Setting Diligence Objectives
Any deal is a trade. In M&A, a business owner is labeled a “seller” and the firm or individual investing is the “buyer.” But technically, both are trading value.
In order to go through, any trade has to be understood as a worthwhile exchange by both parties. At Permanent Equity, we strive for a good deal for both parties, not a perfect deal for either one. This translates into a combination of compromise, good faith and also the idea that we have to fundamentally value certain elements of the deal differently (e.g., a seller valuing guaranteed money today more than non-guaranteed money in the future).
Here’s guidance on how to think about what both sides want to get out of diligence in order to confidently exchange value:
Buyer’s Diligence Objectives
To begin due diligence, Permanent Equity (or any buyer) has made a substantial offer of known value (money) for something we believe has value (your business). As a seller, you’re in a superior position of knowledge about your business, whereas money has a known value. And, up to this point, we’ve relied on information and discussion with you and your advisors to estimate a good and fair value. While there are multiple objectives within diligence (e.g., relationship building), in terms of the transaction economics, diligence verifies that the trade makes sense.
The capital proposed in an offer has market-verifiable opportunity costs. That money could be invested in public stocks, real estate, another business, or be stuck under a mattress (none of which are risk-free). In order for the exchange to make sense for a buyer, the potential investment has to be understood well enough to confidently compare and believe that the prospective investment has the desired potential upside. That doesn’t mean it has to be the least risky or have a certain revenue profile, both because those are measures everyone values differently and also because different sources of capital behave differently. This is why it is perfectly understandable for an individual with 80% of their net worth in one business to have an interest in partial liquidity. And this is also why an investment fund would invest in a business that may need significant operational support in order to grow substantially. We all value things differently.
But unlike money, businesses are nuanced networks of people, relationships, and structures. And unpacking it all is the process of diligence.
Because of the complexity, due diligence can feel one-sided. You get a massive (though already tailored to our understanding of your business, we promise) list of questions and requests, some of which seem quite invasive or blunt.
Our questions aren’t meant to be nitpicky or accusatory. We’re genuinely trying to get to know the business. You’ve lived it. Unpacking the details helps to inform:
How we think about relationships moving forward (individuals, team, customers, suppliers, communities, and more)
How we might structure the transaction (e.g., taxes, entity structuring, risk factors)
Where there are opportunities for improvement in the short, medium, and long term (upside!)
How the purchase agreement should be outlined (details!)
To that end, when we have conversations and make requests in the diligence process, we try to focus on issues and questions that are relevant and important to you and your business. What might seem overwhelming in that process is frequently an attempt at ultimate clarity.
Seller’s Diligence Objectives
Given the buyer's objectives during diligence, it's perhaps obvious that one seller's objective during due diligence is to make sure that the business is accurately represented to the buyer. That's providing complete and transparent information about the company's finances, operations, and legal history. But also, it's about seizing the opportunity to help the buyer see what you see in your business – the value that you believe to be there and that you are exchanging in the transaction, including projections, opportunities, and intangibles.
Fundamentally, this part of the diligence conversation is about demonstrating to the buyer that the exchange of certain value for uncertain value makes sense, i.e., helping us take risk confidently. But as a seller, your objective during due diligence shouldn't only be providing the information required to get the deal done. Again, diligence should be conversational, and a trade must go both ways.
-
We’ve written before about red flags we’ve seen in sellers, but bad behavior can go both ways. If you’re using the diligence period to evaluate fit with your prospective buyer (and you should be!), be on high alert for red flags. Here are a few to put on your radar:
Breaking chain of command without communication/permission (e.g., contacting a customer/lender)
The sources of funds don’t stack up (or remain vague or continue to change)
News starts to spread (i.e., confidentiality agreements have been violated)
You’re missing vital information about their intentions, financial capacity, or plans for the business post-acquisition
They nitpick the valuation – and use diligence as a chance to shave dollars off the price
Everything’s warp speed or snail’s pace (e.g., the time to review financial statements is unreasonable)
The documents don’t reflect your deal (e.g., you’re supposed to partner, but there are no employment agreement drafts)
They don’t know the industry – and they aren’t willing to ask the questions and do the legwork to learn the nuances.
The legacy is unimportant and the future is murky (i.e., the company's history, brand identity, or customer base are downplayed and post-close plans are unclear)
The line between optimism and dishonesty is unclear and milestones keeps moving
So, due diligence is also a time where the seller evaluates the behaviors, attitudes, and communication style of the buyer. While we would argue that this type of assessment and trust-building is important no matter who you’re transacting with, it’s crucial if you’re negotiating a long-term (say, 27-year?) partnership with a buyer. If you care about what comes next for your business, your employees, and your customers, you should use diligence as an opportunity to evaluate:
Does what you’re seeing line up with who the buyer said they were from the beginning?
And does that square with who you want stewarding the business long-term?
What does the buyer’s behavior tell you about a future operating partnership? Brand stewardship? The continued cultivation of customer relationships and company culture?
As a buyer, we have an opportunity, through diligence, to learn the nooks and crannies of a business – what makes it what it is, what makes it successful, what presents risk, what presents opportunities for improvement. And, as a seller, you have the opportunity to help us see the value and potential in your business. On both sides of the equation, we’re able to learn about the people involved – who they are and what they care about, and how we can best work together towards the common goals.
Transactions are about more than money. Approaching diligence as a mutual exchange of information highlights this idea. When approached as a trust-building, cooperative exercise, diligence is about demonstrating good behaviors and instilling confidence in the deal and the future – on both sides.
