Perhaps no other milestone in the selling process is regarded with less enthusiasm than receipt of the buyer’s small business due diligence checklist. At best, owners view it as the necessary gauntlet to be run on the way to the closing table. At worst, business owners describe the due diligence process as the business equivalent of a colonoscopy.
Fortunately, there is a lot you can do on the frontend to turn the turbulent waters (and administrative drudgery) of due diligence into smooth sailing.
Part of preparing your business for sale is anticipating what buyers will request during the due diligence process, then having those items at your fingertips, ready to go.
The buyer’s due diligence checklist typically asks for two forms of information: Answers to questions they have about the business and documentation. Examples of buyer questions could include:
- What are the top three ways you would increase sales?
- Are there any employees who could step up into more senior roles?
- What are the main strengths and weaknesses of your top competitors?
Requests for documentation start with three to five year’s worth of financial statements, tax returns and bank statements. Other document requests include financial reporting, insurance policies, employee handbooks, leases and contracts, etc. In short, any and all documentation associated with running your business.
One of the best reasons to work with a business broker or mergers and acquisitions (M&A) advisor in advance of selling your business is to help prepare both you and your business for the rigors of due diligence.
At Allan Taylor & Co., we start building the client’s data room — a secure, digital filing system that will be shared with the buyer and their advisors during due diligence — when we go through our business valuation. We add to it as we do our own pre-due diligence on the business and create marketing materials to present to buyers. As a result, there’s a good amount of due diligence information already gathered before we ever take a business to market.
Before we jump into the ultimate small business due diligence checklist, let’s start with three frequently asked questions from sellers.
When Does the Due Diligence Period Start?
Here is an example of the progression of a typical M&A deal:
- Analyze business value and major due diligence areas
- Prepare marketing materials for sale of business
- Begin buyer search
- Qualify prospective buyers
- Meet with buyer candidates
- Field and negotiate offers
- Choose buyer candidate and accept offer
- Begin due diligence
- Create and negotiate the Definitive Agreement
- Complete due diligence
- Execute all legal documents (legal transfer of ownership)
- Disperse funds
- Begin post-sale integration and transition period
The sale of a business is always contingent on the buyer being allowed to perform — and be satisfied with — their own due diligence. The Letter of Intent (LOI) will include language about how and when the buyer’s due diligence has been satisfied. Here are two real-life examples:
LOI EXAMPLE #1:
The contemplated transaction is contingent on (a) Purchaser’s satisfaction with its financial, operational and legal due diligence, (b) loan approval with terms acceptable to Purchaser, (c) agreement by the Parties on or before [DATE] (“Commitment Date”) to the Definitive Agreements, including…
LOI EXAMPLE #2:
Due Diligence and Timing — We will perform customary due diligence for a transaction of this nature. This will include examination of business, financial, accounting, industry, legal, insurance, human resources and other matters. Given the importance of certain customer relationships to [COMPANY], we would expect to have brief meetings or conversations with [COMPANY] and key customer personnel at its largest customers. Upon execution of a letter of intent with an exclusivity provision, we would anticipate completing a transaction in approximately [##] days.
Expect the deal to move into the due diligence phase as soon as the LOI is signed. It’s important that both parties understand the milestones and deadlines associated with satisfying due diligence — and stick to them.
How Long Does the Due Diligence Period Last?
The small business due diligence period can take between 30 and 90 days, with 45 to 60 days being about average. You can expedite the due diligence process — with help from our ultimate small business due diligence checklist — by gathering the items you know buyers will ask for before starting the sale process.
Due diligence is performed simultaneously with the creation and negotiation of the Definitive Agreement. These are both time- and document-intensive undertakings. The more you can ease the burden of due diligence on the frontend, the better.
The reverse is also true: The longer due diligence takes the more likely it is that “deal fatigue” will set in. Do not underestimate the negative impact of deal fatigue! Deal fatigue is real. It is also one of the primary reasons deals fall apart.
There’s an old adage in M&A: Time kills deals. And by “time” that often means that due diligence dragged on too long and one or both parties walked away. The faster you can get through due diligence, the more likely it is that you’ll get to the closing table.
