Due diligence essential for successful private equity sale

Due diligence in a sale to private equity (PE) is essential for both buyers and sellers. It involves a detailed examination of a business' financial health, growth prospects and potential risks.

This rigorous process assures buyers of the business' validity yet it can pose certain challenges for sellers, affecting transaction timelines, valuation and completion. Being prepared to navigate these challenges creates a smoother transaction process while conserving the sale value.

This preparation, coupled with an understanding of the due-diligence process, equips sellers to manage this critical phase effectively.

Quality of earnings / financial review: Buyers will hire a third-party accounting firm to do a deep dive into the company's financials and performance. Expect most buyers to look back at least three years.

Up-to-date, possibly audited financial statements are essential. Items to be reviewed will include balance sheets, income statements, cash flow statements, liabilities, accounts payable, accounts receivable and inventory.

One way to ease this burden is to engage in a sell-side Quality of Earnings (QoE), in which the seller engages an independent third party to perform a financial audit that most buyers also will perform.

While this is an additional expense for sellers ($40,000 to $100,000), it can save a lot of time and headache when it comes to this process. I have seen how the QoE has saved deals and preserved any potential price renegotiations.

Legal and tax due diligence: Sellers should ensure all corporate legal documents, contracts, leases, litigation history, intellectual property rights and regulatory compliance are in order. Expect thorough checks on compliance, contracts and intellectual property.

Sellers may sometimes be reluctant to share details about their legal history or challenges. However, experience repeatedly shows that upfront disclosure enables buyers to formulate strategies to mitigate potential risks, reinforcing trust and transparency with the seller.

Addressing legal issues at the outset is crucial, as they can be deal-breakers if not managed properly, helping to prevent any possible negative impact on the transaction.

Operations: A thorough review of the company's operational aspects, such as daily operations, pricing strategies, customer acquisition strategy, supply chain, IT systems and organizational structure, is necessary to identify and mitigate any operational risks. Buyers will require a thorough understanding of your operations.

You'll be asked questions that seem obvious and frustrating, but these answers allow buyers to stand behind their commitment to your business when they are presenting the opportunity to their investment committees. You need to provide buyers with all the tools to justify the purchase to their investors.

Insurance diligence is an essential component for private-equity buyers, scrutinizing the company's risk management practices and insurance coverages.

Buyers will hire specialists to evaluate the sufficiency of current policies, identify any gaps in coverage, and assess the potential for future liabilities. Policy reviews include liability, property, cyber, worker's comp and business interruption, including claims history, renewal terms and contracts.

This review is critical not only for understanding the financial implications of the company's risk exposure but also for planning post-acquisition risk management strategies.

It is important to understand the different categories of diligence, yet the list above is just a sample of common items.

The size and structure of the transaction will dictate categories and depth of the reviews. Diligence often expands beyond these categories and can include customs, cybersecurity, customer diligence and marketing.

Entrepreneurial adjustments: The entrepreneurial spirit of founders often leads to changes during the due-diligence process. Business owners are used to running the business their own way, and sometimes that results in quick decisions — some that can change entire strategic plans.

It's important to balance running the business with the adjustments required for a successful transaction, acknowledging that institutional investors need clarity and stability in what they are investing into.

Financial discrepancies: Disparities between reported and actual financial performance can prompt renegotiations, affecting the deal's valuation or its completion. The financial due diligence is the most arduous of the different diligence streams.

Consider it like an IRS audit of every aspect of your company's financial health over the past three years. Requests will be repetitive, detailed and continue all the way through closing. Be prepared to provide financial updates throughout the entire process.

This process does not end until the ink is dry.

Legal and compliance issues: Unresolved legal matters or regulatory non-compliance can impede the process significantly, emphasizing the need for thorough legal preparation. This is where full transparency in advance will help alleviate legal concerns.

Cultural and management fit: The sale process is long and tedious, so ensuring the management team's alignment with the buyers is essential, especially when they likely are to remain post-acquisition. I have seen scenarios when sellers choose a buyer with a lower offer due to the cultural fit concerns. This is important for both buyers and sellers: Do you see yourself working with these people?

Transitional arrangements and employment contracts: Negotiating terms that reflect the future performance of the business while protecting the interests of the seller can be complex and challenging.

New contracts for essential management team members such as CEOs, can derail a transaction. It is hard not to let emotions get the best of you. It can be challenging for some entrepreneurs to come to terms with reporting to a board when they have been their own boss for so long.

The due-diligence process is designed to uncover risks and validate the value of a business, but it can also present significant challenges for sellers.

By understanding common review categories and issues, sellers can better prepare and mitigate potential risks ahead of time to work toward a successful transaction.

Giorgio Andonian is the managing director at FOCUS Investment Banking.