Seller’s Perspective: Due Diligence

Seller’s Perspective: Due Diligence

Shoot The Moon
Shoot The Moon
Seller's Perspective: Due Diligence

In today’s episode, we are talking about the due diligence process from the perspective of a seller and what to expect.

What’s in before an LOI:

Corporate performance

  • Market share
  • Leadership
  • Technical IP
  • Brand and intangibles
  • Key accounts

Financial performance

  • Revenue
  • Gross Margin
  • Operating Income

Market conditions

  • Market share
  • Comparative valuations / deals
  • Transaction motives

Once a seller has disclosed with a degree of accuracy these 3 main metrics (with several sub metrics) it is acceptable to expect a letter of intent (LOI) surrounding a combination. In that letter a seller should expect a valuation (at least a range), a methodology for getting to the valuation (so that adjustment to the purchase price are based on actuals vs a change in perceived value levers), a list of terms including the currency (cash, equity, earn-out / or a combination of all) as well as a detailed allocation of where the IP value sits and how it is measured.
Post LOI due diligence:

An extensive list of disclosures, documents, and artifacts that verify the information gathered prior to the execution of an LOI.

Below is a sample of the information gathered post LOI but ahead of definitive agreements (whether asset purchase or stock purchase):
OrganizationArticles of IncorporationCompany bylawsOrganization ChartsCapital structureCertificate of Good Standing from state in which company is incorporatedList of regions in which the company is authorized to do businessList of regions in which the company has employees, contract relationships, leases facilities, or transacts businessList of any names (and documentation) under which the company may operate

Financial ItemsFinancial statements for previous three yearsCompany/Auditor correspondence from previous three yearsCredit reportCapital budgetStrategic planning documentsFinancial schedulesContingent liabilitiesIndebtednessInventoryAccounts receivableAccounts payableDepreciation and amortization procedures and accounting methods in previous three yearsFinancial model containing revenue, fixed and variable expenses, and gross marginsAnalysis of internal control procedures
Physical AssetsListing of fixed assets and their respective locationsAny filings for Uniform Commercial CodeEquipment leasesTransactions relating to major capital equipment in previous three years
Real EstateDetailed listing of business locationsCopies ofreal estate leasesmortgagesdeedstitlessurveyszoning approvalsvariancesuse permits
Intellectual Property (IP)Listing of patents (domestic and foreign) and respective applicationsListing of trademark and trade namesListing of copyrights
Documentationtechnical know-howagreements regarding inventionslicenses or assignments of IPpatent clearance
Listing of any claims or grievances against the company regarding IPEmployeesList of employees and associated employment agreements (noncompetes, nonsolicitations, nondisclosure, etc)Resumes for management and key managerial personnelEmployee handbook outlining key benefits and holiday, vacation, and sick leave policiesPlan outlines of company-sponsored retirement plansDocumentation of any employee issues in previous three years (harassment, discrimination, etc.)Listing of any workers compensation claimsLisitng of unemployment claimsDocumentation of employee stock option and stock purchase plans information
Licenses and PermitsCopies of government licenses, consents, or permitsCorrespondence or documents relating to proceedings of any regulatory agency
Environmental IssuesEnvironmental audits relating to properties leased by the companyListing of hazardous materials used by company in operationsDocumentaiton of company procedures relating to disposal of hazardous materialsListing of environmental permits and licensesCorrespondence relating to EPA or other regulatory agenciesListing of environmental litigation of investigations or possible superfund exposureListing of contingent environmental liabilities or indemnification obligations
TaxesFederal, state, local, and foreign income tax returns for the last three yearsStates sales tax returns for the last three yearsAudit and revenue agency reportsAny tax settlement documents for the last three yearsEmployment tax filings for three yearsExcise tax filings for three yearsAny tax liens
Material ContractsListing of all subsidiary, partnership, or joint venture relationships and obligationsContracts between the Company and any officers, directors, 5-percent shareholders or affiliatesLoan agreements, bank financing arrangements, line of credit, or promissory notes to which the Company is a partySecurity agreements, mortgages, indentures, collateral pledges, and similar agreementsGuaranties to which the company is a partyInstallment sale agreementsDistribution agreements, sales representative agreements, marketing agreements, and supply agreementsLetters of intent, contracts, and closing transcripts from any mergers, acquisitions, or divestitures within last five yearsOptions and stock purchase agreements involving interests in other companies
Product or Service LinesListing of all existing products or services and products or services under developmentCorrespondence and reports related to any regulatory approvals or disapprovals of any company’s products or servicesSummary of all complaints or warranty claimsSummary of results of all tests, evaluations, studies, surveys, and other data regarding products or services
Customer InformationListing of the company’s twenty largest customers in terms of sales over the previous three year periodSupply or service agreementsDescription or copy of the Company’s purchasing policiesDescription or copy of the Company’s credit policySchedule of unfilled ordersListing and explanation for any major customers lost over the last two yearsCustomers by ZIP trailing 90 daysAverage Order Value by ZIPDescription of the Company’s major competitors
LitigationListing of all pending litigationDescription of any threatened litigationCopies of insurance policiesDocumentation relating to any injunctions, consent decrees, or settlementsListing of unsatisfied judgments
Insurance CoverageListing of the Company’s insurance policiesListing of the Company’s insurance claims history for past three years.
Service ProvidersListing of all law firms, accounting firms, consulting firms, and similar professionals engaged by the company during past five years

