In Wikipedia, Due Diligence is described as, “a term used for a number of concepts involving either the performance of an investigation of a business or person, or the performance of an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations. A common example of due diligence in various industries is the process through which a potential acquirer evaluates a target company or its assets for acquisition”
Simply put, it is “open book” time where a buyer gets to investigate a potential acquisition in order to make sure that, either intentional or not, the business is in the condition as represented by the seller.
Small Business Due Diligence
Many business brokers for small business operate much like real estate brokers. A standardized asset purchase agreement is used and contingencies for due diligence are placed in the contract. In other words, a buyer agrees to buy the company with the caveat that various conditions are met. The most basic of these conditions is that the books and records of the business are satisfactory to the buyer. Many call this the “book check” and for very small businesses this may be the only due diligence that is done. Either the buyer or a buyer’s agent (like a CPA) takes the books and reviews them for accuracy (hint: if you are reading this for guidance, an important aspect of book check is making sure that cash flow actually did flow – so get bank statements and confirm that the revenue and cash flow match up with deposits and withdrawals).
There may be other contingencies in the contract, and these should be ticked off (in writing) as they are taken care of during the due diligence period. When the last one is taken care of, voila, a binding contract to purchase is remaining, and (unless funding or other issues remain) you are ready to close. Until then, the buyer can usually figure a way out of the deal so if you are a seller you want the due diligence contingencies signed off in writing.
Medium/Large Business Due Diligence
Unlike a small company, due diligence typically starts with a non-binding letter of intent to purchase. A definitive purchase agreement is not created until after due diligence. For larger businesses, due diligence ranges from little more than book check to a team of 100 attorneys spending months digging and researching a company.
Typically due diligence will investigate the following areas of a company:
Financial books and records
Employee benefits, policies and compliance issues
Internal systems and procedures
Condition of Assets
Any key area of concern identified while negotiating the letter of intent
The list can get very very long, and I have some examples of due diligence check lists that are many pages long. I thought about including one here, but one thing that irks me is when buyers use a standard list without cutting it down. It can be a tremendous time consuming effort by a seller (and his attorney will tell him not to leave any items blank) to go through hundreds of items so it isn’t helpful to provide a lengthy list if many items obviously don’t apply.
The purchase agreement is then written to address issues discovered in due diligence. For example, perhaps there were some outstanding warranty issues with customers that were discovered and the buyer has agreed to cover these. The agreement will lay out a structure to handle this (a hold back account, deductions from future payments, price adjustment, etc.).
Should I Disclose Everything in Due Diligence?
As a rule, yes. Your liability as a seller is far far less if you disclose rather than hide, especially during the due diligence phase. The only time you would not disclose something is if it is so proprietary that you only wish to disclose it after the sale is completed. For example, Coke probably isn’t going to disclose their formula until a deal is actually closed, although a cautious buyer may want the formula held in escrow. Sometimes it matters who the buyer is. Coke may also hold back some marketing plans if a competitor were buying them, but would disclose them to a financial buyer.