Due diligence, as we use the term, is a buyer's detailed investigation into the affairs of your company before they acquire it. How you prepare for and respond to the buyer's due diligence can help you receive top dollar for your company, or it can destroy value and force you to live with potential liability long after the deal is closed.
First, understand the scope of due diligence and prepare to satisfy the buyer's requests for information. Buyers want to know about a seller's financial, legal, operational and technical affairs, in other words' everything. The buyer's information request will be many pages long. Sellers should prepare well before the information is requested. Get a sample 'due diligence checklist'. Keep thorough and orderly records and document business processes so you can gather information when required. While this will be necessary for an acquisition, it is also a valuable discipline as your company grows.
Second, understand when to produce sensitive information. Buyers will ask for information about your customers, products, sales pipeline, financial statements, technology, personnel and other aspects of your business. You need to disclose some information to assist the buyer in a purchase decision, but expect the buyer to show commitment to the transaction commensurate with the volume and sensitivity of information they request. Don't get pulled into a situation where the buyer continues to ask for information, making work for you and your employees, without dedicating similar efforts to completing the transaction.
Third, remember that due diligence is about full disclosure. If your company has problems, face the facts and plan how and when to disclose troublesome information to the buyer. Do this before a deal is negotiated. Time the delivery of bad news when you have the most leverage in negotiations. Your goal should be to ensure that the buyer has no surprises during due diligence. Undisclosed good news means you probably haven't captured full value for your company. Undisclosed bad news undermines your credibility and jeopardizes the transaction.
Fourth, in-depth due diligence is time consuming; begin this formal process only after the general terms of a transaction have been agreed in writing, for example, in a non-binding Letter of Intent (LOI). As negotiations draw close to an LOI, sellers should begin compiling information needed in due diligence. A seller should ask the buyer for a formal 'due diligence checklist' immediately after executing an LOI.
Fifth, respond promptly to the buyer's due diligence request with a complete and orderly set of documents. Organize and index the information to correspond with the outline of the buyer's checklist. Sellers gain great credibility and give buyers much comfort about the quality of the business when their due diligence responses are organized, detailed, and complete. Conversely, inaccurate, incomplete, and disorganized responses cause buyers concern because the potential risks related to buying your company cannot readily be identified and assessed. That concern may result in a reduced purchase price, more onerous terms, broader indemnification provisions, greater ongoing liability for the seller, or even a failed transaction.
Sixth, don't hide anything during due diligence, and instruct employees who are involved to be open and helpful. If the buyer requests highly sensitive information that could be injurious to your company if the deal falls through, consider ways that can satisfy the buyer's 'need to know' yet protect your company. For example, if the buyer wants to review highly proprietary source code, you may wish to engage a mutually satisfactory third party and jointly agree on their mandate to provide the buyer with information they need. The scope of the due diligence checklist can be negotiated to meet the needs of both parties.
Seventh, deal intelligently and objectively with issues that come up in due diligence. During the process the buyer may identify new risks or discover financial, technical, operational or legal characteristics of your company that they see as problems. If you are unable to provide solid information to give the buyer comfort about the issue, then work with the buyer to objectively estimate the reasonable financial magnitude and duration of the risk. A clear and levelheaded assessment enables both buyer and seller to negotiate deal terms so that the buyer is protected if the risk materializes after the deal closes, but the seller is not penalized if it turns out not to be a problem.
Last, sellers should be wary of buyers who try to renegotiate the deal after due diligence without good reason. For example, some buyers try to drive the purchase price down without citing any legitimate new information discovered during due diligence (after they made the offer). Or they may overstate the magnitude of an issue and try to reduce the purchase price accordingly. Such tactics smack of bad faith and they probably signal more problems to come, especially if part of the purchase price is to be paid after closing under an escrow, earnout or other contingent payment mechanism.
A version of this article originally appeared in Softletter and Software Success.