Marketing AwarenessDocumentation of articles and press releases relating to the company within the past three years

In summary:

  • Be prepared to share enough information to determine your worth
  • Ensure the information is accurate and defendable
  • Be prepared to share more information as requested in each category
  • Be certain your comfortable with the valuation methodology (this is typically what does not change between LOI, definitives and close)
  • Work with an advisor to ensure you are ready and able to support a transaction without interrupting operations and the business overall.




Mike Harvath  00:04

Hello, this is Mike Harvath with this week’s Shoot the Moon podcast, broadcasting live and direct from Revenue Rocket world headquarters of Bloomington, Minnesota. As you guys know, Revenue Rocket is the premier provider of M&A, advisory services and growth strategy services for IT services companies worldwide. With me today, my partner’s Matt Lockhart and Ryan Barnett. Welcome, guys.


Matt Lockhart  00:30

How’s it going Mike?


Mike Harvath  00:32

It’s good. It’s good. Today we’re gonna talk about seller due diligence, and what in the heck to expect when you are selling your business, and a buyer is looking at doing due diligence on your business, an important phase of all M&A transactions. I think we’ll start maybe Ryan, I’ll turn it over to you to talk about kind of pre LOI due diligence and kind of what to expect to provide someone who’s looking at acquiring your business.


Ryan Barnett  01:00

Absolutely. So just when you go through the process, and the emotional decision to sell your company, and you decided to go list you your business and then get people interested and get the marketing material and have introduction meetings and things are really, really going well. You sign an LOI, everyone’s really excited. It turns to a moment of a bit of fear in which due diligence starts. And today what we want to talk and got questions for both Mike and Matt on. How does the seller really get through due diligence, know what to expect, the emotional toil that it takes on you and emotional toil it takes on you and how you run the business while getting through it. And really what it is kind of the process of surviving. And unfortunately, due diligence feels just like every portion of your business is getting poked and prodded. And there’s ways to get through it that can just help you shine. And there’s ways that can actually be really detrimental to the to the successful close of the business to do so I want to talk about some pitfalls and what to avoid. So maybe Mike, you can just help us understand in the grand context. What should a seller expect? If you’re talking pre LOI? And what should a seller expect for due diligence? In order for someone to put an offer on the table? What kind of due diligence do you think is needed?


