Getting through due diligence without a price cut

Due diligence is the detailed review a buyer does before closing: finances, contracts, employees, assets and risks. It's often where the agreed price slips, because every surprise becomes leverage. To get through due diligence without a price cut, the buyer has to find nothing you haven't already shown them.

What the buyer really checks

Once the letter of intent is signed, the buyer sends in their advisors. Their accountant, their lawyer, often their bank, sometimes a specialist in your industry. Each one has a list. Together, they're trying to answer one question: is what we were told true, and will it last?

In practice, they look at five things:

• Finances. Are the results the ones announced? Does the normalized EBITDA hold up when every adjustment is checked?
• Contracts. Are the big clients bound in writing? Do the agreements survive a change of owner?
• People. Who are the key employees, on what terms do they work, and will they stay?
• Assets. Do the equipment, buildings, software and trademarks actually belong to the business?
• Risks. Disputes, permits, environment, health and safety, taxes.

And a sixth, which matters most in a founder-run business: does the business run without you? The buyer won't settle for your answers. They'll ask to meet your operations manager, your controller or your shop supervisor, and put the same questions to them.

Why prices drop during due diligence

The price in the letter of intent is based on what the buyer knew when they signed it. Anything they learn afterward can move it. And it almost always moves in one direction.

This isn't bad faith. When a buyer finds that a major client has no contract, they see less certain revenue. They have three ways to protect themselves: lower the price, hold back part of the payment, or turn part of the price into an earn-out. Each one costs you.

The second problem is time. A review that drags on wears everyone out. The buyer loses confidence, their advisors keep billing, their bank revisits its terms. The longer it lasts, the bigger the small questions get.

Two versions of the same sale, in Magog

Picture a machine shop in Magog, invented for this example: 40 employees, five million dollars in revenue, a 64-year-old owner. A buyer signs a letter of intent at a price he's happy with.

Version one. During due diligence, three things come out. Two of the CNC machines belong to the owner's holding company, which "lends" them to the business with no lease. The largest client, a farm equipment maker, can end its agreement without notice. And the production planner, who knows every machine's settings and every client's requirements, was never introduced to the buyer: she hears about the sale through the grapevine and hints that she might leave.

None of these is fatal. Together, they give the buyer a reason to come back with a revised offer and a holdback on the payment.

Version two. The owner ran his own review a year earlier. The two machines were moved into the business, with his tax advisor's help. The client agreement now includes reasonable notice. The planner has a retention agreement and already knows how the transition will work. The buyer finds exactly what was described. There's nothing to renegotiate.

Five rules for getting through it

1. Run your own review first. Before opening the door, ask your accountant and your lawyer to read your data room the way a demanding buyer would.
2. Disclose problems yourself. A known problem, quantified and paired with a solution, gets negotiated before the letter of intent. Found after, it gets negotiated against you.
3. Answer fast, and once. Name one person who receives every question, logs it and answers within a set time.
4. Prepare your key employees. Decide who will be told, when, and what they'll be offered to stay through the transition.
5. Put agreements in writing before, not during. Client and supplier contracts get signed more easily when no one is in a hurry.

What gets negotiated even when everything is clean

A review with no surprises doesn't mean a negotiation with no discussion. Three topics come up almost every time, and it's better to know them ahead.

Representations and warranties. In the purchase agreement, you state in writing that certain things are true: the financial statements are accurate, there's no hidden dispute, the taxes are paid. If one turns out to be false after the sale, the buyer can claim indemnification from you. What actually gets negotiated is the frame around that claim: a cap, a time limit, a threshold below which nothing is claimed. And whatever you list in the disclosure schedules, the known exceptions, normally can't be held against you afterward. A complete data room makes those schedules easy to write.

The holdback. The buyer may ask that part of the price be set aside for a period of time, to cover those warranties. The length and the amount are negotiated. A clean file is your best argument for keeping them modest.

Working capital. Many deals set a target level of working capital at closing (receivables and inventory, minus payables), with a price adjustment if you come in above or below it. If your business is seasonal, the target should reflect a yearly average, not the month that suits the buyer best. Have your accountant set that level before the negotiation, not during it.

The exact rules vary with every transaction. Have your lawyer and your accountant frame these three points before you sign anything.

Checklist: 30 days before opening the room

• Financial statements for the last three to five years, with the normalized EBITDA calculation and its supporting documents.
• List of the ten largest clients, with each one's written agreement and its change-of-ownership clause.
• Every asset the business uses is in its name, or its situation is explained.
• Disputes, formal notices and complaints: a complete list, with the status of each.
• Permits, certificates and inspections up to date.
• Key employees identified, with a retention plan.
• The Transition Document is current and shows how the business runs without you.
• One designated person and a log of questions and answers.

Every unresolved item is a question the buyer will ask. Better to have it settled first.

For the big picture of this work, see step 7: the data room.

Do it with a pro

Alone, you discover your gaps at the same time as the buyer, which is the worst possible moment. With us and our regional partner, the business goes through a dry-run review months before the sale, and whatever is lingering gets fixed before a buyer sees it. Start with a free 45-minute audit.

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