What Will Buyers Ask for During Due Diligence?
The short answer is anything they want or need to be confident that they are buying what’s been represented to them. Due diligence also helps the buyer understand the benefits and risks of owning the business, justify the purchase price, and secure financing.
Due diligence requests usually fall into three broad categories:
- Financial: Assess the financial statements of the business for accuracy
- Operational: Review all processes and documentation needed to run the business
- Legal: Confirm there are no current or probable legal issues with the business
Many business owners are shocked when they see the sheer volume of requests on a small business due diligence checklist. Don’t panic! Here’s the good news: Not every request will apply to the sale of your business.
Oftentimes the buyer or their attorney will send over a boilerplate due diligence checklist that includes everything but the kitchen sink. Don’t feel like you have to provide an answer to everything on the list. Your answers to some questions may be “We don’t have/do/track that,” “not applicable,” or simply “no.”
Do the best you can to provide complete and relevant information, but also don’t feel obligated to provide an answer if you don’t have one.
The Ultimate Small Business Due Diligence Checklist
Following is an example of a fairly exhaustive small business due diligence checklist. Keep in mind that there may be questions that are specific to your business or industry that are not on this list. As mentioned above, there may also be items on this checklist that would not apply.
Financial Due Diligence
1. Annual and quarterly financial information
- Income statements, balance sheets, cash flow statements (prepared under both the cash and accrual method) for the past three years
- Year to date (YTD) income statements, balance sheets, cash flow statements (prepared under both the cash and accrual method) for the past three years
- Last 12 months (LTM) income statements, balance sheets, cash flow statements (prepared under both the cash and accrual method)
- Breakdown of sales and gross profits by:
- Product
- Service
- Customer
- Geography
- Sales channel
- Current backlog and work in progress
- Trial balance and general ledger statements
- Copies of the company’s tax returns, both federal and state, including the regular federal depreciation schedules for the past three years
- Copies of all federal payroll tax returns for the past three years
- Copies of all bank statements for the current and past three years
- List of adjustments to cash flow and/or earnings before interest, taxes, depreciation and amortization (EBITDA) with supporting documentation
- Copy of QuickBooks file with user ID and password allowing full access
- Planned vs. actual results
- Management financial reports
2. Financial Projections
- Quarterly financial projections for the next fiscal year
- Major growth drivers and prospects
- Industry and company pricing policies
- Economic assumptions underlying projections
- Any capital expenditures and/or changes to working capital planned or anticipated in the next 36 months.
3. Budgeting Process
- Describe the budget process
- Discuss historical forecast accuracy, where deviations have occurred, and why
4. Capital Structure
- List of all shareholders with description of ownership interests
- Description of any potentially dilutive securities, including vesting provisions and exercise prices
- Summary of all debt instruments, bank lines, and loan agreements with key terms and conditions
5. Other financial information
- Accounts receivable aging report
- Accounts payable reporting
- Discussion of general accounting policies (revenue recognition, etc.)
Products and Services Due Diligence
Description of each product and/or service
- List of current product/service offerings broken down by price, total number of units (with percentage of sales), and average margins
- Projected sales by product/service for current year and next fiscal year
- Key competitors for each product/service
- Key applications of current products/services, and potential additional applications
- Major customers and markets for each product/service
- Historical and projected growth rates
- Market share
- Cost structure and profitability
Customer Due Diligence
- List of top 10 customers for the past three fiscal years and current YTD
- List of strategic relationships
- Revenue by customer
- Description of any significant customer relationships terminated in the last 36 months
- Any other relevant customer information
Competitive Due Diligence
Description of the competitive landscape
- List of primary competitors with description of where they rank in the marketplace along with the company. Include main strengths and weaknesses of each competitor.
Operational Due Diligence
1. Supply chain
- List of critical suppliers
- Contracts and purchase agreements in place (terms, duration, obligations, protections, etc.)
