Why Seller Due Diligence is Vital to a Successful Sale

You’ve heard us talk about due diligence before, but the fact is, the better your accounting practices and bookkeeping are in the first place, the easier it will be in the long run when it’s time to begin the sales process. Buyers of small and mid-market businesses are more savvy these days, and they know the signs of a company that is in distress versus one that is succeeding, well-managed and built for the future. Business, corporate and real estate transactional attorney Michael Schachter is the co-founder and co-owner of the Pearson & Schachter Law Firm in Southern California. Listen as he talks about the importance of staying organized and having the right people in place to help in that process.

Questions Answered For You

A business owner who wants to sell their business needs to get all the due diligence in order to appeal to the buyer themselves.

- Michael Schachter

Key Takeaways

  • A business owner who wants to sell their business needs to get all the due diligence done in order to appeal to the buyer themselves.
  • The key with due diligence is organization and making sure you document everything that has happened in the life of the company.
  • The attorney's role is really to ascertain what the issues could be with this due diligence and help the client get organized and actually expedite the process.
  • It might cost more money to pay an attorney to do these things, but in the long road it expedites the transaction and it could save you a lot of money later if there's litigation regarding certain disclosures.

Read Full Interview

Jeff: Welcome to Deal Talk brought to you by Morgan & Westfield, I'm Jeff Allen. If you're looking to sell your company now or at some point in the future it's our mission to provide information and advice from our growing list of trusted experts that you and all small business owners can use to help you build your bottom line and improve your company's value.

Prospective buyers who are serious about acquiring a business conduct needed due diligence prior to entering the negotiation phase of the transaction process. So the question is: why should you as the seller conduct due diligence on your own company? Why shouldn't the buyer do all the work? After all, they're pursuing you. Let's ask someone who knows a lot about the subject of due diligence. Michael Schachter is a business corporate and real estate transactional attorney, and co-founder and co-owner at the Pearson and Schachter Law Firm, a professional law corporation in Walnut Creek, California. Michael Schachter, welcome to Deal Talk sir, good to have you.

Michael: Thank you Jeff, a pleasure to be here.

 

Jeff: As a business owner, I know that the buyer's going to be conducting all their own due diligence. Why is it important for me as the seller to do the same thing?

Michael: A business owner who wants to sell their business needs to get all the due diligence in order to appeal to the buyer themselves. When you do due diligence you want to impress the buyer and make sure that everything's in order and organized. And it actually helps in order to expedite the transaction by putting things such as general corporate matters, employment matters, contracts, obtaining all these and ascertaining what they are, and organizing them to make you more appealing to the buyer and impressing them, quite frankly.

 

Jeff: Due diligence is something that we have talked about on Deal Talk in the past but business owners may not necessarily have an understanding of the time and the effort that's required here. It's not something that you can just sit down over a cup of coffee and work out with a couple of your key managers over a period of hours. When a business owners knows, Michael Schachter, that he or she wants to sell their company, when should they start the process of conducting that important due diligence?

Michael: When the business owner makes the decision to sell a company I think the sooner the better, start the due diligence process, quite frankly. It also depends on how long the business has been around. There are some companies that I’ve represented have been around 20 to 30 years. And in that instance there's a number of documents and more information than in a company that's been around for a year. So I think it depends on how long the company's been around. But more importantly I think it's important to just get the process started sooner than later. Most of the companies when they make the conscious decision to sell, I think that's when they should start organizing their documents into certain categories such as corporate matters, employment matters, contracts, just to get them in order. Sometimes, depending on how long the company's been around like I said, if the company has been around for a year they might wait until they have a letter of intent in process because in the letter of intent the buyer's going to ask for due diligence at that point. But if you started sooner before the LOI then you put yourself in a better position. So my answer is the sooner the better.

 When the business owner makes the decision to sell a company I think the sooner the better, start the due diligence process, quite frankly.

