Mastering M&A Due Diligence: Key Checklist and Best Practices

17 September 2024

Executive Summary

After you accept an offer or letter of intent (LOI) for your business, the buyer will commence due diligence. Due diligence is the process of acquiring and analyzing information to help the parties decide whether or not to proceed with a business transaction.

This period of time typically lasts 30 days, although it can be extended if both sides agree. In most cases, the buyer has the option to walk away from the sale if they are dissatisfied for any reason during due diligence.

So, what are sellers to do? Begin by conjuring up your best Boy Scout. Begin by being prepared.

Doing proper due diligence on your own firm will reveal any issues and allow you to address them before a buyer notices them. In this essay, we will show you how to do that while also answering the following questions:

What documents are normally provided to the buyer before making an offer?
What documents are typically provided to the buyer when they submit an offer (during due diligence)?
How should the seller handle customers that require excessive information before making an offer?
How long does due diligence typically last?
What can the seller do to expedite due diligence?
What are representations and warranties, and how do they affect due diligence?
What is the average due diligence procedure?
How should you get your business ready for due diligence?

Make sure to check out our sample due diligence checklist in the post below. It features more than 70 things organized into seven basic groups. And you thought this would be the easiest part.

What is the purpose of Due Diligence?

Businesses are complicated—there are hundreds of considerations that buyers must evaluate before determining whether or not to proceed with the acquisition.

When examining a property for sale, purchasers can rapidly make an opinion on the home’s value and suitability before hiring an inspector to do a home inspection. Homes and other tangible purchases frequently require little or no due diligence. However, purchasing a firm necessitates examining several intangible variables that are less obvious and more difficult to examine and evaluate.

As a result of the increased complexity, business buyers must go through a lengthy and extensive due diligence procedure before closing the sale.

This process does not begin unless both parties accept the offer.

In business, the seller’s assertions are only evaluated via due diligence once a letter of intent has been mutually agreed upon. If all buyers completed their due diligence before making an offer, sellers would spend a significant amount of time with many purchasers, risking a breach of confidentiality.

Conducting due diligence with numerous parties at the same time may cause the seller to lose focus on their firm, reducing its value. The buyer must accept the seller’s initial representations before an offer can be accepted; only after an offer is accepted does the buyer have the option to check the seller’s assertions.

Before accepting an offer, the seller should exercise caution about what information is disclosed to a bidder. The vendor should be helpful, but they should not show the buyer everything they request. At some time, the seller should respectfully and delicately invite the buyer to make an offer.

List of documents and when they are shared.

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

A confidential information memorandum (CIM)
Profit & loss statements (P&Ls)
Balance sheets
Summary or abstract of the lease, not the complete contract.
Equipment list
Sales literature and brochures.

Here’s what to say when the offer is approved (during due diligence):

Federal Income Tax Returns
Bank Statements
Invoices and receipts
Full copy of the lease.
Leasing, including premise and equipment leasing
Third-party contracts, such as supplier or vendor agreements
Sales and use tax reports
Staffing and payroll-related papers, such as job descriptions and employment contracts
Insurance-related paperwork, such as workers’ compensation, health, and liability insurance
Equipment inspection reports
Licenses and Permits
Marketing, advertising, and promotional materials
Environmental paperwork and inspections.
Franchise-related documents.

The list above is not typical of all businesses. Each company will have its own unique due diligence structure. Most due diligence inquiries are more detailed than those listed above.

Handling Buyers Who Request Too Much Information

How do I handle a buyer who wants too much information (such as bank accounts and tax returns) before submitting an offer?

Before getting an offer, be cautious about what you display buyers. You should be helpful and communicate with the buyers, but don’t offer them everything they ask for. At some time, you should politely and tactfully ask them to make you an offer.

Explain to the buyer that a complete investigation can only be undertaken once an offer is accepted. Tactfully explain that after an offer is accepted, the buyer will have plenty of time to conduct their due diligence and confirm the truth of your assertions.

