typically occurs toward the end of the sale process, it’s far easier to assemble the data needed by buyers if the effort is an ongoing part of operations. “It’s a discovery process,” says Watkins. “If the company is constantly learning how to improve its customer experience and operate more efficiently, it is performing ongoing due diligence. Then, by the time it gets to ‘due diligence’ in the course of a liquidity event, validating the business is a breeze. Getting and keeping your house in order prior to launching a sales process is critical.” 

That house has one essential room: the data room. In the past, businesses going to market would actually set up dedicated rooms filled with relevant documents for prospective buyers to peruse. Today, however, data rooms are digital repositories for your key files, often hosted by third parties.

Watkins says a growing number of companies establish data rooms well in advance of a sale: “It’s a smart idea to maintain a virtual data room even if you aren’t planning to sell — just to be prepared. If you think in the next three to five years you will be selling your business, then getting out in front of this and beginning the preparation really helps the entire process down the road.”  

Whether your data room is digital or physical, it should include the following three types of information.

Business operations

In Watkins’ experience, five categories of business information can help you answer an outsized portion of due diligence questions:

  • Management team
  • Growth projections
  • Sales and marketing
  • Operations
  • Human resources

Management team

To begin with, positioning your management team as the group to drive the company forward is crucial to the success of any transaction. In particular, Watkins points out that private equity groups need to know that management is invested in setting the strategy, growing the business, and executing day-to-day operations. 

Due diligence information provided to the buyer should illustrate the team’s depth, eliminate any “key person” concerns, and provide transparency to the seller regarding the succession plan and team incentives. That may include information on key hires made to fill management positions and tough retention decisions.

It could also involve documenting that you understand the post-transaction goals of each member of the management team and have put in place proper deal incentives. Your data room should show that deal bonuses are properly incenting all key members of the management team, and that equity incentives are properly aligned, says Watkins. Proper alignment means that the people who participate in the equity pool are the right people, and that the actual incentives are controllable by the people who are participating in the plan, he explains.

“Certain key people in the company have helped you get the business where it is today; they will be meaningful in helping you sell the story and executing that story after the sale,” says Watkins. “Show that you’re taking care of them through a strong deal bonus.”  

Growth projections

If buyers are interested in your business, it’s likely that your growth projections are a big reason why. And while everyone wants to show that their business is going “up and to the right,” buyers will need to believe in the veracity of your optimism. Keep in mind the following as you gather information to make that happen:

  • Formulate detailed and supportable projections — know your model inside and out. It’s far better to exceed a stretch budget than to miss an aggressive one.
  • Highlight cross-sell opportunities and the action plan to achieve them.
  • Document the details of acquisition opportunities: the status of each pursuit, their potential costs and benefits, how they support your strategy, etc.
  • Note that a laundry list of “long-shot” growth opportunities signals a lack of focus and discipline.

Watkins cautions not to show a growth plan that is “in the bag” and easy to achieve, or a “hockey stick” that buyers are not going to believe: “Your growth plan should show a stretch goal that signals a believable story with sufficient hard work. A business that can grow revenue at a double-digit clip on an annual basis in a rational way through organic growth and acquisitions should achieve a successful outcome.”

Sales and marketing

Current sales and marketing strategies for products and services will be a key area of interest to potential buyers. Documentation should demonstrate that you track:

  • All key sales force metrics using quotas, achievement levels, win rates and turnover
  • Gross and factored pipeline, historical revenue coverage and trends 
  • Competitors and reasons why you win or lose against each 

Gather collateral or promotional materials that would compellingly display or demonstrate the breadth and depth of your product and service offering to a buyer. Demonstrate market adoption of newly introduced product/solution offerings and prepare product demonstrations. In addition, document and share your compensation plans for key sales professionals, as buyers will want to better understand how they align with their existing program(s) and what discrepancies exist.

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From an operations perspective, ensure capacity and capital budgets sync with projections, document maintenance versus growth capital expenditures, track key operational metrics, and provide detail on internal controls and information technology strengths and opportunities. Perhaps most importantly, show that you are continuing to operate the business without slowing down. This is a common pitfall, as sellers often want to protect capital and lower their debt balance prior to a sale. They may defer a much-needed capital purchase only to find the deal later falls through and the lack of expansion has hindered their growth. Show that you are investing as if a sale is not occurring. 