Jeff: Let me ask you, is there anything that an owner of a business who is a conscientious owner, they have it maybe in their exit strategy at some point to sell their business. Would it be to their advantage to from time to time conduct their own internal audits of the systems and processes that they have in place and particularly of the numbers of the books so that at some point down the line when they are ready to sell that it may actually shorten up the due diligence process?

Michael: Absolutely, and it makes total sense. For my clients what I do for the most part, I represent some start-up clients and what we do is we start a Dropbox file or a box file. And we start keeping track of all the documents as soon as they're incorporated. The key with due diligence is organization and making sure you document everything that is happening in the life of the company. It gets tedious but I do think that it's a good practice to organize and keep track of all the documents that you have outstanding in one place that makes sense. So for example like I said for startup companies I'll incorporate the business for example. And then I'll make a box file and call it corporate matters, and then I'll keep track of all the signed documents and filed documents in that one file, even though they just incorporated. For the most part, most companies not withstanding the fact that they just incorporated are looking for an exit at some point down the road whether it’s five years, ten years. But the sooner you keep track of these documents the easier it's going to be when you actually have a transaction pending.

 

Jeff: Michael Schachter is a business, corporate, and real estate transactional attorney at the firm Pearson and Schachter in Walnut Creek, California. My name is Jeff Allen. You're listening to Deal Talk. From your experience, Michael, what are the most common areas of concern for most companies when it comes to conducting their due diligence? What area do sellers really need to focus on or clean up during the process? 

Michael: Good question, Jeff. So I would say when the buyer's looking at the seller's company, what they're doing is investigating and making sure everything makes sense. The buyer's looking for inconsistencies, unsigned documents. But the buyer wants to make sure is that they're getting what they're paying for. So as the seller you want to make sure that if you issued any stock to individuals you want to make sure that that's documented correctly. Moreover if people had left the company you want to make sure that you have the separation or release agreement with them and appease the buyer to make sure that there's no issues outstanding. You also want to look at the contracts that you have, existing leases, contracts with third parties, with customers, and make sure that you have the right to actually assign or terminate the contract upon the change of control which either stock purchase or an asset purchase. So you want to make sure that those items are documented correctly. Furthermore, you want to make sure in the agreements themselves that you're allowed to actually disclose the actual contract to third parties and not breach any particular provisions in the agreements. I would say documenting everything correctly such as equity interest especially because the last thing you want is to sell the company and then have some random shareholder that wasn't documented correctly come after the buyer later. You want to make sure that the agreements allow you to actually give the document and the agreement to the buyer without breaching it. And you want to make sure that you can actually assign or terminate those agreements before the deal closes. Those are the types of items that I see that happens a lot that cause some last minutes these. 

So I would say when the buyer's looking at the seller's company, what they're doing is investigating and making sure everything makes sense. The buyer's looking for inconsistencies, unsigned documents. But the buyer wants to make sure is that they're getting what they're paying for.

Jeff: Let's camp out there for just a minute. You're talking about the contracts and agreements with vendors, clients, staff, etc. How often do you see, Michael, that oftentimes these contracts don't take into consideration proper language in order to allow for a seamless transfer to a new owner. Is it pretty common where these contracts are written up and drawn up between the two parties of interest without allowing for any kind of changes down the line between one party and another, particularly in this particular case when you're talking about a transfer of ownership?

Michael: It depends how the deal is structured. If it's a stock purchase then arguably the seller will remain as the seller's entity. If you have an asset purchase then that kind of creates a different kind of situation because the seller will be a new entity and that would trigger the assignment provisions in these contracts. Most contracts you need to look at the assignment provision and all these deals, and all these contracts. Most of them if not all say that if you have an assignment which means to transfer the contract to a third party, a different third party, then you need to get written consent of the third party. The tricky part is like I said in the stock purchase agreement you're actually transferring the contract to a third party where you're going to remain as the party of the contract even though there's different owners. So in that situation you need to look closely as the assignment provision, make sure they don't have any change of control provision where they say, if you sell 51 percent or more of the controlling interest then that is deemed an assignment. So to go to your point about being proactive about the due diligence process, I think it's a good exercise to look at these assignment provisions and ascertain even before you structure the deal about how many contracts are actually signable without the consent of the third party. If you're a construction company for example and you have a hundred contracts with third parties that require the consent then that might be an issue for the seller themselves and the buyer, and you might want to structure the deal differently.

