How to prepare for due diligence ahead of your business exit

Due diligence, new research suggests, is taking longer than ever before. While deals conducted between 2013 and 2020 took an average of 189 days to complete, this timeframe expanded to an average of 247 days in 2021 and 2022.

Multiple factors seem to be involved in these extended timelines: GDPR regulation, ESG, political uncertainty, and increasing digitisation all seem to be pushing scrutiny to an all-time high. And in the world of multibillion-pound M&A, high-profile corporate frauds such as Theranos Inc, FTX Trading Ltd and Autonomy have set the tone for increasing investor caution.

Higher interest rates are also at play: in the period preceding the surge in interest rates, due diligence windows could be compressed because sellers were spoilt with a line-up of potential buyers.  The low interest rate environment also made deal structuring and pricing more forgiving, even if your due diligence or pricing wasn’t perfect.

In this new environment, how can you ensure that the due diligence process goes smoothly for both you and your prospective buyer?

Your responsibilities as the seller

The legal concept of caveat emptor (‘let the buyer beware’) places the burden on buyers to reasonably examine assets before making a purchase. However, it has its limitations. A High Court decision regarding the sale of land with overage provisions in 2022 proved as much, reminding vendors of their duty of disclosure, especially where disclosure of defects is concerned.

Disclosure is also important because of the existence of numerous warranties in the typical sale and purchase agreement (SPA). In business transactions, warranties serve as factual declarations made by sellers regarding the company, business, or assets being transferred.

These statements carry significant legal weight: if a warranty is later discovered to be false, it can expose the seller to legal action from the buyer – either for breach of contract, or sometimes, misrepresentation.

Top tips for a smoother due diligence process

Prepare well in advance to achieve the “Goldilocks” timeline.

Research from Bayes Business School suggests that possible deals with “medium length” due diligence processes were more likely to complete and had shorter completion times than those where the process was shorter or longer.

A medium-length due diligence process strikes a balance between being thorough enough to uncover important information and being efficient enough to maintain momentum. This balance, it seems, leads to higher completion rates and shorter overall completion timelines.

By addressing financial and legal housekeeping well before the due diligence process begins, you can help to keep the deal process within that “Goldilocks” timeframe.

Do your financial housekeeping.

Ensure all company tax returns, accounts, and confirmation statements are up-to-date and accurately filed. You should also prepare an inventory of physical assets and equipment for prospective buyers. This should include all items owned or used by the company, clear descriptions of the assets, ownership details, and the terms of any associated finance leases.

Prospective buyers will also want a list and description of all liabilities not appearing in the most recent financial statements of the company and its subsidiaries.

To prepare for the future, they may also want to see copies of the company’s most recent financial or operating budgets and projected financial and cash flow statements.

Recent high-profile cases of “creative accounting”, such as that involving software firm Autonomy, are also serving as a cautionary tale for buyers, and your prospective buyer may want to investigate whether any differences in accounting policy have affected the bottom-line profitability, or whether there are any balance sheet, off-balance-sheet or accounting concerns.

Formalise your contracts.

Review and formalise all contracts, including those with key customers, suppliers, agents and distributors, and property agreements. Replace any verbal agreements with written documentation.

You may also want to prepare key financial statistics relating to your top customers and suppliers from the most recent full financial year and current year-to-date, outlining the revenue received from your top 10 customers and the costs paid to your top 10 suppliers.

Pay particular attention to property and lease agreements as these often present challenges during the sale process.

For properties that are leased or occupied under licence, you’ll also need to obtain the landlord’s consent for lease assignment. This process can be time-consuming, so it’s advisable to approach the landlord well in advance to secure consent. Be aware that the landlord may require the buyer to provide guarantors and/or a rent deposit as conditions for the lease transfer.

Get your customer data in order.

Whether you use a sophisticated digital CRM system or traditional filing methods, ensure that your customer relationship data is clean, up-to-date, and well-organised.

Not only is proper collection, storage and use of customer data crucial for regulatory compliance, it is also a major value-driver for the acquisition target, being an enabler for targeted marketing and cross-selling.

You’ll want to make sure your Information Commissioner’s Office registration is up-to-date, gather copies of your internal data protection policies, and summarise examples of how you get consent from customers and other individuals for marketing.

Ensure you are ready for an IP audit.

If intellectual property is to be a large part of the deal, assure that you have all the appropriate documentation lined up.

To avoid expensive litigation à la Oculus-Zenimax Media, your prospective buyer’s counsel will want to assess the existence, validity and enforceability of the IP rights owned or licensed by your company. This may cover whether required formalities have been complied with, and whether appropriate fees have been paid to keep the IP in force.

You’ll particularly want to have a close look at any IP developed by contractors and employees. Do your employment contracts ensure that any intellectual property rights (IPR) developed by employees or contractors during their tenure are legally vested in the company?

You’ll also want to audit your software licensing to verify all programmes have been legitimately obtained and properly licensed.

Prioritise HR due diligence, especially if you are a service-based business.

HR due diligence is often underestimated, however will be a key concern for acquirers of service-based businesses where employees are the sine qua non.

Key areas examined during HR due diligence include employee contracts, compensation structures (salaries, benefits, bonuses), existing workplace issues or grievances, and HR policies and procedures.

Acquirers will also want to identify any people-based risks before proceeding with a transaction, such as the likelihood of key roles exiting the business.

Prepare to make a strong case during commercial due diligence.

Bringing as much information to the table as possible will help buyers decide on whether an acquisition will bring significant revenue and cost-saving synergies to their operations.

When compiling the Information Memorandum, you should include an assessment of your competitive position in the market and relative performance, barriers to market entry, your points of differentiation, cost of customer acquisition, and the health and future of the market.

Prepare for “cultural” due diligence.

Buyers are increasingly interested in whether their acquisition targets have a HR culture and corporate values that align with their own.

These values might be reflected in the language you use in your job postings, website or social media: maybe you say you’re “fast-paced”, “entrepreneurial”, “people-first”, “long-standing and traditional”, or something else entirely. Paying close attention to these language choices in the run-up to your business sale is advisable.

Your positioning on environmental matters may also come into play for ESG-minded investors. You may wish to look at your waste management policies, your integration of renewable energy sources, the energy performance rating for your business premises, and your commitment to near-shored or greener supply chains.

How Hilton Smythe can help

Hilton Smythe offers dedicated support throughout the due diligence process – from initial contact through to the drafting of the Heads of Terms and beyond. Your deal executive will be on-hand at every stage, ensuring you’re covering all bases.

The question and answer (Q&A) phase forms the cornerstone of due diligence, often consuming a significant portion of the deal timeline. Your deal executive will act as the intermediary, facilitating smooth and timely communication between all parties.