Mike Harvath  02:31

Well, it’s a great question, Ryan, I think it’s super important that, you know, a buyer has transparency to your financials, right, they’re gonna look at your numbers. And when I say look at your numbers, I mean, you need to be providing access to P&L and balance sheet. Probably on adjusted I mean, I think a smart seller, if you’re actually in the market, are going to be working with an advisor such as revenue rocket, and they’re gonna have made adjustments to that P&L And have the you know, EBITDA optimized for, you know, for review by a buyer, but not assume somebody approaches you and you know, you want to provide your numbers to them, you know, it’d be good to figure out what the heck your add backs are. And that’s where, again, advisors can come into play, but you do need to provide multi year view into your financials, P&L and balance sheet, you need to provide a multi year forecast of what the business is going to do. And that has to align pretty reasonably your historical performance. Or there’s gonna be a lot of questions about what we call the hockey stick, right? If you’ve been growing the business at 5% a year, and suddenly you forecast it’s going to grow at 25% a year, you need to be able to explain well, what’s gonna change post transaction to suddenly and dramatically increase the forecast and, and unless you have a good, you know, discussion and story around that. It’s not credible. And your forecast as well as your numbers will be seen with a bit of a slant eye or, you know, additional scrutiny. When you see that sort of crazy forecasts versus historical performance. I think a more conservative forecast that aligns to historical growth year over year is much more appropriate and probably to be expected, because any buyer that’s going to look at your business and be able to add synergies and accelerate growth is going to want to absorb that synergy for themselves, right. They’re not going to allow you to to take advantage of that and evaluation because evaluation will take into account your forecasts as well as your historical performance. We say that it’s ideal to have five years P&L balance sheet in a five year forecast. If that’s not possible, you need to be able to provide at least three years on both sides.


Matt Lockhart  05:00

You know, Mike, I think it’s great. You jump right into the numbers, right. But, you know, maybe let’s back up and talk about, you know, one of the principles that that, Mike, you’ve, you’ve sort of guided in your, in your 20 years of experience here, that there needs to be three general things in place to find these successful transactions and, you know, marriages of two firms, the the financial fit, which is at the end of the day, what is going to make or break deal on both sides. But then importantly, is the strategic fit, obviously, and the importance to the buyer in terms of the sellers capabilities to match that strategic fit, and, and then the cultural fit, right. And so from a seller’s perspective, it’s important to think about those three things, right. And think about it in the eyes of the buyer, and how you position and how the seller is positioned the firm, strategically, right? Being ready to be able to talk about how the sellers capabilities can evolve. And, and, you know, in, in a post integration that creates an accretive value for for the buyer. Um, and then likewise, on the cultural sides, and most important, culturally, is what are the management practices. So, you know, as you appropriately sort of start with the numbers, in terms of the readiness, because at the end of the day, if those aren’t in place, and and aren’t accurate, then nothing’s going to get done. But it’s also important, you know, it at the first blush, to be thinking about those other fit potentials, don’t you think?


Mike Harvath  07:08

Yeah, that’s a great point, Matt. And thank you for bringing that up. I think it’s also important to point out that, you know, pre LOI due diligence is not providing everything in the world that a potential buyer might want. So sometimes you get stuck in sort of this death by 1000 cuts sort of world where someone who’s looking at doing an acquisition says, Boy, can I have a, you know, your top 10 Customer breakdown, and then I need this, and I need that, and I need this, and I need that. It, it, it really, you know, what’s needed is certainly to make sure that the big three lineup, you know, the strategic cultural and financial fit, make sure they have enough information and accurate information to be able to create a credible offer and valuation. But, you know, things like, you know, the your breakdown of your top clients, you know, spend, certainly there’s some appropriate questions around concentration, right, how much of your business is contained, and maybe your top three or five customers but, but beyond that detailed details about those customers, details about employees should never be necessarily shared pre LOI, just blinded information, if any, is appropriate, to just further that discussion, but it’s a tendency of many buyers, particularly financial buyers to want to have all kinds of information before the letter of intent to look for any cracks in your assumptions around EBITDA. And, you know, oftentimes, that’s just not necessary. And so I think understanding how much detail to provide and what not to provide before LOI is important, certainly all of those requests are appropriate. Most likely post LOI, once you’ve agreed to terms, both price and terms on a deal, you know, then we get into a whole different set of level of of scrutiny around diligence.


Ryan Barnett  09:21

I think one way to think about this as a seller is that first of all, almost everything that’s needed for a buyer to put forth an offer should be contained within the marketing materials that you’re putting forward. So it’s also assumed an NDA is in place, there’s some sharing. So, by the time you have an introduction meeting, and you had the confidential information memorandum released, that sim should have enough information in it for a to a buyer to make at least enough decision to to put forth an offer. And remember LOIs and offers are non binding to nature. So there’s, there’s oftentimes adjustability in the understanding of that, that letter of intent. Another way to think about this is pre LOI, you’re often going to be looking at the business through aggregates and reporting. So you’ll be looking at sales as in aggregates, or sales broken down by a category. That’s different than post LOI, or things we’ll be looking at in a detail level. So expect heavy reporting in the front, but followed up by What’s the proof to the reporting that came with it. So assuming that an LOI is signed, that’s and everyone’s congratulates each other, there’s, we put forward an LOI and sign, like there’s a big clause and it says, respective to due diligence being completed, and just help help sellers understand, why do buyers want even conduct due diligence in the first place? Is there is there something that do they want to simply prove it? Are they trying to discount the deal? What’s, what’s the ideal scenario, the seller should expect? Why buyers are going through this exercise?