2. Manufacturing
- Current utilization
- Identifiable bottlenecks
- Flow rate/flow time
- Areas for automation
3. Warehouse, Logistics and Returns
- Inventory management
- Returns/warranty claims as a percent of sales
4. Physical Assets
- List of all furniture and fixtures, including age and current value
- List of all tools and equipment, including age and current value
- List of all vehicles, including age, VIN numbers, and current value
- General description of standard employee’s laptop and/or desktop computer, (including hardware configuration, operating system, and installed software)
- Exceptions (list of essential items being used in the business that will not be included in the sale)
5. IT Systems and Service Providers
- Details of all key IT systems utilized, including design, accounting, inventory management, salesforce, and customer databases
- List of all service providers (e.g. telecommunications, internet, web hosting, office equipment, SaaS, accounting, payroll, IT support, shipping, advertising), including current leases and contracts
Marketing, Sales, and Distribution Due Diligence
1. Strategy and implementation
- Description of domestic and international distribution channels
- Positioning of the Company and its products/services
- Marketing opportunities and risks
- Description of marketing campaigns, both digital and traditional. Include examples of recent print collateral and any physical marketing assets.
2. Major Customers
- Status and trends of relationships
- Description of contracts/agreements in place, including payments schedule
- Prospects for future growth and development
- Pipeline analysis
- Customer level profitability
- Turnover or churn rate
3. Principal avenues for generating new business
4. Sales Force
- Compensation
- Quota average
- Sales cycle
- Plan for new hires
- Description of sales force training program
- Customers/markets of focus
5. Anticipated changes to current and/or projected marketing budget
Research and Development Due Diligence
1. Description of R&D Organization
- Strategy
- Key employees
- Major Activities
2. New Product Pipeline
- Description of anticipated new products available within the next two years (with % of annual revenue anticipated to be driven by such products)
- Status and timing
- Cost of development
- Critical technology necessary for implementation
- Risks and key competitors
Management and Employee Due Diligence
- Organizational chart
- Historical and projected headcount by function and location
- Summary biographies of senior management and key employees, including employment history, age, service with the Company, and years in current position
- List of any family members or relatives working for the Company and their annual salary paid for the past three years and current year.
- W-2s for all employees (including owners and family) for the current and last three years
- Compensation arrangements
- Overview of program for senior managers
- Copies (or summaries) of key employment agreements
- Employee benefits plans (health, dental, vision, life, and retirement)
- Incentive stock plan
- Profit sharing plan
- Performance evaluation system
- Significant employee relations problems, past or present
- Personnel turnover
- Data for the last two years
- Benefit plans
- Background and/or immigration checks
- List of any outstanding employee loans
Legal and Intellectual Property Due Diligence
- Current litigation against the Company: Description of all current or threatened litigation and all documentation (including litigation files, detail on claimant, claimed damages, brief history, status, anticipated outcome, and name of the Company’s counsel) with respect thereto.
- Previous litigation against the Company: Description of all litigation or threatened litigation concluded or settled within the past three years and all documentation (including litigation files, settlement agreements, decrees, orders, and judgments) with respect thereto.
- Current and previous litigation initiated by Company
- Disputes and other legal issues: List of any disputed liability claims asserted by any of the Company’s vendors, suppliers, or customers.
- Description of any environmental and safety issues
- Safety precautions
- New regulations and their consequences
- Intellectual property: List of material patents, copyrights, licenses, trade secrets, trade names and trademarks whether registered (issued and pending) or unregistered.
- Summary of insurance coverage, insurance claims, and any material exposures
- Summary of material contracts and consulting agreements
- Key books and records for last three years, including bylaws, minutes of member meetings, articles of incorporation and amendments for existing business entities, key contracts, title to real estate, current real property appraisals, description of any joint ventures, business plans, UCC filings, certificates of good standing
- Copies and details of all industry related certifications, licenses, and affiliations
This checklist should give you an idea of the types of due diligence requests you may see from buyers. Due diligence is a necessary part of any small business sale process. While it may not be the most enjoyable part, it can go smoothly and quickly with a bit of advanced planning. The advisors at Allan Taylor & Co. are here to help get you and your business sale-ready. Let’s get started today.
Barbara Taylor is the co-founder of Allan Taylor & Co. You can connect with her on Twitter @ballantaylor and LinkedIn.