 

Jeff: It really does sound like something that could if it's not addressed properly - and sometimes that means getting way out in front - it could really put a hitch in a deal when you consider how valuable that some third party vendors, for example, might be toward the operation of a company or towards the processes that it has if it's a manufacturer, for example. If it's a supplier and the supplier has some questions about any new deal with any new ownership coming in. What about lease agreements for buildings, equipment, anything like that, anything important that we should remember as sellers of a company here with regard to these particular items?

Michael: Absolutely. For the most part, the major contract for sellers is the commercial lease where they have the premises. And a lot of times these leases take a lot of lead time from the landlord in order to get consent. The first thing you need to do is ascertain whether or not you need consent from the landlord. And that's dependent upon how the deal is structured. If you have a stock purchase, for example, the seller will remain as a tenant in the deal. You need to look at the assignment clause and make sure that it says that if you don't have a change of control that's not deemed an assignment. If the explicit language in the assignment clause that says a chance of control such as selling 51 percent or more is deemed an assignment then you're going to have to get landlord consent. So it's imperative that you look at these provisions and make sure that you do not transfer the lease without the landlord's consent. And these things, depending on how reasonable the landlord is, could take time, and time is of the essence in all these transactions.

 I think it's a good exercise to look at these assignment provisions and ascertain even before you structure the deal about how many contracts are actually signable without the consent of the third party.

Jeff: Michael, you know what this does right now, you're talking about things that I'm just thinking, wow, there's so much to remember. This is why it really is imperative to be working with an attorney to help make sure that there's nothing, there's no stone that is left unturned.

Michael: Correct. And a lot of people, the attorney’s role in this transaction is really dependent upon their client and the buyer. Some buyers scrutinize things more than other buyers. And the attorney's role is really to ascertain what the issues could be with this due diligence and help the client get organized and actually expedite the process. It might cost more money to pay an attorney to do these things. But in the long road it expedites the transaction and it could save you a lot of money later if there's litigation regarding certain disclosures.

 

Jeff: We're going to come back in just a moment, Michael, after we take a short break and we're going to talk about small companies versus large companies and their use of an attorney to help them with their due diligence. Due diligence, why it's important, but why you need to get an early start on it. I think that's the most important thing that we're trying to take out of this discussion here. And we're having our guest today, Michael Schachter, on the program to elaborate on all of the reasons why it's so critical that you need to get an early start. My name is Jeff Allen and I'll be back with attorney Michael Schachter when Deal Talk continues in just a moment.


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Jeff: Welcome back to Deal Talk where we are becoming the Internet's go-to resource to help business owners understand what it takes to sell their company successfully. You can find a wealth of resources along with all Deal Talk episodes and their transcripts simply by visiting morganandwestfield.com. I'm Jeff Allen with my guest Michael Schachter, a business and corporate attorney at Pearson and Schachter Law Firm in Walnut Creek, California where he's also co-founder and co-owner, and we have questions from a seller's point of view on the subject of due diligence and all that that entails. 

Michael, let's go ahead and we'll get right back into it here. I've got a small company without a lot of assets. I've got a business here that really I could run from home if I wanted to. Can't I simply conduct due diligence on my own without the aid of an attorney?

