Due diligence- A Trap or Just Part of a Contract
The due diligence process is an integral part of a contract. Often, it is a cunning ruse to continue negotiating under the cover of a contract. A wolf in sheep’s clothing.
To understand this, let us look at how due diligence looks from the perspective of prosecuting the sale of a business.
When you get to where a buyer has decided they are interested in your business and wish to make an offer, there are often two remaining tasks. To reduce the offer to a contract. To get the contract to complete.
In Queensland, the REIQ offers standard business sale contracts that are widely used.
The buyer has usually assessed the value of the business based on the information provided. The contract is to provide the opportunity to verify the information. Of course, it does other things, but we will concentrate on this task here.
This is where a due diligence process will kick in.
We can assess the due diligence process in a couple of broad ways. It can have a specified task of confirming the profitability and veracity of a business. Verifying financial statements against actual performance. Checking up on customer engagement to make sure it is not a phantom business.
There is a historical viewpoint to checking on the business. It takes the stance that the interaction between the buyer and the seller and the market more broadly has attributed a market value to the business.
Do The Numbers Add Up – Simple Due Diligence
Based on data from the past, the buyer has formed an assessment of the Future Maintainable Earnings of the business. A profit multiple has to those earnings to arrive at a value. The multiple considers the risk inherent in the business.
The job of the due diligence is to check the assumptions underlying that risk profile and profitability.
Prior to the start of the due diligence exercise, a seller will have a good idea as to the successful completion of this condition. Of course, there is some scope for surprises to be thrown up, but this is not too frequent.
A seller wants to be confident that a due diligence process will succeed because it means an exclusive arrangement with the buyer. No other buyers can purchase it.
The buyer will want the seller to withdraw the business from the market while undertaking the process.
This type of due diligence is a bit like offering buyer vendor finance. The initial contractual deposit is a first instalment. The main instalment occurs at the successful completion of the contract.
Of course, subsequent staged payments may be part of the contract. However, vesting of the business is more assured to shift to the buyer.
Incidentally, offering some vendor finance is a way of getting the best price for your business.
Does The Business Stack Up – Complex Due Diligence
There is another type of due diligence which is far broader. Its success rests on whether the buyer is ‘satisfied’.
The concept of getting satisfaction is woolly and shifts the balance of power in favour of the buyer.
Rather than vendor finance, this type of due diligence is a bit like offering an earn out. For a relatively minor refundable cost, this type of due diligence provides an option to the buyer to purchase the business. They may choose to exercise this option or not.
Another way of considering a contract containing this type of due diligence process is that it represents the right to keep negotiating. This can occur deep into a long due diligence process.
Imagine being a seller coming close to the end of the all-important due diligence process only to be told that due diligence is not satisfactory. No explanation that is logical to the seller is necessary.
There is very little choice but to run the gauntlet of a due diligence process in the sale of your business. There are a few things that are worth thinking about as you head in that direction.
The Business No Longer Freely Available
It can often pay to provide information that a buyer seeks prior to entering a contracted due diligence process. This way, you don’t have to take the business off the market. You can keep looking for buyers.
If you put the business under contract, it may be worth considering a backup contract if another buyer appears. It does not become actionable unless the first contract fails.
If a buyer says they are not prepared to provide a deposit as part of a contract, be very suspicious. They would part with nothing while you open your business to intense scrutiny and remove your business from the market.
Stepping through the process of selling your business will demand many decisions arising from the demands a buyer will make. Personalities matter a lot. Trust is the lubrication that allows things to happen smoothly.
The best situation is the simplest one where the seller wants to sell the business and the buyer wants to buy it. It is when the buyer wants a long due diligence period based on being ‘satisfied’ with no deposit that you get worried.
The reason I am writing this is that it happened to me recently. A conversation where I wanted to get some details about an offer the buyer made became quite unnerving. I can see now that the buyer was setting me up.
The experience was so different from previous ones where I had proceeded with a lot of latitude towards a buyer.
Deals Happen In Different Ways
I have completed deals with no deposit.
I have completed deals where due diligence, including the buyer meeting important clients, happened on the strength of a term sheet and no deposit.
To sell your business, no one will buy a secret. A buyer will have to be allowed to dig through it. How you allow them to do that is a critical phase of a business sale.
We can approach it from a few angles. But if your intuition is saying there is something strange. Figure out what it is as quickly as possible.
This is where a team effort may be required. Another member of the team in a business sale is the solicitor.
The critical thing here is to use a solicitor who has experience in commercial matters, especially business transactions.
Using one that isn’t experienced in this area means you will be paying them to learn about business transactions. That can end up being expensive as well as risky.