Explain to the buyer that you are making representations, which are validated via due diligence.

How long is due diligence?

Due diligence can take any amount of time, as long as you and the buyer agree. The normal due diligence duration for most small to medium-sized firms is 30 to 60 days.

The duration of due diligence should be determined depending on the following:

The availability of information. If the seller replies quickly to the buyer’s document demands, the due diligence period may be shortened.

Turnaround time. This is dependent on how quickly the customer reviews the material. If the seller offers material that is brief, organized, and clear, the due diligence process will be accelerated.

Communication. The seller’s availability to the buyer may also shorten the due diligence period.

The significance of ‘representations’ and ‘warranties’

Due diligence is never flawless; it cannot identify every potential problem with a firm. You can never be certain that the business is without challenges. There is no such thing as a “perfect” business.

What may be done if due diligence fails to assure that the firm is free of problems?

“Representations” and “warranties” are assertions and promises made by the seller of a business regarding the assets, liabilities, and other aspects of the business for sale. In the purchase agreement, the seller must provide truthful claims about the business’s status, including practically all facets of the operation. These are known as “‘reps and warranties.”

Essentially, the seller is insuring the buyer that their promises are truthful, and if proven differently, the buyer has the right to seek legal redress, which could result in the seller compensating the buyer for damages. The representations and warranties work together to reduce the risk of any material faults that were not detected during due diligence.

A representation is an assertion of fact. If a depiction is false, it is said to be “inaccurate.”

For example, a seller may represent that the business’s assets are in good condition, that all inventory is salable, that no hazardous substances are used in the business, that the business has operated in accordance with all laws, or that the seller has the legal capacity to sign the purchase agreement.

A guarantee is an assurance. If a warranty is false, it is “breached.”

For example, a seller may declare that they will operate the business in a regular and usual manner and will comply with all regulations until closing, or that they would pay all payroll taxes owed from previous operations up to the time of closing.

The purchase agreement’s representations and warranties ensure the buyer that legal remedies are available if the seller fails to disclose any material facts about the business that are not identified during due diligence. This ensures the buyer that further protection is available if the seller fails to disclose all relevant information during due diligence.

The Process

Here’s a summary of how due diligence works in the sales process:

Letter Of Intent

The parties negotiate and accept the letter of intent.

Due diligence

The due diligence process begins immediately after the parties receive the letter of intent.

Purchasing Agreement

During due diligence, the parties often begin drafting the purchase agreement. The acquisition agreement can take several weeks to negotiate and finalize, therefore the process typically begins during due diligence to guarantee a quick closure with minimal delays.

Conclusion to Due Diligence

At any time during due diligence or after it has expired, the buyer may decide that they are satisfied with their study of the business and will proceed with the sale. The buyer may do this because the buyer and seller have resolved the contingencies, or even if there are still contingencies, the buyer may be confident enough to engage into a final agreement.

When this occurs, the buyer and seller will sign an agreement indicating that due diligence is complete. This represents the end of due diligence and the parties’ determination to conclude the investigation and reach a definitive agreement.

Additional Deposit, If Applicable.

For smaller transactions, the buyer will pay an extra deposit to the escrow business after signing off on the completion of due diligence. If the transaction is discontinued owing to the buyer’s fault before a definitive agreement is signed, the buyer will lose both the first and further deposits. Otherwise, the deposits will be used to the ultimate purchase price.

Contingencies that withstand Due Diligence

Bank financing, franchisor permission, lease assignment, and license transfers are common contingencies that survive due diligence. These remain as contingencies and are resolved between the completion of due diligence and the close. If these contingencies are not met, the buyer has the option to cancel the deal.

Closing

Once the conditions are met, the closure may take place. Typically, the purchase agreement is executed at closing. However, it may be signed prior to the closing.

