Pre-Sale Due Diligence as a Part of Normal Business Operations
April 28, 2015
While they have good intentions, owners of small and mid-sized businesses can spend nearly all of their time running their business, and can leave little time to consider and plan the strategy for continued growth and transition to a sale or other exit. Owners hope for a healthy selling climate when the times comes – whether they are ready to retire, cash out and slow down, or sell and find a new venture. Yet, lack of preparation for transition to a sale or other exit can have a negative impact on achieving a high sales price and successful exit.
Many owners end up waiting until the exit is upon them to make time for preparing for the acquisition of their business by a potential buyer. However, many of the actions needed to prepare the business for a sale are also appropriate actions in successfully operating and growing the business. A potential buyer will evaluate the business via its due diligence efforts. Some issues identified by the potential buyer’s due diligence can come as a surprise to the selling owner. Without adequate time for the selling owner to correct these issues, the potential buyer will likely negotiate a reduced purchase price and other more favorable terms for the acquisition. If the owner integrates the due diligence into his normal business operations, then pre-sale due diligence becomes early and organized preparation for a sale. This due diligence efforts allow the owner to then take corrective actions, and allocate associated budget, over a longer period of time.
The pre-sale due diligence will include efforts in the areas of legal, tax and financial advisory and more. Due diligence review of financial statements is most obvious. Increasing revenues and especially net profit will help to create more value in the business. Business brokers can discuss the multiples for specific industries and how to apply them to specific situations. Owners of small and mid-sized businesses must assure that a review of financial statements occurs on a regular basis – at least monthly. Many owners of small and mid-sized businesses have not implemented such financial discipline into their business.
In the legal due diligence review, intellectual property is critical. The value of a business can be increased by acquiring and protecting its intellectual property. Even the simplest business sells goods and services under some type of brand and creates goodwill in the business. Trademarks surround customers every day and help them to make valuable and informed decisions about the goods and services that they purchase. Trademark registration provides nationwide protection of a mark for the associated goods and services, and allows an owner to take action against third parties that may use marks causing a likelihood of confusion with the owner’s mark.
The value of the business is also enhanced by its trade secrets and confidential information. Employees and contractors of the business develop or have access to such trade secrets and confidential information. While owners do not like to see valuable employees depart, some employees will be presented with and take new opportunities outside of the business. The owners must assure that agreements with employees regarding confidentiality, intellectual property ownership, and non-competition are in place. The non-competition limits should be reasonable as to duration and geography. Agreements with contractors are equally important. Many small and mid-sized business owners do not implement such agreements and fail to store them securely even after they are executed.
The equity ownership of the business is also critical and must be carefully documented. A potential buyer should not discover that third parties have claims to equity ownership that the owner has not disclosed or documented. Moreover, a potential dispute about equity ownership of a business could cause a potential purchase of the business to fall apart. Stockholders’ agreements should also be reviewed to identify what rights apply in the event of sale.
Contracts with key customers of the business should be in place. Contracts with a longer duration can be more desirable and can support the financial projections made for the business. Care should be taken to identify what contracts cannot be assigned by the business without consent from the other party to the contract. As a part of its normal contract negotiations, the business can negotiate at least an exception to consent for assignment as a part of a sale of the business.
This article highlights a few of the items on a legal due diligence checklist for a potential acquisition. Other items on the checklist, including without limitation, patents, copyrights, commercial leases, and threatened and pending litigation, should also be considered and worked into the company’s planning.
In conclusion, pre-sale due diligence is critical to achieving a high sales price and favorable terms. Surprises resulting from a potential buyer’s due diligence can be detrimental. Accordingly, pre-sale preparation and due diligence should be made a part of normal operations of a business. With some budgeting and planning, issues identified can be resolved over a period of time and not at the last minute before a sale. The outside advisors of the business can perform many of these pre-sale diligence tasks, allowing owners to focus the majority of their time on running their business.
1 Vasilios Peros is founder and principal of Law Office of Vasilios Peros, P.C. His practice is focused on business, technology and intellectual property law. He has been recognized as one of Greater Baltimore’s top attorneys, including SmartCEO’s 2015 CPA + ESQs, 2014 Power Players, and Legal Elite in 2011, 2010 and 2009. He can be reached at (410) 274-2053 and VPeros@PerosLaw.com.
2 This article is provided for informational purposes only and should not be construed as a legal opinion or legal advice. The reader should not rely on this article in making business, legal or other decisions on any matter without first consulting an attorney regarding any such decision or undertaking.