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June 22, 2020

Due Diligence: A Survival Guide

Key Takeaways

  • No deal is done until it is done; if not successfully managed, diligence has the potential to reopen negotiation.
  • Nothing substitutes for good preparation ahead of the deal process.
  • Don’t go it alone – make sure you have the right team of advisors and employees involved.
  • A good advisor helps maintain momentum and mitigates the risk of unpleasant surprises.

Congratulations, you’ve come to terms on a letter of intent! Sign on the dotted line and the deal’s done, right? If only it were so easy…

An integral part of every successful transaction is the due diligence phase. An opportunity for the buyer to pop the hood and perform a detailed inspection of the business, the due diligence process is often the most agonizing phase of a transaction for a seller. It’s a running of the gauntlet, where a seller must get through a bombardment of questions and requests for information before the deal can be finalized.

What should business owners expect during the due diligence process? What are the secrets to surviving as a seller or manager? And how can this phase of the transaction be used to the seller’s benefit?

Sore Spots

Due diligence is a broad term that has a unique meaning for each individual buyer, seller and transaction. On the buyer side, there are generally three common due diligence objectives:

  • Verify their understanding of the company, its business model and financial position;
  • Identify any risks that could jeopardize the transaction or their return on investment;
  • Gather the knowledge necessary for effective integration and post-transaction operation of the business.

Although some handle these tasks in-house, institutional investors and savvy corporate buyers generally hire subject matter experts to perform due diligence on their behalf. An entire wing of the accounting, consulting and legal industries has grown to serve the diligence process, and these professionals are experienced and skilled.

There are several core areas that tend to be scrutinized in most deals. Accounting or financial diligence is the first that comes to mind for many owners, and often revolves around a Quality of Earnings analysis. Typically performed by a public accounting firm, this analysis serves to examine accounting methods and verify the recent earnings and pro forma adjustments underlying the buyer’s valuation. Other metrics and characteristics of the business, including working capital, tax filings, collection and payment processes will also be evaluated.

Legal diligence is another core aspect of most transactions. A buyer will ask to review organizational documents to confirm a transaction can be carried out as envisioned, or whether it may result in unforeseen consequences. Investors will also seek to understand the terms of major customer, vendor and partnership agreements, particularly in the context of the planned change in control. Additional time is spent examining the company’s intellectual property and the parameters of any existing or potential liabilities.

Although the specific areas of focus vary based on the nature of the company and transaction, the due diligence process can also include:

  • Information systems and IT
  • Employment, benefits, and human resources
  • Insurance and risk management
  • Environmental, health and safety
  • Market, customer and reputational analysis
  • Regulatory compliance

Increasingly, cybersecurity and business interruption diligence have become important. In the current environment, diligence around potential exposure to ongoing health threats and the ability to react to them will also be emphasized.

Prepare, Prepare and …Practice?

Time and again, our experience shows that the companies that fare the best – both in terms of weathering the diligence storm and avoiding unpleasant, deal-endangering surprises – are those that come in prepared.

Owners and managers can position themselves for success by identifying their businesses’ financial drivers and reporting on them regularly. Throughout the marketing and deal process, financials should be closed and full financial reports produced monthly. A centralized database and storage mechanism for contracts is also helpful – particularly with subscription-based and high recurring revenue businesses, and those with customer agreements that regularly vary from standard terms and conditions. Companies can save time and headaches by keeping an updated employee census and ensuring compliance of benefit programs and other HR matters.

A valuable and increasingly popular option for sellers is undertaking formal sell-side diligence. Although it can be extended to any function, sell-side diligence is typically associated with a Quality of Earnings analysis wherein a seller hires its own accounting provider to perform an evaluation. Sell-side diligence can uncover new positive earnings adjustments, identify negatives so that they can be addressed in advance and provide ammunition for negotiation. Just as important, this exercise serves as a test run to acquaint the company with what may be expected by a buyer and to establish the data collection and reporting practices that will help maintain momentum in the process.

Enlist the Right Help

Experienced buyers and investors will present a seller with numerous requests and introduce third-party providers in quick succession, which can quickly overwhelm an owner. Often, the due diligence phase is where it becomes necessary for owners and executives to bring other employees into the loop on a deal. They are frequently needed to answer specific questions or simply to share the burden. But internal communication about a transaction also helps get ahead of inadvertent contact with the buyer’s team or advisors and disruptive rumors. We often encourage our clients to limit interaction to those gatekeepers who serve critical roles in accounting, finance, legal, HR or IT functions. With regard to vendors, some – including insurance brokers and benefits administrators – are not only accustomed to assisting in diligence, they generally appreciate the opportunity to showcase their offering to a buyer.

A seller’s best friend through the diligence phase is a good advisor. Whereas most sellers only go through the process once, good advisors (like most buyers and investors) have experienced the diligence process many times. In addition to helping organize and prepare information, an advisor’s most important role is often knowing when a seller should push back and serving as a buffer between the seller and buyer to protect working relationships.

Flipping the Script

In successful transactions, diligence is more two-way than unilateral. Thorough diligence performed by both buyer and seller can lessen the chance of post-closing surprises, lengthy indemnification claim processes and even litigation. Sellers and managers have an opportunity to verify cultural fit and set the tone for working relationships after the deal, as well as identify any risks on the buyer’s side. A smooth diligence process that validates the company’s strengths and upside potential helps set the stage in the seller’s favor for the detailed negotiation of the purchase agreement.

Challenges for the business that are uncovered in diligence should spur corresponding action plans. It can sting to have a weakness pointed out, but the pain subsides quickly and resulting process improvements can be beneficial whether the deal closes or not.

The post-LOI phase is where communications between buyer and seller can really flourish. Sellers should use this time to discuss go-forward strategy and integration. As mentioned, diligence provides the occasion to communicate and promote the deal to the broader management team to build excitement for what is to come. This is also a good time to develop a plan for communicating the transaction to customers and the broader market once the deal is done.

Along with their advisors and management team, a seller’s job during the diligence phase is to avoid negative surprises, promote open communication and keep the momentum of the transaction going. Due diligence is rarely a purely pleasant experience. But there are ways for a seller to move beyond simple survival and use this period proactively to his or her advantage!

For more insights from the series, The Path to Private Company Liquidity: A practical guide to M&A for business owners, click here.