EP 32 | Inside Due Diligence: Maximize Deal Value & Mitigate Risks

Speaker 0:01

In the world of business, not all deals are what they seem. Fortunes rise, empires crumble, all with the stroke of a pen. Mergers, acquisitions, hostile takeovers. Welcome to Mergers She Wrote, where we examine strategies and stories behind the biggest deals in business. Because in M&A, the real risks are the ones you don't take

Paloma Goggins 0:36

Welcome back to another episode of Merger She Wrote, a podcast dedicated to business owners who are either buying or selling a business. I am Paloma Goggins, the founder of Nocturnal Legal, and today and going forward, I will be joined by our paralegal, Chesney Reeves. Today marks a shift to shorter episodes where we're going to detail lessons learned while working in the trenches with our clients, and from time to time, we will deep dive into acquisitions featured in the news and share what business owners can learn from these deals and any other notable market shifts.

Due Diligence Explained

Paloma Goggins 1:05

In today's episode, we are going to spotlight due diligence, what it is, the typical process, and how to make it better so that you can derive greater value from the sale of your business. Chesney, go ahead and kick off the discussion for us.

Chesney Reeves 1:18

Thank you for the introduction, Paloma. our listeners that may be experiencing, experiencing this for the first time, would you please explain what due diligence is?

Paloma Goggins 1:27

Okay. Great first question. I think for anyone who's going through this process for the first time, due diligence can sound like it doesn't make sense So pretty much think of it as a way for someone to deep dive into your business and get a better understanding, sharing confidential information, key contracts, information about your employees, your financials. Obviously, if you have an LOI in place, you've got some basic financials that you've already shared, but you probably haven't shared major profit and loss statements, balance sheets, maybe even tax returns. So think of due diligence as a way for a buyer to really sort of dig in and learn more about your business from its confidential information and decide whether the deal is something that they want to move forward

Surprising Requests and Staged Disclosure

Paloma Goggins 2:14

with. Can

Chesney Reeves 2:15

So in your experience, what's one thing that a buyer has requested in diligence before that shocks the seller?

Paloma Goggins 2:22

Great question. I would say it can be a little bit of a shock to learn that you are n- needing to disclose all the information about your employees. A lot of times people view their employee information as one of their most confidential pieces of information, so oftentimes during diligence, one of the things that's requested in the purchase agreement is a schedule that details all of the employment information, name, how long they've been there, their title, their annual salary, how much PTO they have, what are their benefits, is there anything additional that they've signed. You know, things that arguably no one would know unless they were looking under the hood of your business. I think that can be a real shocker, and especially when you're starting diligence, the, the questions all come at once. It's not like you're getting to know the buyer and, you know, you get to disclose some of that more privileged information at a later date. I will say as a side note, there is a way to structure diligence if you're worried that the buyer is just fishing for information so that you aren't disclosing the key customers and contract information which could be your bread and butter in the marketplace, right? We see that a lot in the insurance in- industry, is insurance companies might feign interest in smaller insurance groups to take a look under the hood at their client list. And so there is ways to structure that, and we do work with clients in that manner so that you do not have to disclose key information that could put your business at risk unless and until the deal is near closing.

Chesney Reeves 3:59

Absolutely. Would you mind going into a little bit more detail on what the timeline would look like for something like that?

Paloma Goggins 4:05

Timeline for sure. I think, you know, let's... I don't wanna get too detailed about other aspects of transactions, but inherently due diligence touches a lot of them. If you are structuring the deal to have what I call tranches, right, like groups of time periods where you're like, "Okay, first disclosure is this level of confidential information. Second disclosure is, is another- deeper level of confidential information. If we tie this back to earnest deposits, which is a key LOI factor, and I don't wanna go too, too deep into this topic 'cause it's a sidebar. But essentially what we could do is, let's say you've got 60 days to closing, which is a pretty short timeframe for a smaller deal. We could say for the first 30 days you get X, and then for the last 30 days you get Y. And in order to get Y, you would need to make an initial or an additional ear- earnest deposit. And in many cases, we would want that to be non-refundable so that if you're really certain you're moving forward and we're really just, you know, punching down the list of things that you need to know giving over the client list or giving over the employment information or whatever might be really pertinent to your business that could be used against you in the marketplace comes at a price.

Chesney Reeves 5:26

Yeah, that

Data Rooms and Getting Organized

Chesney Reeves 5:27

makes sense. And you menti- you mentioned confidentiality a couple different times, but would you mind explaining how these are actually shared? Are these going-- Is this information being expressed over live calls, emails? What's the most common confidential sharing system that is, that is in place?

