9 Reasons the Seller Should Conduct Due Diligence on the Buyer

As a business owner considering selling your company, it’s vital to understand the importance of conducting due diligence on potential buyers. This post discussed the importance of pre-sale due diligence by the seller, but often the reverse is overlooked. Due diligence on the buyer is not just a formality but a crucial step in ensuring a successful transition and safeguarding your interests.

Here are nine compelling reasons why due diligence on the buyer is imperative:

1. Ensuring Financial Capability: The foremost reason to conduct due diligence is to confirm the buyer’s financial strength. You need to be confident that the buyer has the necessary funds for the acquisition and the ability to manage financial commitments post-sale. This involves assessing their creditworthiness, liquid assets, and capacity for securing acquisition financing. Remember, your financial return, especially in cases involving earn-outs or seller financing, hinges on the buyer’s financial stability.
2. Legal and Operational Competence: It’s essential to verify the buyer’s legal standing and operational expertise. This includes checking for necessary licenses, understanding their experience in the industry, and evaluating their track record in business management. Ensuring the buyer has the legal and operational capability to run your business not only impacts its future success but also affects your legacy and reputation.
3. Aligning with Business Goals and Vision: Conducting due diligence helps you understand the buyer’s intentions and plans for the business. You want a successor who aligns with your business’s vision, ethos, and strategies. This alignment is crucial if you continue to have a stake in the business or its performance impacts your financial returns post-sale.
4. Ensuring an Understanding of the Buyer’s the Income Tax Structure: The tax structure of the buyer can significantly influence the net after-tax proceeds you, as the seller, receive from the sale. This is especially true if the seller is rolling over part of the business in exchange for equity in the buyer. There are various ways to achieve a rollover in a favorable, tax-deferred manner for the seller. The two main methods are via a contribution of an interest in the business to a partnership and a contribution of an interest in the business to a corporation. The seller will likely obtain representations from the buyer that a rollover achieves the seller’s tax deferral objectives, but it’s critical to perform appropriate due diligence to be sure.

Understanding the buyer’s tax structure allows for more effective tax planning strategies for a future sale of any retained equity. For example, if the buyer is a C corporation and the seller’s retained equity is stock in a C corporation, will the buyer’s stock qualify for advantageous Qualified Small Business Stock tax treatment? If the buyer is an LLC taxed as a partnership, what is the “waterfall” that dictates the cash flow going to the seller upon a sale and how will be the tax consequences?

5. Maximizing After-tax Proceeds on the Second Bite at the Apple: By assessing the buyer’s financial stability, business acumen, and tax structure, the seller can ensure that the entity acquiring the business is capable of not only sustaining but also growing the business. This growth directly impacts the value of any retained equity or earnouts. If the buyer successfully scales the business, the seller’s “second bite at the apple” will be larger, reflecting the increased value of the business under the new ownership. See Second Bite at the Apple: How to Structure a Tax-efficient Rollover
6. Mitigating Legal Risks: Diligence on the buyer reduces the risk of future legal complications. If the business underperforms under new ownership, you want to be sure that you’ve done your part in transparently representing your business. This shields you from potential legal claims of misrepresentation or fraud.
7. Evaluating Compatibility and Ethics: Understanding the buyer’s character and ethics is vital. Their approach to business, treatment of employees, and overall ethics will influence the future of the business and its staff. References and background checks are instrumental in this aspect.

Inquire about the buyer’s strategic goals, and their plans for achieving them. Do their values align with yours? As someone who has undoubtedly built a close relationship with existing staff, scrutinize the buyer’s plans for the workforce. How will they handle layoffs, restructuring, pr changes in benefits? Being aware of these plans allows the seller to support the team through the transition, maintain morale, and manage any changes in team dynamics.

8. Planning for Transition and Continuity: A thorough due diligence process helps in planning a smooth transition. By understanding the buyer’s plans, you can gauge how they intend to manage the transition, handle existing staff, and maintain business continuity.

This is especially paramount when the seller plans to work for the buyer post-sale as an employee or consultant. The seller should conduct interviews to understand the management style and corporate culture of the buyer. This knowledge will help the seller anticipate how he or she will fit into the new organization. Will your entrepreneurial approach align with the buyer’s possibly more structured environment? Fleshing out these dynamics in advance can help the seller prepare for a smoother transition and hit any performance-related goals.

9. Building Trust and Confidence: Lastly, conducting due diligence builds trust and confidence in the transaction. It demonstrates your commitment to a successful transition and shows that you are a meticulous and responsible seller.

In summary, due diligence on the buyer is not just about checking off boxes; it’s about ensuring that the sale of your business leads to a prosperous future for the company, its employees, and yourself. This process lays the foundation for a successful transition, protecting your interests and legacy. As you embark on this journey, remember that the sale of your business is not just a financial transaction but a transfer of your hard work and dreams to someone who will carry them forward with the same passion and commitment.