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3 Reasons Why Your Business Might Fail Due Diligence

When selling a business, typically, the purchase agreement will have a stated time during which the buyer may perform their due diligence.  On small transactions, this might be a week, or on larger transactions, it might be several weeks or longer. During this time, and before the business goes into the escrow and closing process, the buyer is able to investigate the seller’s representations about their business, including historical financial results, the lease, the fixtures, and equipment, plus many other areas that the buyer feels is necessary to feel comfortable about their purchase.  Here are three major reasons deals fail in due diligence, and one reason that it should not……

First, let us start with one reason that the business should not fail during due diligence. Prior to making an offer, the Buyer should fully understand the general trends and issues surrounding the target acquisition’s industry. Buyers should not waste their time, or the seller’s time, by making an offer on a company whose industry they know little about.  For example, if the buyer was making an offer to a company that distributes plastic grocery bags, they should not be surprised to discover that there has been a downward trend in revenues over the past 10 years. Or if the buyer makes an offer on a sit-down breakfast restaurant, only to discover that the biggest days are the weekends, and the owners need to work during their busiest times. Prior to making an offer, the buyer should be comfortable with the general industry and what a typical day for the seller might look like.

So, what reasons might the sale of a business fail the buyer’s due diligence?

  1. The buyer has relied upon the seller’s financial statements in making their offer. If they discover something is untrue, overstated, misrepresented, or even omitted, the deal can fail to close. Examples of this might be that tax returns show a completely different financial picture than income statements or that the tax returns have not been filed for over 5 years. Or that the company offers its customers 30 days to pay, but the accounts receivable ageing shows that the average age of receivables is 120 days.
  2. Suppose the business is a high-end fitness center with over $1MM in tenant improvements. The lease has 3 years remaining but has a tenant option to renew for an additional 10 years. In some businesses, the lease does not matter because the business is not location-specific. But with a fitness center, the location is important, and if a lease cannot be renewed, the $1MM in tenant improvements are lost. And if the business needed to be relocated, would the members follow them to the new location? The buyer will want to confirm that they can obtain an assignment for the current term, as well as the extensions, and at a rate at least somewhat similar to the existing terms.
  3. People and Personnel. If the seller works the business but states that he only makes bank deposits daily and little else, that sounds attractive to a buyer. But if the buyer determines that the owner is heavily involved with the business or has a skill set that cannot be duplicated by the buyer, that can be a big issue. Employees of the company can also be an obstacle. Sellers cannot guarantee that their employees will stay with the business after the sale, and that is understandable. Prior to the deal closing, Sellers do not want the buyer to interact with the employees or for the employees to find out the business is for sale.  Typically, the employees are told the day the transaction closes when the new owner is introduced to the employees. That way, the buyer can immediately eliminate any concerns the employees have about a change in ownership, including whether they will lose their jobs, whether their pay or benefits will be reduced, etc. But what if the buyer determines that the manager is the seller’s brother and that while he says he will stay on after the close, there is some lingering doubt that they will?  Or what if the buyer finds out that the chief technical officer is 72, and has been discussing retirement with the seller for the past five years? These could impact the buyer’s ability to run the business and to obtain similar results.

Of course, there are numerous other reasons a deal might fail during due diligence. But most can be avoided if the seller is transparent and discloses any issues using a Seller’s Disclosure Form.  There are often ways to deal with most problems, but only if they are disclosed early, so that the involved parties can work towards a solution.

VRG has sold over 800 businesses, and we work very hard to avoid deals that might fail due diligence. But it still can happen; but the goal, of course, is for that to be a rare occurrence rather than the norm.

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