Due Diligence Checklist

Here’s an example due diligence checklist:

Operations

Advertising contracts
Customer List
Inventory Count
List of key competitors.
Marketing material
Operation manual
Preliminary equipment inspection.
Premises lease
Summary of Key Lease Terms
Supplier and Vendor List
Supplier/vendor contracts

Insurance

Health insurance policies
Liability insurance policies
Workers’ Compensation Policies and History

Assets

Describe any real estate possessed.
Equipment inspection
Equipment leases
Equipment list
List of all assets included in the pricing.
Inventory list.

Financial/Tax

Accounts Payable Schedule
Accounts receivable aging schedule.
Annual personal property tax certificate.
Backup data for financial changes.
Bank Statements
Customer-specific sales breakdown
Sales breakdown according to product type
Copies of current loan or funding arrangements.
Customer or client agreements
Documentation for adding back to financial statements
Federal Income Tax Returns
Financial budgets and predictions.
Full QuickBooks or accounting software file.
A general ledger or thorough list of all transactions and expenses.
List of monthly sales since start.
Merchant account statements
Payroll Tax Reports
Profit and Loss Statements
Sales and use tax reports
Utility bills

Staff

Benefit Plans
Compensation arrangements
A detailed schedule of payroll expenses.
Employment, agency, and independent contractor agreements
Job Descriptions
List of Outside Contractors
Other employment agreements
Overview of personnel turnover.
Schedule of owners, officers, workers, independent contractors, and consultants, including titles, length of service, and financial advantages.
Summary bios of top management.

Legal

Articles of incorporation/organization.
Business license
Certificate of Status/Good Standing from the Secretary of State
Copies of licenses, permits, certificates, registrations, and other documents from all government authorities
Copy of all key contracts.
Corporate/LLC bylaws or operating agreements
Corporate/LLC minutes
Description of environmental liabilities.
Fictitious business name statement (DBA).
Financial agreements
Information for Copyrights
Information for Patents
Information about trademarks and service marks
List of liens against the business.
Additional third-party agreements or arrangements
Pending litigation
Phase 1 and 2 environmental studies
Preliminary UCC search results
Previous acquisition agreement and related paperwork for businesses
Resale permit
Seller’s Disclosure Statement

Tips for conducting due diligence

Be emotionally prepared. Due diligence may be a tough process for sellers. You must be willing to invest a significant amount of time and energy into the process. Some purchasers’ goal is to wear you down, uncover issues, and then try to renegotiate the terms of the transaction. Prepare for this possibility by conducting due diligence to identify and rectify problems before a buyer discovers them. You should also try to maintain an emotionally detached attitude toward the procedure so that you can negotiate objectively.

Buyer type determines thoroughness. Individuals tend to be less thorough than businesses when completing due diligence. However, some people can be exceptionally meticulous if they are detail-oriented, risk-averse, or have a CPA or legal coaching them behind the scenes. Most businesses are thorough, especially if they have made several acquisitions in the past.

Exclusivity. Keep your company on the market even after you’ve received an offer, unless you’ve agreed on an exclusivity term with the buyer.

Do not lose focus. You must be prepared to devote significant time and work to the due diligence process. By the time you reach the due diligence step, you may believe you are almost finished, but this is a vital moment in which the sale can be made or lost. If you lose attention at this moment, the trade could fail. You’re just on the 50-yard line at this moment. There is still a lot of work to perform before the sale is finalized. It is critical that you remain engaged and actively participating in due diligence in order to achieve your ultimate goal of a successful closing.

Involve your accountant. Because much of the material required for due diligence is financial in nature, you should consult with your accountant or CFO as soon as possible to help prepare for due diligence. The more collaboration you get from your team, the smoother the procedure will be.

Designate a point person. The point man should be the quarterback of the deal, coordinating communication with all parties involved and reviewing all information before it is released to the buyer. Many professional advisors will lose you as a customer if the transaction is successful, and they may be hesitant to close the transaction as soon as possible due to their hourly-rate charge structures. Being the point man or choosing someone within the firm would help to streamline the due diligence process.

