Get to know your buyer: Conducting Seller Due Diligence
As a business owner selling your company, prospective buyers will perform due diligence on you and your company. But you should also conduct thorough due diligence on the prospective buyer.
When a buyer conducts due diligence on a company, they want to know that the company’s operations, finances, HR, environmental and legal matters (etc., etc.) are in order.
When a seller of a small business conducts due diligence on a buyer, they want to know that the buyer, whether a corporation or an individual, has:
- the financial wherewithal to acquire the company
- the legal standing to own it, and
- the character and business acumen to successfully operate it.
Banks or other financial institutions lending money to a buyer for an acquisition will conduct their own due diligence on a buyer. However, sellers shouldn’t rely on the bank’s due diligence process because they have their own timing, protocols, and criteria that may not align with the seller’s interests.
Some sellers focus their process principally on financial due diligence, believing that once the company is sold that they needn’t be concerned that the buyer can effectively manage it. This approach is shortsighted even for business owners that are not concerned with their legacy. Many transactions tie the post-sale business performance to the seller’s proceeds through an earn-out or a seller’s note. If business performance suffers under the buyer’s direction, the seller loses too. Even with a 100% pay out at the close of the transaction, when the seller has no post-sale financial interest, they may face legal risks if the buyer whose company is not performing contends that the seller misrepresented the business opportunity.
Minimally the objective of financial due diligence is to determine that a buyer prospect can qualify for acquisition financing and has sufficient capital for a down payment. Regardless of whether the seller is financing part of the purchase or not – a credit check is a standard tool for evaluating a buyer’s credit worthiness and financial capacity. A buyer should comfortably have access to at least 10% of the transaction amount in liquid funds (preferably more than 20%) plus sufficient working capital for day to day operations and a reserve. Lastly, a seller that extends a loan to the buyer should ensure that the buyer has sufficient personal collateral available, in case of default. It should be noted if a bank or other lending institution is involved that they will likely take a superior position on the available collateral.
The seller’s due diligence process should also explore whether the buyer has the character, capacity and legal standing to operate the business successfully. The specific matters to be investigated depend on the type of business being sold and its management needs. A seller should at least understand the buyer’s general business management experience and their experience within the specific business industry.
Below is a list of other areas to explore. Rather than simply providing a due diligence list for the buyer to respond to, a savvy seller may want to interview a buyer to get in-depth answers:
- Does the buyer have the authority to acquire the company?
- Does the buyer face or have they faced any legal issues?
- Does the buyer have the necessary licenses or credentials to operate the business?
- Have they successfully completed an acquisition previously?
- What is their plan to operate the business? What personnel or other changes are planned?
- Will the buyer’s character facilitate successfully managing the business? Ask for personal and business references.
In summary, a small business seller should conduct a reasonably thorough due diligence process on a prospective buyer to reduce risk in the transaction and ensure that the buyer can successfully run the business.
For further information or to discuss selling your business, contact Adam Wiskind at awiskind@exitstrategiesgroup.com or (707) 781-8744 for a no-obligation assessment of your situation.