Paloma Goggins 5:44

Definitely. So we, in our industry, we call it a data room. You'll hear that a lot interchangeably with just a diligence room. You know, there's sometimes people use different phrases. But essentially, it's a space electronically in the cloud where you can upload information. How organized that information is depends on who's collecting it and who's uploading it and creating the data room, but that could be something like Box, Dropbox. There's all sorts of other platforms that law firms and M&A firms use. But essentially, it's a space online where everyone can gain access to it, view documents, and often there's a, a download history, so you can see who's viewed what, what's been downloaded locally, and things of that nature.

Chesney Reeves 6:32

of organization, what is one tip you would give to a seller that is fishing through their own records, trying to get this as organized as possible? What's one thing that they could do that would help this process along?

Paloma Goggins 6:44

would say, this sounds silly, but we've definitely seen it, you and I have, where individuals don't have contracts stored really anywhere, or they have them only on paper, and leading up to closing they've taken two or three staff members and made them full-time copiers where they're taking pages and uploading them digitally. That's like the last thing you wanna be doing while you're also operating your business and trying to sell it. So I would say for anyone who's listening who doesn't really have a reservoir or a contract management system or even just a cloud system where all of your key material contracts live and exist That would be probably step number one to implement. That and just making sure all of your information is collected and saved somewhere, even if it is all on paper which I hope it's not. But if it is on paper, at least having a file system and thinking about it from a digital perspective, you can still have that file system online. But having that in place first allows us and or any other advisors that you might bring into a deal to take the relevant information from your internal database and upload it to the data

Momentum Killers and Deal Fatigue

Paloma Goggins 7:58

room.

Chesney Reeves 7:58

So we've got the diligence uploaded in the data room. Both sides are looking at this with a fine-tooth comb. What is one way that a seller kills the momentum during a deal like this, to where we're asking for more diligence or that nobody's really sure where something is? What, what's something that you've seen happen along those lines?

Paloma Goggins 8:17

I think timeliness can be really important. I, you know, we always say time is the number one deal killer. And there is such a thing as deal fatigue where people just get tired of sort of the process. It drags on, communication can slow, and people feel less motivated because the finish line becomes a little bit blurry. And so I think if you are a seller in this process and you're wondering how could my actions impact momentum, I think some of that comes down to if you've been given a diligence list and you sit on it for a really long time, you don't respond, I think it starts to maybe raise questions in the buyer's mind of like, "Well, what are you hiding? Why can't you disclose this information? Don't you know these questions? They're about your own business." And I also think too, some of this diligence has to be listed in the schedules. We call them disclosure schedules. But this all ties back to indemnification obligations and representations and warranties in the purchase agreement, which can be an entirely separate podcast. We won't go into that today. But The schedules are a really important protection for the seller to say, "Hey, I disclosed everything about my business truthfully, and here's how I prove it in these schedules." And if you're trying to close a deal on a timely basis and you're not uploading the relevant information or you're not granting the proper access so that people can review it, ask questions about it, maybe ask for additional diligence, you're really just slowing down the whole deal, and inevitably you run the risk of deal fatigue at that point. And so besides maybe breeding some mistrust in the buyer, you're also making the process feel more disjointed, which can cause unnecessary delays and could ultimately impact how the two parties interact together.

Chesney Reeves 10:24

That's a lot of great points there for sure.

Buyer Diligence Checklist

Chesney Reeves 10:27

I want to flip the script though for our buyer listeners that may be again doing this for the first time. Do you have a punch list of a couple recommendations of diligence to ask

Paloma Goggins 10:38

I

Chesney Reeves 10:38

right off the bat that may or may not impact their decision as we continue to go through the diligence process?

Paloma Goggins 10:44

would say diligence falls into probably three or four buckets. One is financials, making sure that you're getting more complex financial statements than just what's provided often at the outset when the LOI is being negotiated. Intellectual property, making sure you've been supplied with all the information about what accounts they have for social media, whether they have trade names, trademarks, things that are formally registered with the USPTO. Employees and benefits and insurance, I would consider all that internal operations. Key contracts, anything that needs to be assigned at closing or is material to the business if you're buying the equity. And then probably finally some of the nitty-gritty stuff, permits, things like that, that, you know, maybe you're not assigning at closing, but they're things that you need to know are in place that as a buyer you're going to have to get yourself in order to operate the business. I think sometimes people often get confused that many permits cannot be assigned from one business to another. Even locally, like Scottsdale business permits aren't assignable. You have to obtain your own Scottsdale business permit. And so sometimes people will buy a business and try and operate after buying all the assets and realize that they have like a three-week waiting period. A lot of cities will try and expedite for people who were confused and are waiting to essentially operate their business. But with any government organization, you know, always assume the slowest possible resolution to your problem. And so if you haven't gotten the permit or started the permit process, and obviously you sometimes can't- if you're not operating a business at a location and you're waiting to buy that location factor in that you might have to pause business just temporarily while you're getting permits in place.

