Key insights
- Buyers review your financial performance, legal and regulatory situation, operations, and commercial viability during due diligence
- You must gather and vet a wide range of documents to prepare for this phase
- Hiring an advisor is a good first step and can save you time and smooth your deal’s way to closing
When selling your business, an essential process stands between you and a successful transaction: due diligence. But what is due diligence in the mergers and acquisitions (M&A) field, and why is it so important?
Simply put, due diligence is a prospective buyer’s in-depth review and verification of key facts about your business. This process helps investors confirm the value and viability of your company while identifying any potential risks.
Understanding what is involved in due diligence for a business sale can make the entire process smoother and faster while helping you get the best possible valuation at the end.
What is involved in due diligence for a business sale?
Due diligence is more than just a financial or legal assessment. It’s a comprehensive check on the entire business to ensure it’s a sound investment. The process typically covers four main areas:
- Financials
- Legal and regulatory issues
- Operations
- Commercial concerns
Each area has a particular focus and requires specific documents. Let’s dive into each.
1. Financial due diligence
Financial due diligence gives buyers a deep look into your company’s fiscal and budgetary health. Buyers aim to verify revenue, expenses, assets, liabilities, and overall profitability. This step is crucial because it confirms the financial claims you’ve made during the sale process.
All M&A deals require a base level of financial documentation to pass a rigorous due diligence process.
Documents needed for financial due diligence:
- Profit and loss statements for the past three to five years
- Balance sheets
- Cash flow statements
- Tax returns for the past three to five years, including returns showing compliance with state and local taxes (SALT)
- Records for accounts receivable and payable
- Budgets and forecasts
- Inventory lists
In addition, businesses valued at $10M or higher should have the following documents prepared for potential buyers—the higher value means that investors will devote even more scrutiny into your financial situation:
- Audited financial statements
- A sell-side quality of earnings report detailing the most accurate financial picture of the business
Financial due diligence helps buyers confirm that your business’s financial data is accurate, reliable, and sustainable.
2. Legal and regulatory due diligence
Legal and regulatory due diligence ensures that your business is in full compliance with relevant laws and regulations and that no legal problems could derail the deal. Buyers will assess everything from ownership of intellectual property and employee contracts to any existing litigation or sanctions from regulatory agencies.
Documents needed for legal and regulatory due diligence:
- Ownership and formation documents (e.g., incorporation papers, bylaws)
- Intellectual property records (e.g., patents, trademarks, copyrights)
- Employee and contractor agreements
- Leases and property ownership documents
- Contracts with customers, suppliers, and vendors
- Pending litigation or legal disputes
- Compliance certificates and licensing
Legal and regulatory due diligence protects buyers from unexpected liabilities and ensures that the business can legally be transferred.
Financial due diligence versus legal due diligence
While both financial and legal due diligence are crucial, they serve different purposes. Financial due diligence verifies the financial stability and profitability of your business, while legal due diligence ensures that the business is free from legal risks and can operate within the bounds of the law. Some risks may relate to tax law, so there is potential for overlap.
In essence:
- Financial due diligence focuses on confirming economic value.
- Legal due diligence focuses on eliminating potential legal hurdles and regulatory penalties.
Understanding these distinctions can help you prepare the right documentation and anticipate buyers’ questions.
3. Operational due diligence
Operational due diligence focuses on the efficiency and effectiveness of your business’s processes. Buyers want to understand how the business operates daily and whether it can run smoothly without you.
The more operational excellence you can demonstrate, the smoother your diligence process will be. Make sure your documentation reflects meticulous attention to how your organization runs.
Documents needed for operational due diligence:
- Organizational charts
- Employee handbooks and HR policies
- Standard operating procedures (SOPs)
- Customer lists and service agreements
- Vendor and supplier agreements
- IT infrastructure and system documentation
Operational due diligence reassures buyers that they can maintain and scale your operations post-sale.
4. Commercial due diligence
Commercial due diligence involves assessing the market position of your business, its growth potential, and any risks related to competition.
Buyers want to ensure that your business is well positioned to stay profitable. They’ll focus on your relative advantages in your sector and the likelihood that you can maximize strengths to scale operations.
Documents needed for commercial due diligence:
- Market research and industry reports
- Customer demographic data
- Sales and marketing strategies
- Competitor analysis
- SWOT analysis (strengths, weaknesses, opportunities, and threats)
Commercial due diligence helps buyers assess future profitability by examining market position and growth potential.
How to prepare for due diligence when selling your business
A well-prepared due diligence process can make a big difference in both timing and outcome. Here’s a step-by-step guide to ensure you’re ready:
- Hire an advisor. Consider retaining an M&A advisor with experience guiding sellers through due diligence. An investment bank might be the best choice if your business’s likely value is more than $10M. Your advisor can prepare you to address buyer concerns in advance and ensure your documentation is complete.
- Organize your documents and prepare a data room. Gather the necessary records early to avoid delays. There may be hundreds of these documents, so create a secure, organized digital space where buyers can access and review them and your advisor can easily add to the bundle. A well-ordered data room simplifies the review process and speeds up due diligence.
- Check for accuracy. Make sure all records are accurate and up-to-date. Double-check financial statements, legal documents, and operational information. Your advisor or investment bank will figure out how to present the most attractive picture of your company’s value backed by all this hard data.
- Address any red flags. Work to resolve any pending legal or regulatory issues, debts, or operational inefficiencies before going to market. It’s better to fix problems in advance before they become stumbling blocks to a high-value deal—never underestimate the sophistication of your buyer and the thoroughness of due diligence.
Final thoughts
Due diligence is a complex and often arduous process, but preparation can make it manageable. By understanding what’s involved and organizing your documentation in advance, you’ll smooth the road to a more efficient sale process and a better outcome for your M&A deal.