What is Formal Due Diligence?
Formal due diligence is a contingency of a business deal which allows the buyer to thoroughly investigates a business to its satisfaction prior to closing. The formal due diligence process should only occur after a deal is ‘under contract’ whereby there is a written agreement in place (either a Letter of Intent (LOI) or purchase agreement) typically accompanied by a refundable deposit. The buyer requests whatever information they seek about the business through a formal due diligence request list. The seller usually incurs significant time and expenses in providing the requested information, and may not always be able or willing to provide all of the requested information.
Preparing for Formal Due Diligence
Preparation from both the buyer and seller is the key to simplifying formal due diligence. The buyer should carefully prepare their formal due diligence request list prior to making an offer. The seller should prepare their financials and company records for formal due diligence the moment their business is listed for sale. The manner of formal due diligence varies greatly by industry norms, so the business broker should inform the seller what to expect. In order to simplify due diligence, the buyer and seller should agree on the scope of formal due diligence prior to a deal going ‘under contract,’ the buyer’s formal due diligence list should be tailored to the specific business being purchased, and the seller’s financials should be as transparent and organized as possible.
Scope of Formal Due Diligence
- As a part of the LOI or purchase agreement that puts a business deal ‘under contract,’ the buyer should propose a formal due diligence request list.
- This details exactly what information the buyer wishes to obtain and how the buyer desires to obtain the information.
- The scope of formal due diligence may in some cases be unobtainable because the seller either does not have the requested information or does not wish to accommodate the buyer’s method of obtaining the information.
- For example, a seller may not have the buyer’s request for historical financials because the business has not been established long enough.
- Further, smaller or locally owned businesses may not have the detailed records and data (such as employee productivity reports, sales by categories reports, or monthly financial reports) requested by certain buyers.
- In such instances, the buyer should be informed prior to the deal going ‘under contract’ that the seller may not be able to comply with their formal due diligence request list.
- It is then up to the buyer whether they are comfortable to move forward with the deal based on what information is actually available for formal due diligence..
- Another area of formal due diligence concerns the method by which the buyer will gather information about the business.
- Where traditional financials (such as tax returns or profit and loss statements) are unavailable or do not tell the true financial picture about a business, buyers may request that they be allowed to physically ‘observe’ the business (common in retail industries) for a period of time.
- Other buyers may request that they be allowed to speak with the seller’s employees as a part of formal due diligence.
- Many business owners will be hesitant to allow this prior to closing for fear of breaching the confidentiality of the sale.
- Such requests regarding the scope of formal due diligence should be negotiated between the buyer and seller prior to the business going ‘under contract.’
Tailor Formal Due Diligence Request List
The buyer’s formal due diligence request list should be specifically tailored to the business being purchased, and not simply a ‘boilerplate’ list lifted off the internet. By tailoring the request list to the specific business being purchased, the buyer will not waste time by requesting items which do not apply or are unobtainable. A buyer should not request five years of historical financials if the business was established two years ago. Nor should a buyer request information concerning the lease when the business is home-based. The buyer should tailor their information requests based on the attributes of the specific business being purchased, while also realizing what information is customarily provided to buyers during formal due diligence within the specific industry.
Organized Financials Helps Simplify Formal Due Diligence
An organized, transparent, and coherent set of financials (such as tax returns, profit and loss statements, or bank statements) is the most important way in which a business owner can simplify the formal due diligence process. Proving the ‘adjusted owner benefit’ via financials is often the most difficult part of formal due diligence. If the seller has financials going back at least three years with accompanying documentation substantiating any personal expenses that flowed through the financial statement, the formal due diligence process will be much smoother with a far greater chance of satisfying the buyer.
Sellers Often Need Help from Accountants
Business owners frequently need the help of their accountant in order to get through formal due diligence. This is especially true when sellers do not input their own financials themselves into an accounting software (such as Quickbooks) and instead solely rely on their accountant to prepare their financials statement and file their taxes. Many sellers are uncomfortable paying their accountant for help in complying with formal due diligence unless a deal is formally ‘under contract.’ While accountants (and attorneys) play a critical role in helping navigate many business owners through the selling process, the seller should remember that they are the principal and that they are in charge of the deal.
Simplifying the formal due diligence will greatly reduce the stress and expense associated with selling a business. The buyer and seller should agree on the scope of formal due diligence prior to a deal going ‘under contract,’ the buyer’s formal due diligence request list should be specifically tailored to the business being purchased (not a ‘boilerplate’ request), and the seller should prepare an organized and transparent set of financials.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.