Mike Harvath  11:18

Well, there certainly is a business case to be made for doing an acquisition, we’ve talked a lot about that right? In the past that you got to have a solid business case, it needs to line up the three ways for the seller just like it does, or for the buyer, just like it does the seller right strategically, culturally, financially. And there needs to be an aspect of the deal, it’s sort of one plus one equals three, right, you got to be able to get somewhere together that you can’t get apart. And thus, that drives sort of thinking around the acquisition for the buyer. So when you begin to think about, you know, all the different components of due diligence, they want to make sure that the financials are accurate, that essentially, what you say you’re selling, is what you’re selling. There’s not, you know, cracks in the foundation, that the growth trajectory that you’re forecasting is attainable, based on what you’ve built so far. And they want to understand sort of the health and wellness of the business, in how it relates and integrates into their existing business. Right. So if it’s a, what we oftentimes call sort of an adjacency strategy, which might be a revenue expansion in a different area of the business, you know, how does that business work? And, you know, how could it be adjacent to their core business as an acquire looking at your business? Or is it more of a, you know, more kind of a line extension? is what we’ll say, is another way to say, you know, is it? Is it something that’s new for acquire? Or is it something that’s very similar? Or the same as to what their core business is? And then how does it relate from a key metrics perspective into that business? Or is your business more profitable than theirs? And why is that? Or is it less profitable? Or there’s areas for optimization? You know, again, how do you get to somewhere together that you can’t get apart? Those questions have to get answered? Beyond the, you know, accuracy of the actual data in the financials? And that’s why, you know, people look at can you transfer the contracts, you know, how you should they structure the deal? Is it an asset deal or stock deal? Are there benefits and reasons for such and, you know, there’s a bunch of questions that have to get answered. And it’s frankly, you know, again, not to play the commercial again, but, you know, this is there’s a lot of, you know, hundreds and hundreds of things that need to get negotiated. And frankly, you know, if not hundreds 10s of reasons why buyers do due diligence the way they do, and being able to have an advisor on your side that can help navigate all that certainly will make this process go a lot smoother for you.


Matt Lockhart  14:12

A couple other things, I think, important to sort of prep for so you hit financials, and obviously transparency and accuracy and correctness and blah, blah, right. Pretty common sense. However, oftentimes, you see sellers who aren’t ready to be transparent with with an accurate view, from a reporting perspective into the financials. So I think that’s a just continuing to highlight that you brought up customers, right and and having a being ready to demonstrate a good view into those customers, the depth of the relationship, the history of it, how you know how the seller firm is providing strategic value to their customers, because buyers are going to want to know that those customers are going to be sticking around, or most of them are going to be sticking around, and or there’s cross sell and growth opportunities for, you know, within those customers. And so, you know, that customer piece is, is absolutely critical. You brought up the contract, what is the contract status, you know, transferable, the duration of the contract all of these things and, and, you know, you can just go layer by layer into the depth and, and that, I think speaks to Ryan’s point, that, that’s post LOI when you’re getting into that really depth and so managing, you know, what is pre LOI versus post LOI is, you know, a consistent theme here, you know, the other piece that I, you know, I think is, is also important for the seller, to be ready for is being able to demonstrate the quality of their team, right their people, and, and how those and how that team is going to be an asset to the buyers organization. So, you know, which members of the management team are, ya know, to be highlighted, and, and prepped, as part of the selling process post LOI, to be able to demonstrate that, and then just the overall team, you know, within the organization, the selling organization, and, and the strength, you know, lack of attrition rates is, is really important and, and the like, so, you know, financials, customers, team, those, those seem to be pretty common themes.


