The purpose of a due diligence period is to allow the Buyer to fully investigate all of the claims, warrants, and representations a Seller has made regarding the status of the company.  Are the financial statements accurate? What protections are in place to lock in key customers, employees, technologies, and other assets upon which the value of the company is based?  What are the internal structural components, processes and procedures used by the company to allow these employees to service these customers?  How old is machinery and how well maintained? Does the company have any hidden liabilities such as pending litigation?  Is insurance in order? Does the company have any liens or tax issues?

As you may imagine, the complexity and detail required to satisfy a due diligence process rises exponentially as a function of company age, number and type of business lines, and organization, structure and record keeping practices.  ANY misrepresentation or attempt at obfuscation by the Seller identified by the Buyer during this period puts a cloud over the entire negotiation and could very well kill the deal.  This is why I advise my clients to always keep their house in order as if they are preparing to sell, and equally important – don’t hide from your liabilities.  Have a plan in place to address them and be upfront.  If a Buyer isn’t willing to take on those challenges before you negotiate an LOI, they certainly aren’t going to be willing to do so after they discover it at great cost during the due diligence process.

Let’s say, however, that the Buyer doesn’t turn up anything significant during due diligence (because you are a good and honest Seller), and they still want to change the terms of the deal.

This is a significant Red Flag and I usually advise my clients to immediately disengage and look for another Buyer.  Again, because I recommend that all issues be put on the table BEFORE the signing of an LOI, there should be no miscommunication between Buyer and Seller as to what the expected value of the transaction is going to be, and the deal’s general structure in terms of cash vs. debt.

This is especially relevant when a Buyer has negotiated something less than an all cash deal.  If you can’t trust them to stick to a term sheet before they buy, how can you trust they will ever pay out on a note or earn-out?

But what if due diligence does turn up something significant?  Perhaps, as honest and straightforward as you are, a liability turned up of which you were simply unaware or had thought was resolved.  An example might be a major customer stating that new ownership will result in them reconsidering the business relationship.

The question then becomes one of; will it cost me more to accept a lower price today and hand this liability over to the Buyer, or will it cost me more to postpone or cancel the sale and address this liability myself?  In my experience, I’ve seen owners take either path.  As long as the decision is based upon numbers and not emotions, then it is a valid response.

One important part of the negotiation process is to maintain an understanding of the psychology of your Buyer.  Does the value proposition appear so great in terms of synergies between his firm and yours that the cost of the liability would be insignificant to his Return On Investment?  How big a firm is sitting across the table?  I have experienced situations where a large firm will raise an issue discovered during due diligence and ask for a discount, but ultimately back off because they have the internal resources to address that concern at minimal marginal cost to their operations.  Be careful here because you don’t want to kill a deal over a potentially minor point.

However, you must always remember the cardinal rule of selling your business, “Never fall in love with your deal.”  At the end of the day, you need to meet your bottom line and you need to walk away from the transaction believing that the deal is fair for all parties.

This entry was posted on Tuesday, March 9th, 2010 at 5:00 pm and is filed under Strategic Advisors, Selling a Small Business, Sell Your Business, Professional Advice, Exit and Answers, Exit Stories, Emotional Selling. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.