Getting ready for due diligence requires the seller to plan ahead, but the investment of time can pay off in several ways. First, anticipating the types of information that a buyer may want will help minimize delays that can lead to a loss of momentum in negotiations. In addition, having an advance preparation strategy bolsters the impression that the seller’s business is run professionally. That may increase the prospective buyer’s confidence in the value of the company and could lead to a higher sale price.
Here are some of the major areas that sellers should anticipate when preparing to run the due diligence gauntlet.
Any buyer will (or should) want to undertake a comprehensive financial review of the business. For larger (over $2 million) transactions, the seller also should prepare audited financial statements (balance sheets, earning statements, and cash flow statements) for the current year-to-date and the three prior years. Buyers also will want to inspect the business property and equipment.
Sellers should have a list of expenses that will not be considerations for a buyer, including what the current owner takes out of the business and any related expenses such as “fringe benefit” expenses like golf club memberships, company paid vehicles, and the like.
Itemize the company’s intellectual property (IP), such as patents, inventions, designs, copyrights, trademarks, service marks, trade secrets, computer programs, confidential information, and know-how. This should include a list of company IP as well as the documents, including any licensing or royalty agreements, relating to use of the IP.
Help the buyer understand how your business works by summarizing current processes and procedures, listing key supplier and vendor relationships, explaining inventory management, management systems, and customer relations.
Many small business owners want to know what their business is worth. The answer, as in any transaction, is what a buyer is willing to pay. And what a given buyer will pay may depend on a host of factors regarding the particular industry and the condition of the business. For detailed information, it pays to use a business valuation expert such as Dan Gilbert at Gilbert Valuations, LLC.
Business brokers often use shorthand formulas based on multiples of earnings to project a potential sales price. This makes sense because earnings are more relevant than gross sales. And buyers tend to view the purchase of a business as an investment. Using a multiple of earnings formula allows the buyer to have a sense of how long it will take to recoup that investment and begin making a profit.
Simple enough so far, but how to know what it means for a particular business? For starters, which earnings do we mean? Last year’s? A rolling average of past earnings? Current earnings? Or projected earnings that forecast the future? Assuming we can agree on the right time period to measure, the next question is how do we calculate those earnings? Most accountants commonly use a formula that measures earnings before interest, taxes, depreciation, and amortization (“EBITDA”). It sounds complicated, but the goal is simple – finding out how much cash the business generates from operations.
After deciding which earnings and how to calculate them, the third question is what multiplier to use? For most businesses, it’s somewhere between 3 to 5 times EBITDA. For a buyer, this would mean recouping your investment in 3 to 5 years from profits of the business.
The bottom line is that rules of thumb are simply a shorthand way to “guesstimate” a possible sales price. Many factors come into play, and there’s no substitute for using a qualified professional to evaluate the particulars. As they say, actual mileage may vary.