Due Diligence: “Reasonable steps taken by a person to satisfy a legal requirement, especially in buying or selling something.”
Sounds simple enough, in fact, there are only three (3) sectors: Legal; Environmental; Operational/Accounting required to complete Due Diligence. Sadly, that’s where the simplicity ends; there are dozens, if not hundreds, of sub-sections to each sector.
Here are six steps to ensure you survive the process:
Understand What They’re Looking For
The very best salesman in any company is the owner. The owner should be able to elaborate on the business, what it does and how it does it, experience within its industry, employees, key management, history, etc. However, that’s not what investors are looking for; they’re waiting for your answer to performance. Lists of management reports to manage the business, supplemental financial data prepared for management, strategic plan to include operating maintenance and capital expenditures, information on any acquisitions or divestitures, listings of transactions including profit and expenses on such transactions and summarization of any unusual or nonrecurring items affecting operating results.
Review All Documents for Accuracy
“WHAT DOCUMENTS?” For starters, the company’s charter documents, as amended to date, operating agreement, Certificates of Authority, Good Standing, Tax Status in jurisdictions where the company conducts business, employment contracts, compensation packages, key employee life insurance and disability insurance policies, licenses, permits orders, variances, schedule of known violation of codes or rules, copies of all documents, correspondence, filings, proceedings, profit-sharing plan, list of bonuses, to name a few. Due Diligence is not a final exam that can be “crammed” into an “all-nighter.” It is ongoing and thorough process that requires continuous maintenance.
Be Realistic with Financial Reporting
You will achieve the best results if you recognize that your financial projections should help you demonstrate an understanding and the actual scalability of your business model. The process begins with general financial, accounting and management reports, budgeting process, receivables management, inventory management and control capital expenditures, payables management, debt management, accounting policies, financial statements inclusive of recent annual and interim financial statements(income statements, balance sheet, cash flow statement) for the last three years, unrecognized liabilities, capitalization, debt, federal and local taxes, assets and other material agreements Include plans for future financing and strategies for achieving specific financial metrics, rather than an overly optimistic projection.
Recognize that You Might Need to Adjust Your Valuation
Business owners often have a justifiably emotional attachment to their businesses. This bias is likely to lead them to value their businesses more than an outsider would. This means if you are not relying on a term sheet from a legitimate outside investor or an independent professional appraisal, the valuation you are giving your business might be unrealistically high. Apart from having discussions with current investors, you should research comparable market statistics and supporting data so you are able to clearly explain to your investor how the terms of your financing round were determined.
Put in the Time and Effort
Once you begin due diligence, be aware that your potential investor will scrutinize every aspect of you and your company. This exercise is comparable to an interview process. After an initial phone call or meeting with a potential investor, do not let days go by before you get them the requested information or updated documents. Provide whatever is requested from you promptly. How quickly you do or do not respond to them is a direct reflection of you and your company.
Hire an Advisor
A professional advisor with the relevant experience can help make the process less daunting and intimidating. They typically provide guidance in shaping the company’s narrative and can help a company reach a targeted and more relevant list of potential investors. A good advisor can and should help with determining valuation supported by market data of comparable transactions. The hiring of an advisor adds one crucial ingredient. Many corporations or private equity groups choose to sub-contract their due diligence to an outside firm that specializes in only that segment of a transaction. They’re thorough and objective, not subjective are not interested in the dynamics that you have achieved or could achieve. In an initial proceeding, if the Buyer/Investor determines that you have been transparent about the inner workings of your company, they will do the due diligence in consort with your hired advisor, delays will be minimized and surprises mitigated. The dynamics of the company always remains intact, leading to a quicker and happier conclusion.