Chesney Reeves 12:31

Yeah,

Contract Assignments and Consents

Chesney Reeves 12:32

absolutely. And bringing up assigned contracts is so important because I feel like that's one thing that gets overlooked a lot. And would you mind just going through that process as far as what it looks like when, when there is a contract in place that requires written consent prior to the reassignment of that contract?

Paloma Goggins 12:50

That's a great point. One thing that a lot of business owners don't realize is that contracts, especially in an asset purchase, must be assigned at closing. And if you haven't really thought about your contracts from an exit perspective, they should always include the option to assign the contract with obviously written consent of the other party. There are times when we do help people go through the sale process, and we realize many of their contracts actually include explicit prohibition on assignment, which then, even though we do ask for consent, they don't have to obligate. You know, there's no obligation for them to actually provide it, which could create some lost value, some lost revenue. It could impact your purchase price. So, you know, one thing I would say for anyone who's listening that is currently just in operation and exiting or selling to a third party is in the future, start looking at your contracts now. Start entering into contracts that are new with negotiations on the assignment provision so that perhaps you don't have to get consent. You can just assign to the new owner. But what it is really in essence is there's a provision. It's in usually the bottom half of the contract. We call it the boilerplate provisions. That's super lawyerly term, but is essentially standard language that's at the end of every contract. And the assignment provision says, "Don't... You know, you don't c- you can't get to assign your obligations under this contract without at least giving us the chance to say yes or no." There's ways for us to draft that provision to be easier on you if we're talking about the pre-planning stage. But if you're in the process of actively exiting, that assignment provision can be key to us obtaining consent leading up to closing so that you're not closing without half of your important contracts, and all of a sudden, the buyer has a reason to say, "Well, maybe we should negotiate some sort of holdback provision where you don't get the whole purchase price because what if I don't get these contracts assigned," right? So I think it can really unnecessarily create a lot of doubt and anxiety, which could impact how much money you take home at closing day. For sure

Materiality Thresholds and None Schedules

Chesney Reeves 14:58

again, going back to some more examples here, what are some numerical thresholds that you see in diligence as far as not being flooded with $50 contracts to $50,000 contracts? Or for diligence in general?

Paloma Goggins 15:12

There is no, quote-unquote, "standard minimum", but I would say setting thresholds for disclosures is key so that you're not out there, let's say you're a construction company, you've got thousands of contracts that perhaps you've had in the past that are sort of evergreen, so they're technically still active even though there's no active project for them, and perhaps hundreds of actual active contracts that are currently in place and a project is happening. And so what happens is in the purchase agreement, there's a provision that stipulates that you need to list all of the contracts that are material or key, right? And, and f- for you, for example, if you are a construction company, that could be hundreds of contracts. So in order to prevent this process, this diligence disclosure process from becoming a full-time job and taking away from your ability to operate your business day-to-day leading up to closing, we often try to include some sort of threshold in there that makes it so that you are still disclosing material contracts, but they're limited to those that are truly material. So that could be $20,000, it could be $50,000. On the low end, we see $10,000, right? It really depends on your business and the circumstances, but essentially we want to find a happy medium so that you're not having to upload hundreds of contracts, and also, you know, swamp the buyer in this giant diligence review that isn't maybe necessary. And, and also a separate total, you know, related point is that if you have contracts that are not active or have completed or are terminated or expired, you don't have to list those, and we wanna make that clear in the purchase agreement too. Because at the end of the day, even if you can assign a contract if it's no longer active, we don't want to assign it at the end of the day.

Chesney Reeves 17:07

Yeah. That leads up to another question that I had as well, and our listeners may relate to is, if a schedule doesn't pertain to them whatsoever at all but is still listed in the purchase contract, what happens on the disclosure schedules or what happens with diligence?

Paloma Goggins 17:21

Great question. So as silly as this sounds, you get to put none on that schedule. You know, if there's nothing to disclose, it, the schedule still exists in the contract, you just say that there's nothing to disclose. And so we see that often when- The purchase agreement asks about current existing or past litigation over the last three years, and for many individuals in their business, they don't have that, and so they just get to put none on that schedule and move on to the next.

