But don’t let them negatively affect earnings.
When selling your business, a buyer will firmly establish their commitment and seriousness with a Letter of Intent (LOI). The LOI establishes the price that will be paid for your business, if nothing is discovered during the due diligence process to follow. The LOI also establishes the payment schedule, what will be paid to you at closing and how subsequent earn-out payments are tied to dates or achievement milestones. Receiving an LOI that offers an acceptable price and reasonable payment terms is probably the second-most-exciting part of the M&A process. (The most-exciting part of the M&A process is, of course, the actual closing, when funds are exchanged.)
Immediately after the LOI is received and signed by buyer and seller, the due diligence process begins. The due diligence process is the comprehensive review of your business that must be undertaken before a Definitive Purchase Agreement (DPA) is issued by the buyer.
In every deal that we have ever been involved in, the seller severely underestimates the amount of time the due diligence process will consume. Beyond that, the seller is invariably shocked at the sheer magnitude and breadth of what the buyer wants to know. The demands for documentation seem endless: Financial records, insurance records, employee contracts, HR policies, real estate appraisals, lien waivers, proof of an absence of litigation, software license agreements, equipment valuation, equipment replacement values, leases, inventory statements…the list goes on and on. What’s more, there are often multiple parties involved in the due diligence process, and many of our clients have called us up in a huff and said, “Didn’t we provide this information already?” Compounding these problems, you probably don’t want to tell key employees that you are selling, so it’s hard to get them involved in the due diligence process, without tipping your hand.
Perhaps most important, the frustration about the due diligence process will often extend beyond the information and documentation requirements, because the time demands will start to impede on your ability to run your business. This distraction is no small thing. Very often, the LOI ties the payment at the closing to financial performance reaching back 12 months (also called your “trailing twelve months,” or TTM). If you project your earnings to be at a certain level at the closing date, and you miss those earnings figures—no matter what has distracted you—the buyer may very well push to proportionately reduce the value of your business. Given that valuations for lumber dealerships are running between 5X and 6X adjusted EBITDA, a $20,000 drop in earnings can easily dock you $100,000 to $120,000 in the valuation paid. (Heck, for $120,000 you could have hired someone four times over to manage the due diligence process for you!)
The cruel irony here is that you would have hit your numbers if only you hadn’t been supplying documentation to the prospective buyer.
There are few ways around the due diligence dilemma other than hard work and focus. But you can prepare. Even before you engage an investment banker to take your company to market, start to line up essential documents: Financials (income statements and balance sheets reaching back three years), insurance documents, real estate documents including valuations and fair rent estimates, HR policies, and employee contracts. Then, at the time you receive and sign the LOI, immediately ask for the due diligence request list from the prospective buyer. This list is often presented in a spreadsheet form. The list may seem daunting at first, but delegate the list to your key in-the-know employees.
Even after you supply items from the list to the prospective buyer’s due diligence team, get ready for another wave of questions, which will come up as a result of what you sent earlier.
Finally, don’t take the requests and counter-requests personally. No one is questioning your integrity; they are just being thorough. Once you’re done, and the DPA is signed, with the closing date set, you’ll feel a huge weight off your shoulder…and an inflow to your bank account that will reflect a life’s work.