Be ready for any offer that may come your way
Congratulations! You just received a Letter of Intent (LOI) from a company that wants to buy your business.
But wait! Don’t break out the champagne just yet. The Letter of Intent (LOI) is just a formal invitation to the high-stakes game of mergers and acquisitions (M&A).
First of all, the LOI isn’t a legally binding offer. Plus, the purchase amount mentioned in the LOI simply indicates how much the buyer would be willing to pay if they are satisfied with everything they learn about your company during due diligence.
During the due diligence phase, multiple experts from the buyer’s transition will ask you to provide thousands of pages of documents about all aspects of your business. And they are likely to ask hundreds of follow-up questions about details contained in the documents. The process can be grueling – particularly for sellers.
But the process is necessary, because when millions of dollars are involved in an asset purchase, the buyer wants to minimize risk and avoid post-sale surprises.
It’s Never Too Soon to Prepare
Whether you plan to sell your business in 2023 or hope to get an unsolicited offer, it is essential to be prepared for the due diligence process. Once you sign the LOI, most buyers of middle-market companies will expect to get the deal across the finish line in 6 to 9 months.
First, buyers set up a due diligence working group and give them a checklist of items to be examined. The content of due diligence checklists vary, depending on the size and type of company being acquired, the structure of the deal, and the strategic goals of the acquiring company.
Here is a quick overview of some of the items you must be prepared to discuss or document during the due diligence phase.
1. Overview of Business: This includes your company’s history, current ownership, the background of its founders, and its organizational structure. Buyers may also request biographies of the current executive team and board of directors, and banking, financing, or investing relationships.
2. Product Lines: Present up-to-date details on your company’s primary product lines, their profitability, and forecast growth rates. Document planned expansions to your product portfolio.
3. Primary Markets: Describe your company’s main target markets, including how they are segmented and the estimated size and growth of each market.
4. Competition: List primary competitors along with their strengths and weaknesses. Discuss how potential new competitors might disrupt your business
5. Customers: List the top 10 to 20 customers for each of your product lines and calculate what percentage of your company’s sales comes from each customer. Discuss the terms your company offers customers and any special pricing agreements you might have with key customers. Describe how your company collects late payments.
6. Marketing, Sales and Public Relations: Provide details about the marketing, sales, and public relations tactics your company uses to acquire and retain customers, prospects, strategic and partners. Describe your marketing organization, including all outside marketing, public relations, and advertising agencies.
List the key marketing strategies for each type of product or service your company offers and relevant strategic relationships. Provide samples of sales collateral, brochures, press releases, advertising, and direct mail. List any recent customer complaints or public relations issues that affected your company and how the problems were resolved.
7. Suppliers: List types and costs of materials used in your production processes as well as the factors that affect the pricing and availability of materials. List all suppliers and describe your company’s relationship with them. Provide details on all major vendor agreements, loans, or advances. Explain how you have responded to supply-chain disruptions.
8. Property: Present details about the state, age, location, function, and ownership of your equipment and facilities. List the size of each facility and how many employees work at each one.
9. Operations: Outline the steps and equipment used to make each product. Provide the full capacity and average capacity utilization levels of each production device. Note seasonal variations in production. Describe software that is essential to production and measures taken to protect IT systems from data breaches.
Mention operational improvements that can be made by purchasing new technology. Describe what steps are taken to assure quality and comply with regulations.
10. Inventories: Provide details on how much inventory is maintained for each product line. List steps that are taken to control inventories.
11. Historical Financials: Make it easy for the buyer to compare income statements, balance sheets, and cash flow statements for at least the last 3 to 5 years. List fixed and variable expenses, and provide details about one-time charges or other abnormally high expenses.
Because the 2019-2022 time period includes the COVID shutdowns and its aftermath, the buyer may want an independent Quality of Earnings (QOE) assessment. A QOE assessment determines if any one-time events or accounting tricks have skewed the numbers over the past few years. For instance, if your company received PPP (Paycheck Protection Program) loans that were forgiven, your financial performance on paper will look more robust than the “quality” earnings that are achieved from higher sales or lower costs.
12. Projected Financials: Chart the financial performance you are expecting for at least the next three years. Include projections for sales, expenses, capital expenditures, and working capital and explain what assumptions lead to those projections. Break out depreciation and amortization with relevant schedules.
13. Liabilities, Security Interests, and Financial Restrictions: Provide documents that detail your company’s debts, such as loans, loan commitments, letters of credit, bonds, mortgages, guarantees, etc. List all contracts that restrict your company’s ability to upstream or downstream cash. List all agreements related to prior funding rounds and stock purchase agreements.
14. Accounting: Be prepared to share auditor review letters, annual management letters, and internal audit reports as well as all reports by internal or outside auditors or consultants. Discuss any major accounting changes your business made over the past five years.
15. Taxes: List all tax examinations and assessments over the past 5 years including withholding, excise, payroll, gross receipts, property, sales, and use taxes. Prepare to answer questions about pending tax liabilities and provide copies of tax sharing agreements, corporate tax filings, other related documents.
16. Employee Relations: Be ready to present information about compensation, incentives, 401(k) and health plans. A buyer might also request resumes of your current executive team and a list of all employees by function, with details on their salaries, bonus programs, length of service, and turnover.
Other documents you may be asked for include: copies of collective bargaining agreements, severance agreements, and employee claims related to worker’s compensation, employment discrimination, sexual harrassment, or unfair work practices. Information about labor disputes, strikes, or work stoppage may also be requested.
17. Acquisitions, Divestitures, and Reorganizations: Provide documents related to any acquisitions, divestitures, and reorganization over the past five years.
18. Legal: Furnish details about the status of current or pending lawsuits against the company or initiated by our company. Outline information about patents, copyrights, licenses, and trademarks as well as an overview of insurance coverage and any joint venture agreements.
19. Regulatory: List all foreign, federal, and state regulations and statues to which your company is subject and provide external correspondence, internal memoranda, notices of violation or default. Also list licenses, permits, and government authorization and provide copies of accident or injury reports made to federal, state, local governmental entities.
20. Environmental: Provide copies of internal or external reports related to properties currently owned or operated by your company as well as documentation regarding greenhouse gas emissions and the generation, treatment and disposal of hazardous substances and solid waste. This includes documents related to problems with pollution control or environmental contamination and/or all notices, lawsuits, or complaints received from the EPA or state regulatory departments. Describe any environmental certifications your company and its products have earned.
Industry-Specific Items
The items described above are just some of the items you may be asked to provide. You can read a more comprehensive list by downloading Axial’s Due Diligence Checklist for buyers of middle-market companies.
Within the label, packaging, and specialty-graphics industry, buyers may also ask about the pricing models your company uses for each product, your working capital needs, the level of digital transformation, ESG-related data, and current workplace culture.
Why It Matters
A seller must fully prepare for due diligence because the information that is either disclosed or withheld during the process can prompt the potential buyer to walk away from the deal (e.g. Elon Musk and Twitter).
As you can see from the areas listed above, trying to assemble all the data necessary for a quick due diligence process can consume much more time and money than your team may be willing to spend. Even worse, it can distract your executive team from their everyday involvement in growing the business.
Call me at 561-543-2323 to discuss how our team of experts can help you prepare for the due diligence process. We can also advise you on how to make sure the information you disclose during due diligence won’t be shared with others who might compete against you.
If you are a newcomer to the M&A process, download our complimentary glossary, Demystifying M&A Jargon.
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