An entrepreneur selling a business might think a deal is nearly done when a prospective buyer signs a “heads-of-terms”, showing an indicative price. But this will be subject to due diligence; when the buyer has a detailed look “under the bonnet”, to validate that the business that they think they are buying is indeed that same business. Jeremy Furniss, Partner at M&A advisory firm Livingstone, says: “It is a necessary but intrusive, time-consuming and occasionally bruising process.”
Martin Brown, of Elephant’s Child, a consultancy that advises entrepreneurs on exit strategies, stresses that poor preparation for due diligence can be costly: “Buyers often look for a reason to discount the sale price or secure additional protection by introducing warranties.”
These ten steps offer an introductory guide to preparing.
1. Start now (even if selling isn’t on the radar yet)
Some elements of preparation can be sorted out in a few weeks. Others can take years. According to Martin: “We know that the vast majority of SMEs that go to market for the first time fail to sell their business, often because they’re just not ready for a sale process.”
And Jeremy points out an additional benefit: “You never know when a white knight might come charging over the horizon waving their cheque-book. Always anticipate that you are two weeks away from due diligence. If you have all the necessary data at your fingertips, then your ability to respond quickly and efficiently looks good in the eyes of the buyer.”
2. Assemble the “deal team” of staff and advisers
Jeremy says that resourcing in anticipation of due diligence is as important as having all the paperwork to hand. There has to be someone who can devote as much as 50-70% of their time to managing the process and responding to information requests. This would typically be the most senior finance person in the business, or for smaller businesses, it could be an interim resource.
Martin also points out that managing all of the external advisers can be tricky for a seller, whose reaction is often: “I am about to realise all this value and suddenly five or six advisers have popped up and they have all got their hands out”. But a trusted “lead adviser” will help sellers understand how to appoint, manage and reward necessary advisers such as corporate financiers, business brokers, accountants, solicitors and tax specialists.
3. Tackle “commercial due diligence” first
This is the part that can take years. But it has a big impact on valuation.
The buyer will want to analyse the market: how big it is, how fast it is growing, the competitive and customer landscape, and where the seller’s business fits in.
Sellers will want to present evidence of a compelling, differentiated offering; a track record of growth with a fully supported justification of future growth forecasts; strong, consistent profit margins; and revenue not dominated by one or two large customers.
4. Prepare all shareholders in advance
Some may want to restructure their shareholding on the recommendations of tax advisers. And the last thing any owner-manager wants is for a minority, or family, shareholder to derail a sale, late in the process. They may need to be bought out or a new shareholders’ agreement negotiated.
5. Be pedantic about accounts and financial processes
Jeremy says that financial due diligence tends to focus on three things:
Firstly, that the accounts of the business are fully compliant and the historic performance of the business can be easily understood. Expect buyers to scrutinise statutory and management accounts and to want access to auditors and audit papers.
Secondly, that the business is producing high quality management information (such as monthly management accounts and key performance indicators) and that it is actually used to make management decisions. He says: “Buyers derive disproportionate comfort from seeing a business that is generating lots of data and is doing so in a way that can be acted upon.”
Thirdly, that forecasts for the current year and the next two years are credible. Buyers will want to see historical budgets for the last three years and how the business actually performed against them, so that a history of performing to target is proven. And then, that forecasts are prepared on a “bottom up” basis, forecasting revenues and margins client-by-client, contract-by-contract.
6. Cover all legal bases
A solicitor should review all legal aspects of the business; from ensuring contracts with customers and suppliers are robust, to protecting intellectual property. Legal disputes or litigation should be resolved. If they are not, expect buyers to insist on an indemnity from the seller, whereby if a legal dispute costs the business money in the future, the seller will be required to compensate the buyer.
7. Ensure IT systems are up-to-date and protected
IT systems and data need to be protected from cyber attacks, adequately backed up and have redundancy, with no single point of failure e.g. the failure of a single server won’t cripple the business. Robust operating procedures will also be important e.g. control over personal devices used for business. In 2018, compliance with the EU’s General Data Protection Regulation will be top of mind for buyers.
8. Address strategic and operational HR requirements
Jeremy emphasises the strategic element of HR if the seller is intending to exit the business: “Most buyers will want to have seen a succession plan implemented – demonstrably successfully – before they are prepared to write a cheque for the business.” If the buyer sees the seller as still being a critical part of the business, they are likely to insist that the seller remains in the business until the succession plan is fully implemented, receiving only a portion of the sales price upfront and the balance at the end of this period.
Operationally, HR policies will need to be formulated and documented, employment contracts brought up to date, and disputes resolved.
9. Identify and address risks
Buyers will want to see a comprehensive risk register. This should identify and document how the business deals with more obvious risks (such as insuring against fire and having a disaster recovery plan) as well as less obvious risks (such as how to deal with a key supplier going out of business).
10. Anticipate how to handle “customer referencing”
This last step can be sensitive, particularly when other businesses are customers, but Jeremy says: “Most buyers will insist that they will have an opportunity, before the sale is completed, to interact with the seller’s customers, to satisfy themselves that those customers are happy, content and likely to continue as customers under new ownership.” It is a little easier for businesses selling to consumers, as targeted customer satisfaction surveys can be done relatively easily.
Customer referencing is typically one of the very last steps in the sales process but sellers will need to think about the best way to satisfy this requirement.
Where the opinions of third parties are offered, these may not necessarily reflect those of St. James’s Place.
Exit strategies may include referral to a service that is separate and distinct to those offered by St. James’s Place.