Well-funded buyers lead serious groups who pay top dollar for valuable holdings. Valuation is key, but the intangibles matter and they are examined in procedural detail during the due diligence component of the transactional process. You and your team built the workforce, management team, clients/customers, and grew the geographic footprint. It is built for the diligence process. Now the transaction becomes real, buyers start spending money, and all latent deal impasses are uncovered. The due diligence process is the critical component to closing and the more fundamentally prepared a seller is for the diligence process, the more likely they will get to transition.
The diligence process will reveal latent insights, uncover valuable operational awareness, and disclose foundational questions:
- Why are you selling?
- What are your most immediate challenges?
- If you had longer runway, unlimited resources, & no obstacles; what would you do next?
- Who are your key team members and what makes them valuable?
- What separates you from your competition?
What Is Due Diligence? Why Is It Necessary?
Due diligence is a comprehensive and thorough process that investigates and verifies business reporting information before finalizing a transaction. It allows a buyer group to confirm risks, validate assumptions, and authenticate value.
A strong proactive diligence process will include current and accurate financial reporting, including tax records, internal financial statements, contracts & agreements, employee & management information, etc… A Quality of Earnings review will evaluate revenue trends and profit margins, customer mix, recurring revenues, competition, market positioning, and the seller’s daily operational responsibilities. This exhaustive review will prove out buyer assumptions, generate confidence, and validate that they are making a well-informed decision.
Buyer groups develop trust over the course of rigorous analysis. When a seller provides clear and consistent documentation, buyers can move expeditiously and negotiate with confidence. Incomplete or contradictory information generally leads to slower more scrutinized analysis that often leads to re-trading and unfavorable deal terms.
Key Areas of Focus During Due Diligence
Most due diligence processes are procedurally predictable. Educated buyers can employ a team of accountants, attorneys, lenders, and transactional specialists depending on the industry and deal structure.
Conceptually, the process is built on three components:
1. Financial Records that will verify historical earnings and cash flow
2. Contracts & Agreements that confirm existing contracts and legal solidity
3. Employee & Management Information that verifies foundational transferability
Financial Records
Solid and accurate financial records are the fulcrum of the diligence process. Accurate and current financial statements, recent interim results, tax returns, and supporting schedules are critical to validating the business enterprise value and lead to top end valuations. A buyer starts underwriting risk when they cannot confirm their assumptions.
Buyers commonly request:
- 3 to 5 prior years of profit and loss statements, balance sheets, and cash flow analysis
- Revenue quality (recurring vs one-time purchases, customer concentration exposure, revenue seasonality, and accounts receivable consistency)
- Margin stability and cost driver analyses
- Historical and ongoing working capital requirements
- Historical and ongoing debt, liabilities, and any off-balance-sheet obligations
Contracts and Agreements
Any major customer agreements, vendor contracts, leases, financing arrangements, or legal commitments that materially affect operations are part of a comprehensive diligence examination.
They will want to identify and analyze:
- Assignment and change-of-control clauses
- Renewal terms and termination rights
- Volume commitments or exclusivity provisions
- Non-competes, non-solicits, and confidentiality obligations
- Pending disputes, claims, or compliance issues
Employee and Management Information
Buyers focus their org chart diligence on transition and continuity. They will count on your team’s ability to execute through transition and beyond. Expect diligence evaluation to include headcount analysis and org chart assessment that examines compensation and benefit review, key role analysis, and retention risk.
Commonly requested items include:
- Org chart and role descriptions
- Compensation and incentive plans
- Benefit plans
- HR policy handbooks
- Key person risk and succession coverage
- Open roles, turnover history, and training documentation
Seller Readiness Checklist: Are You Due Diligence Ready?
Any time we see a lack of transparency & inconsistent communication, an inability to move according to process timeline calendar, and/or incomplete or inconsistent reporting, it is generally a sign that we need to slow down and realign motivations, priorities, and expectations. We work diligently to connect w/serious buyer groups who are deal friendly and will not waste a business owner’s time. We ask that business owners remain focused, make the transaction a priority, and work w/us diligently on information requests and follow along the agreed upon transaction timeline to close.
As you plan for an eventual exit, keep these items current and accurate; and regularly stress test your diligence readiness before you move forward w/buyer engagement. A strong database of accurate and current information will help streamline due diligence and sustain momentum.
- Historical Financial Statements (accurate monthly P&L’s, balance sheets, and cash flow statements)
- Current and reconciled interim financial statements
- Federal and state tax returns
- Clear, accurate, and detailed non-recurring items and cash flow add-backs
- Customer and vendor contracts (assignment & change of control language)
- Accurate and current top customer summary (revenue percentage, engagement terms, and historical longevity)
- Lease agreements, loan documents, and key obligations
- Comprehensive org chart (job descriptions, rates of pay, responsibilities, etc.)
- Historical compensation trends, benefit offerings, and incentive plans
- Documented core processes and policy handbooks
Overcoming Common Due Diligence Challenges
Well-funded buyers search for businesses w/strong fundamentals. They will pursue businesses deficient in various categories, but will chip away at valuation when there are clear warning signs of:
- Disorganized, inconsistent, or inaccurate financial reporting
- Customer concentration or informal vendor and supplier agreements
- Over reliance on owner daily operational responsibility
- Legal difficulties including threatened, past, or pending litigation
- Obsolete, antiquated, or overworked equipment
- Lack of online presence
Challenge: Disorganized, inconsistent, or inaccurate financial reporting
Fix: Tie financial statements to tax returns, clarify add-backs with support, and provide a clean bridge from reported to normalized earnings.
Challenge: Customer concentration or informal vendor and supplier agreements
Fix: Detail agreement renewal history, streamline agreements where possible, and maintain accurate relationship characteristic summaries
Challenge: Over reliance on owner daily operational responsibility
Fix: Delegate responsibility, document process, and develop transition plans that speak to long term operational continuity
Challenge: Legal difficulties including threatened, past, or pending litigation
Fix: Speak w/legal counsel and examine your vulnerabilities
Challenge: Obsolete, antiquated, or overworked equipment
Fix: Determine your short term and long term capital expenditure needs and analyze your annual repair and maintenance expense. Make sure equipment stays in good working order
Challenge: Lack of online presence
Fix: Analyze how customers find you and whether online spends or marketing efforts can create immediate, intermediate, or long term growth
How SMP Capital Partners Supports You During Due Diligence
SMP Capital Partners helps sellers navigate due diligence with structure and discipline. Your team at SMP Capital Partners will guide you and your shareholders through the daily transactional grind. We ask you to make sure your team is aligned w/the same vision, understands the proven plan for business improvement and team member success, and fits w/in the responsibility they are tasked to accomplish. Being good relationally makes transactions and, more importantly, transitions operate efficiently.
We will help you:
- Present clear financial and operational information
- Coordinate diligence workstreams to prevent overburdened deal fatigue
- Support negotiation when diligence impasses impact price or terms
- Maintain forward momentum while protecting your influence and confidentiality
Well managed due diligence supports a streamlined closing and well ordered transition. Collectively the SMP Capital Partners team have over 50 years of transactional experience and we have spent that time incrementally improving our deal processes while completing hundreds of sell side transactions in nearly every industry.
We do not offer a cookie cutter assembly line process. We have developed very specific and customized deal processes in every industry we have completed transactions. Our team creates bespoke valuations, marketing memorandums, and acquisition target identification indices. From valuation to transition and beyond we do not take shortcuts, we are diligent and persistent; and our process is transparent from the very start.
It is never too early to start a conversation. Contact SMP Capital Partners for expert support and long term planning today.