Michael: Jeff, I wouldn't advise doing that, not withstanding the fact that it's a small company. There's still a lot of issues that could arise when you're a seller of a company. Everything seems fine until something goes wrong. So it's not to say that something would go wrong if you did it on your own but I wouldn't advise doing it. The attorney's role in these transactions especially on the due diligence is to ascertain what is potentially wrong. Every company is going to have skeletons in their closet. Other than getting the money from the transaction when you sell, the disclosures to the buyer are the second most important thing. So in every transaction you're going to have representations in warranties in these agreements, and they're going to ask you everything about the company, even if you're a small company or large. And the extent of the reps and warranties in these agreements will depend on what type of industry you're in and how long you've been around. But pretty much most if not all of them are customary. And in addition to these reps and warranties the seller needs to disclose certain items that are not true in these representations and warranties. And without an attorney's guidance you'd be lost. A lot of these representations or warranties are very intricate and they ask things that you might not understand. And then rather than guessing and getting in trouble later by not disclosing things it'll be much advisable to seek an attorney to help you get through this process and figure out what could potentially be the issues moving forward.

It might cost more money to pay an attorney to do these things. But in the long road it expedites the transaction and it could save you a lot of money later if there's litigation regarding certain disclosures.

Jeff: And that's where I want to talk to you a little bit more. You touched on some things before we went to the break. You were talking about how involved an attorney could get in the process. From where you sit, Michael, you’ve probably had a chance to be involved in many different levels and to many different extents. But let's just talk about maybe the common garden variety if there is such a thing, a due diligence process where a company gives you a call, and from the time they give you that first phone call to the point where you've agreed to work with them. Tell us a little bit about how you work with the business owner in the process. 

Michael: Right, good question, Jeff. When I represent sellers of the company for the first time this is just assuming that I haven't represented them before. What I do as the seller's attorney is I give them a due diligence request list which is pretty extensive. And I actually do my own investigation of the company themselves so I can ascertain what potentially could be an issue when you disclose it to the buyer and in due diligence. And one of the items that that I'll ask for is the capitalization table which is the ownership table of the owners of the corporation, for example, or LLC. And we want to make sure that every issue once we have given to these particular shareholders and members of the LLC is documented correctly. And I will go through this due diligence request list with my client and do my own investigation of that message as if I was the buyer's attorney so I can ascertain what issues could arise and try to clean them up at this point. And a lot of the clients really appreciate that because these are the same questions that the buyer's attorney asked them when the deal is in progress and it actually expedite the transaction.

 

 

Jeff: And so they kind of know what's coming and because they know what's coming they can respond and react with confidence and provide them with the information that the buyer is looking for. This is all obviously a very involved process and I'm really appreciative of what my attorney is able to do for me in terms of get me prepared for the workload that's kind of involved. Then there is going to be some work involved. I've got a business to run but because I am serious about selling my company and I want to do what's right I'm going to take that list that you provide me and I'm going to get to work on it. But who else can help me out there? Who else can I involve in the due diligence process, Michael?

Michael: Good question, Jeff. A lot of times the due diligence process actually inundates the business owner, and it becomes like a full-time job. And it's kind of frustrating for the business owner because they need to run their business but at the same time they're intrigued and fascinated by the exit. So there's a challenge there. So what helps is try to figure out from the owner of the company who the people are in the company to ask certain questions like if there's financial questions you ask the CFO. If there's operational issues you ask the COO. So you figure out who these people are and you actually figure out which questions are directed at who because you'd be amazed how many times you could ask the question and some of these people wouldn't know the answer. And you can actually expedite it and figure out who to ask the question to. So it's an intriguing process. But what you need to be careful about is how many people you tell in the company about this transaction because it should be on a need to know basis. Because the last thing you want to do is have every employee involved with the company know about the transaction and they might get worried about whether or not they're going to be staying on after the deal closes. It's an interesting dynamic and the people who will give you the best answers are the actual owners of the company themselves and the officers and directors. So you would seek their guidance to ascertain who to ask these questions to. 

So what helps is try to figure out from the owner of the company who the people are in the company to ask certain questions like if there's financial questions you ask the CFO.

Jeff: What about people like my CPA for example?

Michael: The CPA, I would put them on the same level as the attorney. The CPA would probably know as soon as the attorney knows about whether or not if they have a potential buyer for the company. The CPA's going to be involved with all the financial issues that arise and the tax matters. What I do is once we get the first draft of the definitive agreement such as the stock purchase agreement or asset purchase agreement I will actually have the CPA review the agreement simultaneously with me. So I know these answers to a lot of the representations and warranties regarding tax matters and financials. And the CPA will ascertain and figure out what they need to provide to the buyer as well. So we work hand in hand for the most part.

