Due diligence has no pass mark

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Owners talk about passing due diligence as though it were an exam. There is no pass mark. Everything a buyer finds turns into price, structure, or a clause you live with for years. The only choice you get is who finds it first. Two years out, that choice is yours. Three weeks from completion, it belongs to the buyer.

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It usually starts with something small: $30,000 sitting in the wrong line of the accounts, in a business earning several million a year. Everyone in the room agrees it’s immaterial, the buyer’s accountant included, and on the money alone they’re right. The trouble is the question it puts on the table, and once it’s there nobody can take it back: what else haven’t we found?

From there the review changes shape. The payroll reconciliation gets pulled. Then the supplier terms. Then the revenue out of the CRM, to see whether it agrees with the management accounts. Every request is reasonable, and every one costs the owner’s team a day. By the end of the week a $30,000 classification error has turned into a question about whether anyone can rely on the numbers, and that question gets priced very differently from an accounting slip.

From the buyer’s side of the table, that week is routine. From the seller’s side, it’s often the first time the owner understands what due diligence actually is.

What the buyer is actually doing

Everything before due diligence is the story. The growth, the margins, the customers who’ve been with you for 15 years, the second site you’ve been meaning to open. A buyer listens to all of it, and some of it is why they’re in the room at all.

Due diligence is where the story meets the evidence. The buyer is working out how much of what they’ve been shown they can rely on, and their accountants and lawyers are paid to find the places where the two don’t match. Where the evidence backs the story, confidence goes up and everything after it moves faster. Where it contradicts the story, every claim that follows gets read more slowly, by more people, with a sharper pencil.

That’s why the $30,000 does the damage it does. It changes how carefully everything else gets read.

Uncertainty has a price, and a buyer has more ways of charging it than most owners realise.

Where the findings go

Here’s what a buyer can do with something they’ve found.

They can take it off the price. If they can’t establish that $300,000 of your earnings will keep coming, it comes out of the earnings figure the multiple is applied to. At six times earnings, that one finding is worth $1.8 million to them, and it costs you the same.

They can move it into the structure. Some of the price stops being paid at completion and starts depending on what happens after you’ve handed over the keys.

They can hold money back. A slice of the proceeds sits in escrow until the window for claims closes.

They can write it into the contract. Wider warranties, a specific indemnity for the thing they found, a condition that has to be met before the deal completes.

Or they can walk.

There’s no fail on that list, and there’s no pass either. A buyer can complete due diligence, sign, and pay, having quietly rearranged the economics on the way through. The transaction survives. Your original deal doesn’t.

Which is why “we passed due diligence” is one of the most expensive sentences in selling a business. It’s usually said by someone who hasn’t yet added up what passing cost them.

The only choice you get

You can’t stop a serious buyer from looking. They’ve got a checklist, a team, and far more practice at this than you have: you may sell one business in your life, and they may buy several this year. The search is going to happen. What you control is whether theirs is the first.

Running the buyer’s due diligence on your own business before anyone else does sounds like preparing your answers. It’s the opposite. The point is to find the problems while you can still do something about them.

The simplest place to start is the data room, built before anyone has asked for one. Go looking for the signed copy of the shareholders’ agreement and come up empty. Good. Pull the contracts for your 20 biggest customers and discover that four of them have expired and everyone kept trading anyway. Good. Reconcile the monthly management accounts against the annual accounts and find a gap nobody can explain. Good. Every one of those is the exercise working. You found it, and you found it while it was still yours to fix.

Who finds a problem changes what it costs. A problem you’ve found, explained, and put a number on can usually be managed. The same problem found by the buyer, in a place you clearly should have looked, arrives with a second problem attached: they’ve stopped trusting you.

Why the clock decides it

Some problems can be fixed in a week. A missing document turns up in somebody’s filing cabinet. A misclassification gets corrected. A registration gets filed.

Others need history, and history can’t be produced on demand. You can’t manufacture three years of clean monthly reporting by next Thursday. You can’t prove that cash reliably follows profit with two months of evidence. You can’t rescue a customer contract once it’s lapsed and the customer has started taking calls from your competitors. You can’t build a track record retrospectively, and a buyer can tell a track record from a tidy-up at a glance.

That’s why I treat the 12 to 24 months before a likely sale as the preparation window for most businesses. What it buys you is the one thing that disappears the moment a buyer is involved: choices. You can clean the records, put the handshake arrangements on paper, settle the dispute everyone’s been ignoring, and then watch a full year of results to see whether the fixes held.

I’d rather find an ugly problem while I still control the timetable. A year out, a weakness is a management problem with a solution. Three weeks from completion, the same weakness is a negotiation, and the only thing left to negotiate is who pays for it. Negotiation problems have a habit of becoming expensive.

None of this changes if you’re raising money rather than selling. An investor taking a slice runs the same process over the same records, and prices what they find the same way.

If you are the buyer here: a seller who has run this rehearsal is easier to buy from. You may end up paying nearer their number, but you’ll spend the process assessing the business rather than reconciling its paperwork, and the surprises will already have been priced.

What to do this week

Write down the five things you’d most want a buyer to believe about your business. Your margin, your best customers, your management team, whatever you’d lead with. Next to each one, write down the record that already proves it: the one that exists today, rather than the spreadsheet you’d build if somebody asked.

Then go and find them. Time how long each one takes, and notice which ones only one person in the business can produce or explain. Anything you can’t find, can’t reconcile, or can’t explain without a long story is your first finding.

Good. You found it first.

Over the next 13 articles I’ll move forward along that clock, from two years out to completion day: the earnings, the paperwork, your own absence, the people, the technology, the growth story, the documents a buyer reads, the meetings, and the negotiation, one finding at a time.

The 10 categories a buyer will examine are set out in Preparing Your Business For Sale Tips, and the full financial and legal rehearsal, from normalising your earnings to building the data room, is in Financial and Legal Essentials for Selling Your Business. Both are free to download from the Download Vault, alongside the other five parts of the guide: manolutions.com/downloads.