Roughly half of all business sales and/or capital raise events fail during due diligence. Some deals fall through when CEOs or owners who haven’t been through due diligence don’t set themselves up for success from the start and experience the impact of “you don't know what you don't know” when it’s too late. In other cases, high-potential companies often get close to deal completion but don’t reach the finish line because inattention to one or more important areas erodes buyer confidence.
The pivotal points that contribute to due diligence deal failure are many and span both the financial and non-financial sides of the business spectrum. CEOs and business owners shouldn’t be expected to possess the full breadth of experience and skills needed within themselves or their internal team to prepare for due diligence. They should, however, get access to expertise that fully understands and can execute on the issues that could sidetrack a transaction. Let’s start with a look at six imperatives for surviving and succeeding in due diligence.
Would-be purchasers typically wish to buy out ancillary investors and start with a clean slate that may include only the CEO and core management team. That’s why it's important to have a strong handle on who the shareholders are and what terms they came in on. Here’s an example:
An early-stage software company raised $3M from 170+ friends and family members who each contributed different amounts. An SEC filing was not required, and no CFO was in place. Ahead of a Series A funding phase, an external resource was brought in to audit the investments and ensure the proper issuance of shareholder certificates. Series A was successful. However, when Series B funding was sought later, the wide array of friends-and-family shareholders and unclear governance delayed and ultimately derailed the transaction. In this case, the Series B investor did not want to enter a relationship with more than 170 different investors. One option that could have been pursued was using one term sheet for all of the early investors and preferably lining them up with a lead investor that represented the group. Knowing that going into a raise can inform actions that will best support planned or likely future transactions.
Clean cap tables translate to cleaner courses through due diligence. Demonstrate that your business house is in order and give investors the confidence they need. Questions to evaluate before investors ask them include: Are there non-employee shareholders? Angels from early rounds with terms that would interfere with a transaction? Vesting issues? Unissued options? Questionable internal/external valuations?
Corporate governance documents often get insufficient attention because many executives and business owners view completing them as administrative check-the-box activities and discount their real importance. Potential purchasers and investors need assurance that the business has been run in a compliant manner – assurance that isn’t provided when governance documents are prepared and managed haphazardly.
Would-be buyers also want to examine corporate governance documentation to determine whether any rules may be in place that would guide and potentially complicate how an offer to buy the business would be voted on and approved. Here again, a lack of clarity can lead to delays, unforeseen expenses, and a deal that doesn’t get done.
Well ahead of due diligence, it is highly recommended to conduct an HR audit that identifies areas of risk and then addresses those risks. This includes areas such as non-compete agreements, proprietary information, key employment agreements, and HR/employee documentation. This doesn’t necessarily mean that the business has to have a senior HR leader in-house. A fractional HR leader will have the expertise required to execute the audit and can identify the best paths for remediating the risks.
For example, another company headed into Series B wasn’t yet large enough to warrant having an internal senior HR leader while they were still building out their technology. To show investors that their HR risks were mitigated, the fractional HR leader they brought on helped them identify and remediate what would have been some areas of concern in due diligence. Assessing and remediating HR risks matters before you get into a transaction matters because concerns could result in a discount in the purchase price and any unknown liabilities may be a deciding factor for whether a purchase moves forward.
Devoting sufficient time and energy to ensuring rock-solid GAAP financials and reporting practices is not a top priority for many CEOs and owners, but it should be. An audit may also be in order, especially if the organization’s financials include beyond-the-norm complexities or extraordinary evaluations. An effective audit will include disclosures that provide clarity and drive understanding.
Companies planning to undergo diligence should ensure the development of comprehensive financial statements and a financial model that's extremely granular and transparent about how assumptions were vetted and impact calculations. This approach instills forecast reliability and leads to fewer questions because most anticipated questions will have already been baked into the model. In short, having proper financial statements and reporting practices in place instills confidence in a buyer, accelerates due diligence and generally leads to higher valuations.
Potential investors want an accurate view and clear understanding of your company’s earnings. Your EBITDA will be highly scrutinized because it is typically relied upon to inform the valuation of your business. Adjusted EBITDA goes beyond the inclusion of interest, taxes, depreciation, and amortization expenses as it also includes adding back one-time and discretionary expenses to bring the earnings picture into better focus.
One-time or non-recurring expense addbacks may include facility improvements/remodels, moving expenses, certain consulting fees, and more. Discretionary expense addbacks may include owner salaries above or below market levels, personal travel, and entertainment. An experienced advisor can help you evaluate your addbacks to ensure that your company’s earnings are not over- or under-inflated.
While investors are interested in what a prospective company has done in the past, they’re far more concerned about what it can do moving forward. Related to the comprehensive financial models noted above, an experienced fractional CFO can help CEOs and owners illustrate any gaps in financing that are preventing the company from realizing new levels of growth and success. The CFO can also find and present opportunities for addressing those gaps.
In some cases, it may make sense to execute new financing opportunities ahead of due diligence. If not, proactively assessing them will allow you to effectively tee them up for evaluation during the transaction process.
The proactivity, discipline, and structure that are required to support successful navigation of due diligence processes can initially feel like a constraint to executives and owners. The time will come, however, when it will be the wind at their backs. The good news for these entrepreneurs is that they don't have to do this work alone or have a team of experts on their internal staff to do the work for them. Focused external experts can perform these tasks and provide a CEO or business owner the knowledge and skills needed to set their business up for a smooth and highly successful transaction.
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