Halfway There – The Purpose of Due Diligence

When evaluating a house for sale, a buyer can quickly form an opinion on the value and suitability of the structure and hire an inspector. Houses and other tangible purchases often require little to no due diligence. But buying a business involves assessing many intangible factors that aren’t readily apparent and are more difficult to assess and evaluate.

Purpose of Due Diligence

Businesses are complicated – there are hundreds of factors buyers must take into consideration when deciding if they want to move forward with the transaction. As a result of this complexity, purchasers of businesses go through a lengthy and thorough due diligence process before deciding whether to move forward with the transaction. This process begins the moment you accept an offer. 

With a business, your representations are verified during due diligence only after you mutually agree upon a letter of intent. If all buyers conducted their due diligence before making an offer, you would spend a tremendous amount of time with many buyers and risk a confidentiality leak. 

Conducting due diligence simultaneously with multiple parties may also lead you to lose focus on your business, causing the value of your business to decline as a result. The buyer must accept your initial representations before an offer is accepted; only after an offer is accepted does the buyer have the opportunity to verify your representations.

Before accepting an offer, you should be cautious regarding what information you show to a buyer. You should be helpful to the buyer, but you shouldn’t show them everything they ask to see. At some point, you should politely and tactfully ask the buyer to make an offer.

Explain to the buyer that a thorough investigation can only be conducted after an offer is accepted. Point out that once an offer is accepted, the buyer will have plenty of time to perform their due diligence and verify the accuracy of your representations. 

List of Documents and When They Are Shared

Here’s what to share before the offer is accepted:

• Confidential information memorandum (CIM)
• Profit and loss statements (P&Ls)
• Balance sheets
• Summary or abstract of the lease, but not the entire document
• Equipment list
• Sales literature and brochures

Here’s what to share during due diligence after the offer is accepted:

• Federal income tax returns
• Bank statements
• Invoices and receipts
• Full copy of the premises lease
• Equipment leases
• Third-party contracts, such as supplier or vendor contracts
• Sales and use tax reports
• Staffing and payroll-related documents, including job descriptions and employment contracts
• Insurance-related documents, such as workers’ compensation, as well as health and liability insurance
• Equipment inspection reports
• Licenses and permits
• Marketing, advertising, and promotional documents
• Environmental documents and inspections
• Franchise-related documents

This list isn’t typical for every business since each business will have a unique due diligence process and list. Also, many due diligence requests are more extensive than the list above. 

In most circumstances, the buyer can walk away from the transaction if they are unsatisfied for any reason during due diligence.

Length of Due Diligence

Due diligence can take any period of time, as long as both you and the buyer agree. The typical due diligence period for most small to mid-sized businesses is 30 to 60 days.

The length of due diligence should be based on the following:

• Availability of Information: If you respond promptly to the buyer’s document requests, the due diligence period can be shorter.
• Turnaround Time: If you provide concise, organized, and clear information, you’ll speed up the due diligence period.
• Communication: If you are easily accessible and available to the buyer, this may also shorten the due diligence period.

Outcome of Due Diligence 

The outcome of due diligence can actually determine the scope of the reps and warranties. The buyer’s due diligence may be less thorough if you are willing to provide more extensive reps and warranties. But reps and warranties should not be a substitute for thorough due diligence. Likewise, thorough due diligence shouldn’t be a substitute for thorough reps and warranties. Instead, the two should work hand in hand.

Bear in mind that due diligence will never uncover every problem in a business. There is always the possibility that something may slip through the cracks during the due diligence process. Because of that possibility, buyers rely on reps and warranties to offer them protection for issues they may not uncover during due diligence. 

The scope of due diligence and the reps and warranties are driven by the type and size of the business. An industrial business will require an entirely different due diligence and reps and warranties framework than a technology business. Regardless, due diligence and the reps and warranties should work in concert with one another. By preparing for due diligence, you’ll have the opportunity to reduce the potential scope of the reps and warranties in the purchase agreement.

The Importance of “Representations” and “Warranties”

Due diligence is never perfect – it can never uncover every potential problem with a business. A buyer can never be absolutely assured that the business is without problems. In fact, there is no such thing as a “perfect” business. 

If due diligence doesn’t ensure that the business is problem-free, what can be done?

“Representations” and “warranties” are statements and guarantees by the seller relating to the assets, liabilities, and other elements of the business being sold. In the purchase agreement, you will have to make factual statements regarding the condition of the business, covering nearly all aspects of the company. These are referred to as representations and warranties, or “reps and warranties.” 

The reps and warranties collectively mitigate the risk of any material defects that aren’t discovered during due diligence. Essentially, you’re assuring the buyer that your representations are true, and if proven to be otherwise, the buyer is entitled to seek legal remedies, which could result in you reimbursing the buyer for damages. 

• Representations: A representation is a statement of fact. If a representation is untrue, it is “inaccurate.”
  • For example, a seller may represent that the assets of the business are in good repair, all inventory is salable, there are no hazardous substances used in the business, the business has operated in compliance with all laws, or the seller has the legal capacity to sign the purchase agreement. 
• Warranties: A warranty is an assurance. If a warranty is untrue, it is “breached.”
  • For example, a seller may warrant that they will operate the business in a regular and normal manner and will comply with all laws until closing, or that they will pay all payroll taxes that will come due from past operations up to the time of closing. 

Reps and warranties in the purchase agreement assure the buyer that legal remedies are available if you fail to disclose any material facts regarding the business that aren’t discovered during due diligence. This ensures the buyer that additional protection is available if you aren’t fully forthcoming during due diligence.

The parties normally begin preparing a draft of the purchase agreement during due diligence.

The Process

Here’s a summary of how due diligence fits into the sales process:

• Letter of Intent: The parties negotiate and accept the letter of intent.
• Due Diligence: The due diligence period begins immediately after the letter of intent is accepted by the parties. 
• Purchase Agreement: The parties normally begin preparing a draft of the purchase agreement during due diligence. The purchase agreement often takes several weeks to negotiate and finalize, so the process usually starts during due diligence to ensure an efficient closing with minimal delays.
• Conclusion of Due Diligence: At any point during due diligence, or upon its expiration, the buyer may decide they’re satisfied with their investigation of the business and will proceed with the transaction. When this happens, the buyer and seller sign an agreement stating that due diligence has concluded. This signifies the completion of due diligence and the parties’ decision to end the investigation and proceed to a definitive agreement.
• Additional Deposit, if Applicable: For smaller transactions, the buyer will place an additional deposit with the escrow company upon signing off on completion of due diligence. If the transaction is canceled due to the buyer’s fault before a definitive agreement is signed, the buyer will forfeit both the initial and additional deposits. Otherwise, these deposits will be applied to the final purchase price.
• Contingencies That Survive Due Diligence: Often, some contingencies survive due diligence, such as bank financing, franchisor approval, lease assignment, or license transfers. These remain as contingencies and are resolved between the conclusion of due diligence and the closing. The buyer may cancel the transaction if these contingencies aren’t resolved prior to the scheduled closing date.
• Closing: Once the contingencies are resolved, the closing may occur. In most cases, the purchase agreement is signed at closing, although it may sometimes be signed prior to closing.