Ryan Barnett  16:56

If I could add something here, the, as a seller, you’re going to get a big list of an ask, what we often will see this broken down, expect, quite literally hundreds of items to be covered. So there’s a big portion of this, that you just be prepared, that a buyer is going to ask for way more than you may even have. So a lot of times we see a boiler plate due diligence template come across it, which has things that are asked for, that are not relevant to the deal at all. So the first thing as a seller to think about is what’s the priority of that list? And how can you get that through that list in a in a meaningful way, that helps the buyer make the right decision in moving forward. And frankly, it gives comfort to the, to the buyer on the assets that they’re giving. So give when you get the list, work with an advisor to make sure that you prioritize that list. From there, start hacking through that and just be able to prioritize that. Mike is there, you know, who typically gets the brunt of the work from a seller? When they’re going through through a process through through to through due diligence? Well, what should what should functional teams like marketing, sales or finance expect when going through this?


Mike Harvath  18:30

Yeah, that’s a great question, Ryan. I mean, it certainly finance teams need to be heavily involved. You know, usually owners, clearly, are the first to be contacted and will be involved with making strategic decisions on whether to, you know, entertain an option or not. But beyond that, there’s, you know, a lot of questions around sort of the strategic, I mean, all the big three, right, you can think about it, if it’s about strategic sort of alignment, you know, cultural alignment. And, and cultural alignment, oftentimes is is outlined, as, you know, customer care, philosophy, employee care, philosophy, and how those align, you know, those are two good proxies for, you know, how do you have that cultural alignment, and then financial alignment, so you can think that, certainly leadership will be involved. Now, it’s important to note that most, most sellers want to keep the communication and the distraction associated with this conversation, to a minimum, someone to adjust owners. Others will open it up to maybe a financial leader, but generally that’s it and the lion’s share of the gathering and data management and parking that data, you know, typically reside and ownership and financial leadership. And, you know, it is our recommendation that you know, you keep it These actions quiet until they’re imminently going to close. And so that sort of adds a lot of complexity when you might lean on your team to, or want to lean on your team to be more involved in order to put the best foot forward to a potential buyer, it creates a conflict as to, you know, who needs to know, I often say that it’s need to know basis, and most members of your staff frankly, don’t need to know. So try to keep it contained to, you know, the ownership and maybe financial leadership. And I say maybe, because it depends on how fortified your numbers are, and how transparent you are with those financials to be able to provide the data that a potential buyer might need. And I think, you know, certainly you need to bring in probably others as you get past the LOI into more substantive due diligence, because the requests and substantive due diligence are vast, and they’re going to want to understand strategic plan and go to market philosophy and sales approach and pipelines and, you know, customer management approaches, and, you know, everything you can imagine as their vetting, you know, a business for for acquisition. So, you need to be able to provide that information yet, you know, keep the information inside of the team and on a need to know basis.


Ryan Barnett  21:28

And Matt, we recently just signed a deal in, which is pretty extensive due diligence. And the seller was just fantastic providing it. What advice did you give that team to help just keep steady, kind of emotionally steady, during this, and it’s, it’s interesting, because the buyer wants to get a deal done. And they see if they, let’s say strategic value there is there and, and cultural. There’s cultural fit, and you’re really building culture throughout this, but all sudden, you’re still like, in a bit of a prove it mentality that the buyer sending and trying to look at poking holes and assumptions. Matt, what advice did you get? Did you get through to our sellers to help them emotionally navigate this approach or this? This bridge?


Matt Lockhart  22:22

Yeah, thanks, Ryan. It’s, it’s as much of an art as it is a science, right? Because you’re talking about for a seller, it’s, well, a big deal. Especially for in many of the, you know, many technology organizations, and IT services organizations are founder lead. And they there, they’ve been driving their company and the value of their company for, you know, decade or decades, right. So there’s a piece of them that is tied up as part of the business, right? Um, and so, you know, right out of the gate, you just talk about the emotionality of it, right, and being able to talk about it and advise them, that it’s gonna feel weird, you know, they may feel some seller regret. At some points. It’s like, oh, man, I’m letting go of this thing. And I think that’s the, the first place to start. And you can refer back to that and go, remember, we talked about this, that, that there’s going to be a piece of, of emotion tied up into it, you know, when the buyer comes in, and, and maybe questions some of the story or the information and, and the seller can go well, wait a second, I’m, uh, you know, I’m a good guy, I’m honest, guy, girl, you know, and, and I’ve been super transparent, how could you question anything? Well, the buyers just doing their job, right. And so you can’t take it personally. And so, you know, being emotionally ready, is is super important. It’s really the first step, you know, as a seller to, to make sure that that’s in place and, and so being able to refer back to keeping your eye on the prize, keeping your eye on the finish line, and knowing that there will be a bit of ebb and flow and knowing that there’s going to always be a negotiation in place. And so to not take any of those things personal. You know, Mike, you’ve talked often about the fact that, you know, deals just on a percentage basis, they don’t get done unless there’s an advisor in place. And and, you know, our job is to, is to take as much of the emotional baggage, right, on behalf of our clients and, and minimize that for them just for their well being, but then also, you know, referring back, Brian to saying, hey, the sellers gotta continue to operate the business. Right. And and that is absolutely critical to operate the business as though there wasn’t a transaction going on. And you know, you’ve got to you got to be have a steady hand at the tail to be able to do that.


