Making a Case for Capital

Warts and All

Business owners are often amazed by how much effort they must put into the due diligence process. “It is a royal pain in the tush to produce all this stuff,” says Tom Martin, a partner at the Minneapolis-based law firm Dorsey & Whitney. “It takes time and a lot of work.”

Sellers sometimes are also put off by the need to reveal detailed information about their companies. “People who haven’t been through the due diligence process before are often offended by the degree of disclosure and documentation required,” Martin says.

Some sellers feel annoyed that potential buyers won’t take their word for anything, and find it painful to reveal potentially embarrassing information. “People are afraid that, by disclosing the problems, they may get a lower price or even look unsophisticated or stupid,” Martin says.

Push past that worry, Martin suggests. Every company has warts, and disclosing problem areas helps build credibility that goes a long way toward completing the deal. “It’s not in anyone’s best interest to hide a potential problem,” he says, especially as it can delay or even derail transactions if the seller is evasive.

“If you know you have some issues and you try to hide them, that’s the kiss of death,” Cavanagh agrees. “They’ll be found out during the transaction, which will change the terms and conditions of the deal, or they’ll be found out after the transaction, which could result in a lawsuit.”

Good due diligence, by contrast, acts as a litigation defense for a seller. Reveal all you know about a company, and a buyer has little ability to win a post-closing lawsuit against you. “Fail to tell someone something important, and you could be in trouble,” Ekberg says. “You’ll prevent a lot of pain and suffering—and costs on both sides of the table—if you get problems out in the open right away.”

Fix the Problems

Because comprehensive due diligence is so time consuming, it’s difficult for business principals to both run the firm and prepare information for potential buyers. Companies use a variety of strategies to shoehorn due diligence preparation into the ordinary business day.

Some collect due diligence information as part of a company’s everyday procedure, spreading out the effort over time. “It makes a lot of sense to have a lot of this information compiled in a business plan or updated business profile,” Cavanagh says, noting that the data can help owners better run their companies. Other firms hire consultants to help them organize and assemble due diligence materials. Accounting firms, investment banks, and consultants are all potential resources.

Some due diligence work may also be done by a company’s chief financial officer, controller, and vice presidents of sales, marketing, operations, and customer service. Of course, these people have regular job duties, with limited time to spend on due diligence, so they’ll probably need help from other in-house or vendor sources.

Make sure the company’s senior leadership are involved in the due diligence process, and in reviewing preparations made by others. “Due diligence is not glamorous, but it cannot and should not be completely farmed out to consultants—including lawyers—or even to lower-level employees,” Ekberg says. “The senior leadership of the company needs to be hands on and very involved in the process”—if only because they have the most to lose from a sloppy process.

Cavanagh estimates it takes up at least one person’s time for between two weeks and a month. The bulk of that time will be spent making lists and looking for documentation. “You generally have the information, though you may not know exactly where it is,” he says.

You’ll also spend time looking for gaps or errors in your company’s documents. Pay particular attention to financial statements, which Cavanagh says are “the biggest area where we run into problems.” Consider getting yours reviewed or audited. It might cost between $15,000 and $45,000 for a company with less than $25 million in annual revenue, Cavanagh estimates.

The review or audit, Cavanagh says, “gives the investor a lot more confidence that your financial house is in order. If you can mitigate that risk you may get a better price or better terms on a deal.”

Watch out for unrecorded tax liabilities, too, suggests Amy Roberts, a tax partner at the Minneapolis office of the Grant Thornton accounting firm. “Make sure you have your tax filings in order,” she says. “We look at what you have filed, but pay more attention to what you have not filed.”