Due Diligence in Selling a Business

In the normal course of buying or selling a business, buyers typically want to be sure that they fully understand what they’re acquiring, and sellers want to prepare their business for sale, address potential issues beforehand, and verify the buyer’s reliability for making the purchase.

Buyers might ask for documents, financial statements, tax returns, insurance policies, employment information, and more, as well as written promises that there are no issues. Sellers might request financial documents that show if the buyer can pay for the business, as well as proof of reliability. Additionally, they should ensure that all promises made are true to prevent issues down the road.

This process of examining a business, buyer, or transaction beforehand is known as due diligence. If you’re planning to sell your business, it’s helpful to understand how to protect yourself throughout this process.

About Due Diligence 

Naturally, sellers want to get a deal done and limit the amount of time and energy they have to spend getting ready, and that works fine if they get to sell the business and its assets “as-is”.

However, in most deals, there are representations and warranties made in writing by the seller where they promise that everything is clean, there are no issues, and all information provided is accurate. As a result, if it turns out that there are any problems, the buyer has the right to go back to the seller after closing to seek damages.

For protection, sellers should go through a due diligence review on their own company, just to be sure that the promises can be safely made and limit any possible issues post-closing. The seller must also review those representations and warranties in detail to be sure that they are true, and if not, negotiate changes and add language to note any exceptions.

This is helpful for buyers as well, as having to make claims afterward is time-consuming and expensive.

What Does This Look Like?

The first draft of the purchase agreement from a buyer often contains a representation about financial statements that is phrased something like this:

"The Company being sold does not have any material obligation or Liabilities other than (a) Liabilities reflected in the Financial Statements and (b) Liabilities which have arisen after the date of the Interim Financial Statements in the ordinary course of business or in connection with the transactions contemplated by this Agreement."

What Should the Seller Do?

1. The seller should read and understand the definitions of capitalized terms in the agreement.  It may sound simple, but the definition of “Financial Statement” can be those financial statements prepared in accordance with generally accepted accounting principles, on an accrual basis, and audited by a certified public accountant. In many cases, the selling company uses cash-basis financial statements, and they are internally prepared.  Changes to the definition are important, and once this is changed, the buyer may then want even more changes to the agreement. 

2. The seller should review their books and records and ask for help from their legal and accounting advisors to confirm that the representation is true, or to find out what changes need to be made to ensure that it is accurate. This can help to avoid problems later.

3. The seller may not have enough time or knowledge to find everything, but they might have a key employee who knows about the possible deal and the business operations and can help dig through the files to find what the buyer asks to see.

4. If there are any possible issues, then the seller should negotiate a change. It may be as simple as adding language to the representation, such as, “Except as set forth on the Disclosure Schedule.” Then, the seller could describe the issue or change on a schedule that is attached to the agreement.

5. It’s important to note that all of this is subject to buyer’s approval and acceptance of these changes.

Protecting Yourself as a Seller

Representations and warranties in an agreement can be as short as 5-6 pages or as long as 15-20 pages. It may seem time-consuming, but it is typical in agreements for buying and selling a business. Further, sellers should be thorough in protecting themselves from any possible post-closing claims from the buyer.

Another protection for the seller often put in the agreement is a limit on the amount of damages that the buyer can recover, and perhaps a deductible so that there is an established minimum amount of damage needed before any claim can be made.

Due diligence is not the time to “hide the ball.” Full transparency benefits both sides, because it eliminates surprises and lowers the risk of litigation arising after the deal is done.

Reach Out Today

Our team at MKP Law can help you understand more about due diligence as a seller or buyer, as well as what representations and warranties should be given. We can also help you with the due diligence investigation process.

If you have questions or would like more information, reach out to us today, and we can talk about your goals and what might work best for you.