Mike Harvath  25:33

That’s right, that’s for sure I’ll weigh in a little bit on the stats on, you know, likelihood to close, I think, you know, it’s this process, you’ve heard us say this before, it is the most unnatural act in business and it is challenging to get all the work done and and to try to manage the distraction briza be operating the business while you’re closing, and certainly having competent assistant advisors around legal accounting, and dealmakers which you know, is the role that an M&A advisor plays certainly can help you want to get the work done, which there’s a ton of work that needs to be done. But also do it in a in an efficient manner. In one, ultimately, that is successful, because the likelihood if you’re missing any one of those three legged stools of advisors, getting them done is the likelihood that that gets done goes way down. And when you look at statistics, they range anywhere from you know, you have a 1% probability to get the deal done if you roll your own, to, you know, as high as maybe 40%. But it’s certainly low. And I would say that most companies that are thinking about quote unquote, rolling their own as the term we use, you know, being may include while you definitely need to include your lawyer, because the deal has to be fortified accordingly, and legally binding when you’re working through the agreements. But, you know, sometimes people try to do it without a tax advisor without an M&A adviser. And those are two really critical roles that if you don’t have competent advice in either area, you run the risk that you know, some something’s gonna bite you and the deals not going to get closed. And I think you want the experience of all of those three constituents of advisors, to make sure that if you run into a snag, which you will, there’s always some challenge or snag or thing that needs to be negotiated or aligned, that you bring that collective experience of those team members to the table the solid, because the likelihood up there an experienced M&A lawyer and experienced tax advisor around M&A and experienced deal maker in IT services. They’ve seen this before, right? They’ve seen a lot of these challenges and in questions that come up before, and they can provide a experience in a context that you can’t really get any other way. So just food for thought. Ryan, back to you.


Ryan Barnett  28:14

Thanks. Thanks, Mike. And one last thought here before I sum it up. When you work with an advisor, make sure that if there is something concerned, don’t just puke up raw data in a report, work with an advisor and actually analyze the report and come up with data that could be troublesome. So your advisors are there to help and to help you get through sticky situations. And things can be explained or they can be negotiated and so on. However, if you just throw up a report that shows something bad the same customer churn that’s unexplained, that can can torpedo a deal. So please be careful with some of the data that you’re releasing. Make sure that it goes through a second pair of eyes, and that it’s something that that the buyer can understand. So when you think about this, and just wrap it up, remember, pre LOI will only give you the information that’s needed to get to the LOI. Once an LOI, you’re going to get a list. Mostly prepare yourself for getting that list. prioritize it. Let’s start to work through the functional areas of the business pained especial attention to financials, contracts, and operational type work. expect this to be a really tough process, but you’ll get through it. At the end of the day. Everyone at the table may hate each other just slightly. But that’s when you know that deals just about ready to be done. The due diligence is what’s there to help a buyer be comfortable with the business and you’ll be working together. Once the business is sold so work together towards getting the deal done and it can be successful for the future. So great, Matt and Mike, really appreciate your thoughts today. And Mike, I’ll turn it over for you.


Mike Harvath  30:07

So it’s great Ryan, thanks a lot. So with that is you know we’re gonna tie ribbon on it for this week. And look forward to next week as podcasts so I encourage you to tune in as we continue to explore topics around how to successfully and profitably grow your IT services company and help you get M&A transactions done. With that, take care