Human resources

Human resources is a particularly important area of due diligence in today’s tight labor market. Buyers will want to see what you are doing to attract, engage and retain talent, and how well your efforts are working.    

Key areas to document and track include:

  • The recruiting, hiring and onboarding process
  • Voluntary and involuntary employee churn
  • Employee disputes or non-compete issues
  • General benefit plans
  • Training
  • Incentives

Financial results

Financial statements

Buyers will focus on the accuracy of your financial statements, says Watkins: “For most investors, whether they're corporate buyers or private equity groups, the first line of review for an opportunity is looking at the financial statements. Numbers have to be incredibly tight and tie to your growth story.”

It is very important — regardless of whether or not you've had financial audits from a third-party accounting firm in the past — to have a quality of earnings (Q of E) report to share with potential buyers.

Considerations include:

  • Ensure revenue recognition policies comply with industry best practices
  • Clean up accruals and reserves well in advance
  • Develop and monitor appropriate working capital metrics
  • Identify and document any potential “add-backs”
  • Remember that buyers will be reviewing all monthly packages
  • Document pro forma financial results for recent acquisitions, customer wins, etc., and rigorously track performance and synergies
  • Ensure tax compliance

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Systems and controls

Buyers will also focus on the strength of the systems and controls around financial data. The systems have to be scalable to support your growth plan and, just as important, the people managing those systems have to be strong in both communication and financial knowledge. Be prepared with information that describes your IT environment and accompanying controls. Note that your Q of E provider (or another third party) can also provide IT diligence to help support this effort. And showing the ability to close the books within 15 days of month-end demonstrates that your financial processes and technology work smoothly.

Legal documentation

Legal due diligence involves scrutiny of the company’s potential exposures, contingent liabilities and litigation. Legal review will cover every element of the business through a lens of potential financial exposure and reputational risk — buyers will want to look at every customer contract, every supplier agreement and every employment letter.  

Records, contracts and agreements

As such, make sure all records, contracts and agreements are organized, including those related to real estate (such as liens, title insurance and surveys). This includes documentation on the rectification of any environmental issues, as well as the status of any labor agreements. Wherever possible, show that you have mitigated product liability and warranty issues and cleaned up nuisance lawsuits.

Insurance

Insurance should also be documented. Does the company have adequate insurance coverage? Are there ways to mitigate rising expenses? Are there any issues with workers’ compensation insurance and related claims? All of these are important questions that documentation should address. 

Intellectual property

Another important component of legal due diligence is evaluation of any and all intellectual property. Gather documents for copyrights, trademarks and any documentation regarding infringements. Be prepared to demonstrate how the company protects its intellectual property. If you spent years developing what you believe to be a proprietary process or piece of equipment, show that you are taking that through the patent process. At the same time, make sure that your materials aren’t overselling a trade secret as something more than it is. The goal is to represent patents and trade secrets fairly to the buyer. 

Off-balance-sheet issues

Finally, gather information regarding pension liabilities, employee stock ownership plans (ESOPs) and other off-balance-sheet issues, and be knowledgeable about the financial impact that they could have on the transaction. For example, when businesses have either full or partial ESOPs, there are different fiduciary and documentation requirements compared to other ownership structures, and those points must be meticulously managed through the diligence process. Getting ahead of such issues is important.

Conclusion

As buyers and investors enter the due diligence stage, they are looking to validate the feasibility of the growth strategy that management intends to achieve, as well as to understand their potential risks. The more thorough and accurate the seller’s supporting data is, the more confidence it gives the buyer.

Being proactive in building and maintaining a comprehensive data room greatly aids the process. Organizations that are diligently learning, making sure that issues are addressed in advance, and maintaining thorough and well-organized records can be confident in delivering a smooth due diligence process. 

As Watkins points out, “For every day you lose in due diligence due to responding to document requests, you are extending the calendar and increasing the odds of a negative event within your business. Having the necessary information at your fingertips makes all the difference and keeps the momentum in your corner.”

Most importantly, sound due diligence helps the company itself by allowing it to assess its strengths, weaknesses and opportunities. The three key pillars discussed here create a solid foundation for the business, and enable value creation before, during and after a sale process.

To receive a sample data room checklist, please contact William Watkins.

This article is one in a three-part series. 

Part One: Five Considerations for Business Owners

Part Two: The Exit Checklist for Business Owners

Published June 2019