Chesney Reeves 17:48

Perfect.

Case Study Vehicle Payoffs Chaos

Chesney Reeves 17:49

Let's keep talking about some examples here as well. And I would like to know something, and other listeners may as well, but what's something that you

Paloma Goggins 17:57

I

Chesney Reeves 17:58

come across through a deal that may have been proposed as a small issue and overlooked in the early stages of diligence and then turned out to be a big problem?

Paloma Goggins 18:06

would say we recently saw a transaction where there was a lot of vehicle payoffs, and this can be very common in the trades world, right? You have a lot of heavy equipment, you have a lot of vehicles, work vehicles, and vehicle payoffs can be, and/or equipment payoffs, can be a very big component in collecting diligence and essentially saying, "Hey, at the end of the transaction, the escrow agent or the, the potentially the parties," right, if you don't have an escrow agent. I, I would say the escrow agent is a, is a nice bow on top because you don't have to have either party make the payoff. You can always say, "Okay, third party's gonna make the payoff and make sure that it's done correctly so that all the assets are lien-free, debt-free," right? This specific transaction had a lot of vehicle payoffs, and when you do not have a, a good organized system for how you're gonna pull this information together, right? Because it's a shifting, the shifting timeline. So if the closing date gets extended and the payoff letters are only good through April and closing is in May, those payoff letters are going to have to be updated because the money has changed, right? And so what we saw and, and what Chesney was alluding to was kind of this rapid fire, last-minute collection of payoff letters, trying to figure out what the dollar amount was, trying to connect them because the payoff letters did not have the license plates. Some had VIN numbers. And so it was sort of like a, an Easter egg hunt in a way where we were, like, trying to figure out how to match the the correct information, finding these little pieces of information from the payoff letters and matching them to the, the vehicle information and trying to figure out what was the right amount, dollar amount. And also making sure that incremental interest was included, right? Because, you know, if the closing occurs in a middle of the month, not the end, and the billing date is at the beginning or the end of the month, you could also have additional payoff amounts that just aren't on the payoff letter. And so it gets really complicated very fast, and for us, it was one of those moments where if seller had taken the time To get an initial payoff letter for every vehicle and create sort of a chart that made it easy for us to pull up the diligence and say, "Okay, here's the vehicle, here's the payoff letter. They match. Here's the amount. They match." And then also just we could update them closer to closing, right? But at least we would have something to be able to match initially. And unfortunately, that just wasn't the case. We were on this hunt, puzzle piecing it together, and arguably it, it sort of diverted our attention away from the more important negotiations, which was on the purchase agreement and the ancillary documents. And so I think the lesson learned for anyone who's going to or plans to go through the diligence process, if you're thinking about it from the buyer's perspective, the buyer wants to have the easiest possible time sorting through the information and confirming what's accurate and what's not. And if, if you're creating a mess in the diligence process, you're, you're just really creating chaos on top of what is already a very complicated and complex situation. And I think there's ways to make this process better that can start even earlier, as Chesney had mentioned in one of the questions. You know, there's ways to organize this early on, and doing that really streamlines this process in a way that helps alleviate some of that confusion.

Avoid Bottlenecks and Start Early

Chesney Reeves 21:50

Absolutely. And one additional point I wanna make is for both buyers and sellers to be wary of a bottleneck effect to where only one person in this situation really knew how to find this information and had access to the information. And so Paloma and I were both experiencing pinging this person nonstop to get the information in order to get across the finish line at, at closing. So I think it's important for both parties to realize that if only one person has that information, the earlier that they share it, the better.

Paloma Goggins 22:22

I would just say as a final note that diligence is something that you can be building long before you have an LOI in place, and arguably, if you start building your data room three, six months, even a year in advance, granted, there are some things that are gonna change in your business. You might be updating it over that year. But it is going to help you have such a smoother transaction. You're going to derive greater value, and most importantly, the buyer is going to have trust that what they're buying is really worth it. It's organized. Look at all the stuff you've already collected, and you haven't even started the process of negotiating the documents yet. So think long and hard if you're planning on exiting your business. Work with your advisors. We love to work with our clients early on in the process if they're thinking about selling in the next one to five years. We love working with them early on so we can get them set up for success. I wanna thank Chesney for asking all the hard-hitting questions today. If you enjoyed this episode, please like, share, or subscribe to listen to more, and tune in next time for our next topic on mergers and acquisitions.