Due Diligence and How to Survive It

Nothing quite takes the shine off an acquisition like due diligence.

It’s long, tedious, and often stressful.

After the elation of the offer, it’s like a bucket of cold water over your head.

Well, as someone who’s been Acquired twice, I can quite confidently say that yes, due diligence is a pain, but there is a right and a wrong way to go about it.

I’m going to explain the right way.

But first…

What is diligence?

Diligence is convincing the buyer your startup is as good as you say it is. Like buying a used car, they’ll kick the tires, take a test drive, ask many questions, and sometimes find ways to haggle down the value. So if your treads are worn smooth and odometer bust, you’ll put the sale – or your asking price – at risk.

The buyer’s mission during this stage of the acquisition is to find the skeletons in your closet. They’re looking for troublesome contracts, liabilities, ongoing litigations, intellectual property disputes, or account discrepancies. Due diligence will therefore affect every one of your departments, particularly legal, accounting, and HR.

Accounting, financial, and tax diligence

This is where you’ll spend most of your time. It’s also the principal area of due diligence a buyer will leverage to lower your startup’s valuation. Don’t let them! Consider and prepare for the following:

Business performance and health

  • Do you have annual and quarterly records for the last 3-5 years that showcase the performance and health of your startup’s finances?
  • Do this year’s projections fall below or above your startup’s budget?
  • Should the quality of earnings report be conducted?
  • What is the status and health of your startup’s assets and liens?
  • What does your company’s EBITDA suggest about the performance and health of the startup?

Future growth

  • Are profits increasing or decreasing? And by how much?
  • What are the financial forecasts for the coming years and how accurate are they?
  • Do you have enough money and assets to continue operating comfortably, particularly from the period of diligence to the projected close date of the deal?
  • How much working capital do you need to continue growing and operating the business and how is working capital defined?

Taxes

  • Do you have tax returns and other related documents for the past 3-5 years?
  • Are there any local, state, foreign, or federal tax regulations that the buyer should know about?
  • What are the tax implications of the acquisition deal itself?

Accuracy and transparency

  • Have all your financial and accounting records been properly checked for errors and discrepancies?
  • Are there any outstanding debts?  How and when will those be repaid?
  • Have your financial documents, accounts, and statements been audited by a third-party? How recently?
  • Are all liabilities, current or contingent, laid out in these financial documents?
  • Are your future projections reasonable and based on believable trends in your finances?
  • Do accounts receivable have any issues that need to be disclosed?
  • Have any capital expenditures been deferred? Is this affecting your operating budget?

If you have legal issues nipping at your feet, expect the buyer to give you a wide berth. It’s up to you to convince the buyer that you’re squeaky clean, or at the very least, have ongoing issues under control. Legal diligence involves matters such as:

Claims and litigations

  • Do you have a complete record of all files on all pending litigations, claims, complaints, and so on?
  • Are any of the complaints current or ongoing? What about legal claims in arbitration?
  • What are the sources of these legal matters? Are any from governmental sources like the FDA or FTC?

Regulatory and antitrust issues

  • If your startup is in a regulated industry, is there a governing body with the power to approve or deny the acquisition?
  • Has the startup had any regulatory or antitrust issues in the past?
  • Are there any consolidation issues that would negatively impact approval?

Environmental issues

  • Are there any ecological liabilities or obligations, whether past or current?
  • Do records exist of past environmental audits or reports, particularly for a company’s properties and facilities?
  • Do you produce or use any hazardous materials, and if so, how are they handled and/or disposed of?

Intellectual property diligence

Often, buyers are interested in obtaining your technology or intellectual property. So in this area of due diligence, you want to demonstrate that you’ve adequately protected your IPs.

Properties

  • Do you own any patents, including foreign ones or pending applications?
  • What about registered, common law trademarks, or copyrighted products and materials?
  • Do you use any third-party licensed software, machines, or other products and how essential are they to the business?

Security

  • Has your company performed the necessary steps to protect its intellectual property assets?
  • How do you preserve confidentiality? Are there any issues with past or current employees infringing on this agreement?
  • Have any trade secrets been leaked?
  • Are there any ongoing litigations or disputes over patents, intellectual properties, licensing, or other relevant matters?
  • Are there any third-party companies infringing on your startup’s intellectual property rights?
  • What other liens or issues exist with regards to your intellectual properties?

Team and employee diligence

Likewise, some buyers are interested in your teams. They might like your office locations or your employees’ specialisms. So be prepared to explain to the buyer how you manage, contract, and compensate your teams.

Organizational structure and fit

  • What’s your startup structure and what background can you provide on its employees?
  • Which employees are essential and will they stay on after the acquisition?
  • How quickly will your employees integrate into the buyer’s structure?
  • What are your company policies and how do these align with those of the buyer?

Compensation and incentives

  • Can you provide a summary of compensation and employee benefits, including pensions, deferred compensation, retirement plans, non-cash benefits (company cars, and so on)?
  • How much will the acquisition cost in terms of severance and other layoff benefits?
  • Will key personnel need an incentive to stay?

Other issues

  • Have there been any labor disputes in the past or currently?
  • What about internal issues between employees or management?

Sales and marketing diligence

The buyer might also be interested in absorbing your market share. They’ll certainly be curious about your customers, because they are going to be acquiring them in the deal, too.

Customers

  • Who are your target customers and audiences?
  • How loyal are customers and how satisfied are they with your product or service?
  • Are these customers expected to persist after the acquisition?

Sales and revenue

  • Are sales/revenue affected by seasonality?
  • How much revenue is generated by the top customers?
  • How do you incentivize sales staff (if at all)?

Marketing

  • Is marketing handled in-house or through an agency?
  • Are there detailed records of the market that your startup serves?
  • How do your marketing messages align with the buyer’s?
  • How will acquisition affect your competitiveness in the market?

Feeling a little overwhelmed? I get it. Due diligence is that 500lb gorilla standing in the way of the finish line. But if you prepare well, answer these questions, and provide the right evidence to support your answers, diligence should be a breeze. And remember you don’t have to do it alone – hire some expert assistance and you’ll be over that line with a cheque in your pocket in no time.