Early communication with the landlord is essential. The lease is one of the most important aspects of the process and must be carefully managed. Lease transfer issues are widespread, thus the process must be handled carefully. Landlords are not compelled to authorize the lease transfer, and delaying their involvement can cause complications that delay or prohibit the completion. We advocate involving the landlord as soon as feasible in the process.

Prequalify the buyer. Before you negotiate and accept an offer, be sure you’ve pre-qualified the buyer. You want to be sure you’re negotiating with a buyer who has the financial resources to complete the acquisition.

Tell the Buyer You’re Prepared. If you’ve prepared your business for sale and organized all of the documentation, make sure to highlight it in your initial interactions with purchasers. You could say something like this.

“I am a determined, serious seller who has readied my business for sale with the assistance of a certified public accountant (CPA). I have all of the documentation needed for due diligence, including tax returns, leases, equipment lists, financial statements, and more.”

Why should I prepare for due diligence?

Can’t I just prepare the documentation as the customer requests them?

Preparing your business for sale significantly improves your chances of success. Laying the framework for due diligence encourages the buyer to agree to a shorter due diligence period and reduces their sense of risk in your organization.

By structuring the documents so that they are ready for review, you may make the process go more quickly and smoothly. Immediately after accepting an offer, the buyer can begin reading the documentation. Time is your greatest adversary. All negotiations can be lost due to time constraints. By planning for due diligence, you can potentially accelerate the process and drastically increase your chances of finalizing the acquisition.

You also boost the likelihood of receiving an offer. Buyers are often hesitant to make an offer on a firm because they do not want to put their time and money at risk by doing due diligence just to discover an unreported problem. Preparing for due diligence alleviates these issues for buyers.

We strongly advise you to start preparing for due diligence as soon as feasible. Here’s where your accountant or CFO can really help you acquire the necessary paperwork.

Due diligence in one recent deal we worked on was severely delayed because the seller did not have copies of bank statements on hand, and it took several weeks to receive copies from the bank. Because the economy suffered during this time, the delay resulted in a price reduction.

When you put in the time and effort to prepare your business for sale, you show the buyer that you’re serious. Buyers want to work with motivated and prepared sellers. Buyers are more willing to spend time with a vendor who they know has prepared for the transaction.

How Do I Prepare for Due Diligence?

Preparing your business for due diligence is simple.

It entails gathering and collecting the documents that most purchasers require and analyze during the due diligence process. You should then hire a third-party expert to analyze these documents and identify any flaws that the buyer may find during due diligence. You should next address any faults that are discovered.

The benefit of preparing for due diligence is that you will be able to handle any difficulties on your own schedule, without the extra burden of the transaction being contingent on its outcome. The importance of having your finances prepared and structured, as well as ensuring everything is operational and legal, cannot be overstated.

Preparing for financial due diligence is one of the most crucial steps in effectively selling your business. Because missing or inaccurate financial records are the leading cause of business sales failure, you should prioritize ensuring that your financials are in order. Otherwise, you risk losing the buyer because financial irregularities would most certainly be revealed during due diligence.

Nobody likes to spend a lot of time with a buyer just to lose them due to something that could have been avoided. A third party, preferably a CPA, should do financial due diligence prior to the sale. Ideally, this should be done three to six months before starting the sale process. This will allow you plenty of time to address any issues that arise during the procedure.

Conclusion

We strongly advise that you devote time to preparing your business for due diligence. Most business owners skip this phase completely. Preparing for this process will significantly increase your chances of a successful sale. Furthermore, indicating to the customer that you have prepared for due diligence boosts their confidence in your company and minimizes their impression of anxiety.

Due diligence can mean paradise or hell. If your financials are in order and everything is in place operationally and legally, due diligence should go smoothly, and your business venture will take off, bringing you one step closer to realizing your dreams. If you are unprepared and the buyer discovers issues during due diligence, you will find yourself in a difficult situation. Being prepared can help you achieve your desired objective.