 

Jeff: If I don't necessarily have a buyer interested or trying to get more information about my company yet and I'm kind of taking the process, the bull by the horns, and moving forward with my plans to put my company up for sale and to list it, when might be a good time for me to get a business broker involved if I don't already have someone approaching me? 

Michael: Right. I think you need to make a conscious decision that you're ready to sell. And at that point I think it's a good point to ascertain and find a business broker for you. It's similar to the analogy you gave when you're selling your house, at some point you realize that it's the right time to sell it and I think the business owner will have the same inclination with their own business. And at that point it would be good to seek out a third party business advisor, business broker. And they help out with the due diligence as well. And for the most part they only get paid if the deal closes, so I think it will be a good partner for any business owner to try to seek one out when they make a conscious decision to sell the company.

Right. I think you need to make a conscious decision that you're ready to sell.

Jeff: You mentioned that they help out with the due diligence process. Can you point to any examples of how they would be helpful in that process? 

Michael: In my experience I've actually given due diligence request with some work with business brokers and the client together to put together these items that I've requested in the due diligence request list. And honestly, quite frankly it's cheaper for the business owner to use the business brokers, someone who's experienced. They can't give legal advice obviously but they can help organize these items to make my job easier.

 

Jeff: Understood. Michael, we are running short of time here. If there are maybe a couple of key take aways, if you're riding up an elevator for example to the top of a metropolitan high rise, and you're off to a meeting there, and you've only got about 30 seconds left what would you tell the person you're riding with about selling their business and what they need to be mindful of as they get ready to embark and go down that road?

Michael: I would say the most important thing is to keep organized and document everything that's happened in the life of the company. Every company is going to have skeletons in their closet, and whether or not that's a big issue or not isn't up to the client themselves but should be judged by an attorney. That's why it's important to get an attorney involved with the process and help expedite the transaction with the buyer. I think the attorney's role in this process is imperative and should be sought as soon as the business owner makes a conscious decision to sell the business.

 

Jeff: Very, very good. Michael Schachter, this has been a great conversation. I really do appreciate your time and I know that you're busy there and you've got to get back to matters at hand. But if there is anyone in our listening audience to Deal Talk and they may be in your area at Walnut Creek in Northern California. They'd like to contact you, get your advice, maybe discuss the possibility of having you assist them with their due diligence needs and as they're may be preparing to sell their business. Or if they have any other business-related questions for you, perhaps would like to seek your counsel. How can they reach you?

Michael: Sure, thank you Jeff. You can reach me at 925-954-7248. I give free consultations and I'm happy to discuss with any business owner any potential questions they have. You can also reach me via email at mschachter@pearsonschachterlaw.com

 I would say the most important thing is to keep organized and document everything that's happened in the life of the company.

Jeff: pearsonschachterlaw.com, and again that phone number if you would just repeat that for us.

Michael: Sure, 925-954-7248.

 

Jeff: Again, Michael Schachter, I appreciate all the time. Thank you so much for joining us on Deal Talk. Hopefully we can have you back on again.

Michael: Thank you Jeff, my pleasure. It's been fun.

 

Jeff: Michael, Schachter, business corporate and real estate transactional attorney has been my guest today. We hope you enjoyed the discussion.

To listen to more Deal Talk, visit morganandwestfield.com and click on the podcast link at the top of the site. And if you consult- or work with business owners prior to, during, or after the transaction process, you'd like to join us as a future guest to share your expertise contact me directly at 888-693-7834, ext. 190, or email me at jeff@morganandwestfield.com. Deal Talk is presented by Morgan & Westfield, the nationwide leader in business sales and appraisals. Find out how Morgan & Westfield can help you at morganandestfield.com. For everyone at Deal Talk, I'm Jeff Allen, thank you for listening.

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