What Happens When a Buyer Finds a Problem During Due Diligence?

For a business owner, reaching the due diligence stage can feel like a major milestone. A buyer has agreed to move forward, made a sizable deposit towards the purchase price, and the basic terms of the transaction have already been established. Now the buyer has the opportunity to look closely into the business.

This is when questions, discrepancies and unexpected issues can surface.

So what happens if a buyer finds a problem during due diligence?

The answer depends on the nature and significance of the issue. In the majority of cases, if handled well and not a fundamental issue to the current agreement, discovering a problem does not mean the transaction is over. The key is how you respond as the seller.

What Does a Buyer Examine During Due Diligence?

Due diligence is the buyer's opportunity to verify any and all information about a business (other than sensitive client lists, account numbers, etc.) and develop a deeper understanding of what they are acquiring.

A buyer may review:

• Financial statements and tax returns

• Bank and accounting records

• Customer and vendor contracts

• Employee and management information

• Leases and equipment

• Outstanding debt and liabilities

• Licenses and permits

• Legal or regulatory matters

• Customer concentration and revenue trends

It's common for this process to uncover information that wasn't apparent during the initial negotiations.

Common Problems Found During Due Diligence

Some issues are minor and can be resolved with additional documentation or an explanation. Others may require more attention.

For example, a buyer might discover that certain personal expenses were included in the company's books that weren't previously disclosed, certain financial records need clarification, or that a large customer represents a significant percentage of revenue - leading to a client concentration risk for the buyer.

Other concerns might involve an important employee who may leave if the business is sold, an expiring customer contract, unresolved legal matters or excessive dependence of the business on the owner ("the owner is the business" situations).

The important question isn't simply whether a problem exists. It's how materially that problem affects the business and the buyer's expectations.

Don't Hide or Minimize the Problem

If a buyer raises an issue, the seller should resist the temptation to become defensive or dismissive.

Trying to conceal information can create a much larger problem than the original issue, as well as distrusting the seller. A buyer who discovers that something was intentionally withheld will begin questioning the accuracy of other information as well.

Instead, the seller should determine exactly what the issue is, gather the relevant documentation and provide an accurate explanation.

If you don't know the answer to a buyer's question, it's better to say so and obtain the correct information than to guess.

Does Every Problem Affect the Purchase Price?

No.

Some issues simply require clarification. Others can be corrected before closing. A buyer may also accept an issue once they understand its scope and financial impact.

More significant problems, however, can lead to renegotiation of the purchase price or terms of the transaction. Other options are an escrow or holdback, or additional contractual protections.

In particularly serious situations, a buyer may decide not to proceed. That's why it's always best to have a clear inventory of any and everything a buyer may look into.

Should You Fix Problems Before Selling?

Whenever possible, sellers should identify significant problems (and resolve them, or factor them into the price) before putting their business on the market.

No company is perfect. Focus on issues that could materially affect a buyer's understanding or confidence in the business.

Cleaning up financial records, documenting important processes, resolving obvious contractual or legal issues and organizing business records will make the due diligence process substantially easier.

The Best Approach: Prepare Before the Buyer Looks

The strongest position for a seller is to enter due diligence knowing where the potential problem areas are.

An experienced business broker or M&A advisor can help identify issues that may attract a buyer's attention, organize the information needed for due diligence and help facilitate communication between the parties.

The goal isn't to have a business without any problems. All businesses have them.

The goal is to fully understand what these problems may be, resolve them where possible, disclose them appropriately and be prepared to address legitimate buyer concerns.

When a buyer finds an issue during due diligence, the transaction isn't necessarily in trouble. Often, the difference between a manageable issue and a serious transaction problem comes down to preparation, transparency and how effectively the issue is addressed and resolved.

If you're considering selling your business, contact Capital Business Solutions to discuss how you can prepare for the due diligence process before going to market.