Selling Your Business Soon? What You Need to Know About Due Diligence Now

A guest post by Calvin Wilder , Founder & CEO at SmartBooks that offers a mix of CFO, bookkeeping, controller, payroll, and tax services to small business owners.

In the first post in this series on selling your business, Glenn Grant gave you everything you need to know about evaluating your readiness to sell—personally and professionally.


If you’ve decided you are, in fact, ready to sell your business, and you’ve done the work to build value before selling, it’s time to start getting your financial house in order.


It’s called due diligence. It takes time. It costs money. And it’s not very fun.


However, due diligence is critical to getting the price and terms you deserve for the business you worked so hard to build.


This post covers off on some of the major items you need to address in your due diligence—and pitfalls to avoid in the process. You can also download my sample due diligence worksheet for more details.


General accounting


At the end of the day, the cleaner your books, and the cleaner your documentation behind those financial statements, the more credibility you’ll have with a buyer.


Prospective buyers will want to see:


At least 3 years financial statements

Buyers want to know your books are kept in accordance with generally accepted accounting principles, and they will pay a lot of attention to accounting policies.

You can internally prepare financial statements and deliver them to the buyer and certify that they’re accurate and identify all of the deviations from GAAP, etc. But nothing beats external validation of your financial statements from a CPA firm.


Your financial statements align with the business story

If you’ve been telling a story about how you’re scaling, achieving economies of scale, and your margins are expanding as you grow, your prospective buyers will want to see your revenue and corresponding profit margins growing. As Glenn explained, buyers are buying a future profit stream.


Add backs

These are discretionary costs driven by business owner preferences. As such, they go will often go away with new ownership.


Let’s say your business is paying for three car leases, you paid $100k for your home office renovation, your kids’ college bills are paid through business’ educational assistance program, etc. These are real costs, but they’ll go away under new ownership—they can be added back to expenses you’ve been reporting. This allows the buyer to increase profit margin, so it’s important that add backs are all added up and factored into the sale price.


Audits


I mentioned nothing beats external validation of your business’ financial statements. You have a couple of reasonable options for getting this validation.

  • Full external audit. This is the most effective option because it’s the most stringent and removes most risk from the equation for potential buyers. However, it can be difficult for small businesses to pass and is pretty expensive ($25K+ per year). This level of external assurance is not necessarily required for smaller businesses.

  • External review. Consider it a mini-audit. A review is a step down from the full audit, and standards are a bit less stringent. However, it costs about half as much and still provides prospective buyers a reasonable amount of external validation. This is a good option for most small businesses and should typically be done yearly.

You may have also heard about something called a compilation. In this scenario, a CPA firm basically takes your internal financial statements and puts them on their letterhead—of course, with a bunch of disclaimers. This process doesn’t actually provide any assurance to buyers, and most firms won’t do them anymore. Stay away from the compilation.


Taxes


There are a few things to look out for regarding taxes as you prepare to sell your business. Consider them all early because they can be hard to change or renegotiate further along in the sale process.


Asset sale vs. stock sale

The most common tax issue that comes up in the sale of a business is the tax structure.

In an asset sale, you continue to own the stock but you sell your assets to the buyer. In a stock sale, you sell complete ownership—because the buyer owns the entity, they also own the assets. Each has different tax and liability implications, and you need to decide what makes the most sense for your sale.

Sellers tend to prefer stock sales because they can guarantee long-term capital gains tax at a slightly lower rate.

Buyers tend to prefer an asset sale for two reasons:

  1. They can get slightly better tax treatment with higher deductions on the purchase price.

  2. The asset sale shields the buyer from legal liability. If some sort of lawsuit comes out of the woodwork a few months after the sale, it doesn’t attach to the assets—it stays with the ownership of the legal entity. The buyer is relatively insulated.

Installment sales

If you can’t achieve the purchase price in an upfront cash payment, you may be looking at an installment sale—but these can be tricky when it comes to taxes.

At the federal level, the IRS will allow you to defer paying tax on future installment payments you have yet to receive. However, it’s all over the board state-wise. If you’re considering an installment sale, make sure to check in with your CPA regarding tax implications in your state.


Stinger tax on an S-corp asset sale

For those selling an S-corp, this is often an unhappy surprise. Like a partnership, the S-corp has no tax payable at the entity level. All tax liability passes through to the owners. If you sell the assets of an S-corp, however, states start to impose revenue-based or profit-based taxes on the business.

This surprise could cost a few hundred thousand dollars at closing, so it’s important to factor into your sale.


IRS documents

Getting IRS documents in order may seem like a minor task, but this is all very important paperwork your prospective buyer will want to see to understand your tax situation. We’re talking the likes of your EIN, your S-corp election, etc. If you can’t find them, it will take some time to request and receive new copies—and this time could cost you credibility with an interested buyer.

Get all of your documents in place early so that when prospective buyers ask for it, you have it handy.


Legal items


There are a few legal concerns you’ll want to cover off on before embarking in any sort of M&A activity.


Unconsummated equity commitments

In the early days of the business, you may have offered key hires some sort of stake in the business—but never got around to officially executing these agreements. It’s important to clean up any of these situations with shareholders, partners, option holders, etc. and get official commitments in place sooner rather than later.

Once the sale becomes more imminent and people catch get wind of it, they may hold out for better terms, and you will lose some leverage.


Cap table

A cap table is basically a list of who owns any part of the business and what the terms of the ownership are. This could be simple and straightforward if you own 100% of the business. It could be relatively complicated if you have stock options outstanding at multiple strike prices, if you have some convertible debt, etc.


The most common due diligence pitfall


I’ve seen it time and again—business owners wait until they have a bona fide interested buyer on the line to start taking care of these accounting, auditing, tax and legal items.


But when you get that phone call, you want to be able to provide your prospect with everything they’re asking for in short order. The more you make them wait, the less credibility you have, and you less likely you are to get the price and terms you deserve.


Next Up - Process & Timeline For Planning The Sale


If you’re feeling confident about your readiness to sell, check out the next step in selling your business: planning for the sale.


Or check out our full webinar on selling your business here.