Selling your practice: What is confirmatory diligence?
Now that you’ve been presented with a preliminary valuation on your practice (see our last blog post) and you’ve decided to accept it, what happens next?
The next step in selling your practice is that the buyer will present you with a document called a Letter of Intent. This letter will list the preliminary valuation of your practice, the buyer’s intent to purchase the practice at that price if there are no significant concerns found in diligence, and a time frame of exclusivity where you will not be allowed to communicate with or otherwise engage with other buyers. That exclusivity window provides time for the buyer to perform confirmatory diligence in preparation to close the sale. Letters of intent are typically non-binding for both parties, meaning that either side can walk away at any point prior to closing the sale without any repercussions (make sure that the Letter of Intent is not one-sided, meaning that both you and the seller have the right to walk away; some buyers might try to use one-sided letters to give them an upper hand).
What is confirmatory diligence?
Confirmatory diligence is the process of a prospective business buyer taking time to make sure that the opportunity that they think was presented to them during initial diligence actually is what they expected. They will check to see that there are no significant “red flags” that would change their valuation of the business or their interest in buying the business altogether. Confirmatory diligence has three primary components: financial, operational, and legal.
Financial due diligence: This is the most involved area of confirmatory diligence. The buyer will dive deep into the practice’s financial documents to ensure that the financial health of the practice is in good shape (or at least matches their initial assessment), that all the add backs to the valuation EBITDA are justified, and that the core financial numbers that the valuation EBITDA was based on are accurate. There are various levels of depth to which a buyer can choose to perform financial diligence. Buyers will typically perform deeper diligence for practices with higher acquisition costs, disorganized bookkeeping and accounting, or in situations where they have reason to believe that a seller is not presenting information accurately and in good faith (more on this topic to come).
Operational due diligence: The seller is going to want to understand how your practice operates. This will involve inspecting the facility and learning your practice’s day-to-day logistics including scheduling, practice management software, ownership responsibilities/duties, and learning who the key players are on your team. The buyer will likely want to meet with those key players and negotiate new employment agreements with them to ensure their continued work post-sale. If you haven’t already looped your key players in on your intention to sell the practice, now is the time that you will need to do so. The buyer wants to be ready to run the business effectively after buying it, so this time is important for them to learn the details of how it operates.
Legal due diligence: The buyer will review all contracts (employment contracts, equipment and real estate leases, etc.), potential liabilities of the business, and otherwise vet that the practice is in good legal standing.
What should you expect when your practice is in diligence with a buyer?
The buyer will expect full access to financial and operational aspects of the business in order to validate their valuation and their interest in purchasing your practice. It’s fine to set some ground rules to make sure that the diligence process isn’t unnecessarily disruptive, like requiring facility inspections to happen outside of normal business hours or restricting contact between the buyer and non-leadership members of your staff. However, being overly restrictive in access (especially preventing a buyer from talking with key/leadership staff members to negotiate their retention) could cause a deal to fall through. There will likely be several rounds of data requests, follow up questions, and further negotiation of the details of the sale. A good/savvy buyer will clearly communicate their expectations at the start of the process to avoid sticking points or delays later in the process.
How can you make diligence go smoothly and avoid having a sale fall through?
1) Anticipate what the buyer will need and have it ready in advance. Gather business tax returns, P&L statements, full bookkeeping information, staff list, payroll information, financial documents to prove add-backs (personal expenses that you have run through the business that were added back to the valuation EBITDA), employment contracts, and vendor contracts as well as any other relevant documents that you think the buyer might ask for. Having documents at the ready will significantly speed up the process. It demonstrates to a buyer that your business is well organized and worthy of a strong valuation. Taking excessive amounts of time to provide information to a buyer without reasonable explanation is concerning to a potential buyer, as it raises many questions about why that information is not readily accessible to the practice owner.
2) Honesty is critical. While the temptation may be to try to present the “best possible version” of your practice to a buyer in order to maximize your return, any savvy buyer will see through sugar-coating of facts and even the slightest hint of bad faith in the process will trigger deeper, more time-consuming diligence by the buyer. A buyer is very likely to back out of a deal entirely if they feel that the seller is not presenting fully truthful information. Lying to a buyer during diligence on a deal that ends up being completed under false pretenses can leave a seller vulnerable to legal action for any economic damages that the buyer might suffer as a result of that dishonesty. The diligence process is meant to make the buyer feel comfortable with the investment that they’re going to make in your business, and uncovering unexpected concerns during this process can quickly derail their comfort level and with it their interest. The most common reason for a deal to fall through during confirmatory diligence is because the buyer feels that the actual state of the business does not match with the business that was presented to them by the seller during initial diligence. If you find yourself in this situation, you need to reassure the buyer that the misrepresentations (if any) were not intentional and try to find a path forward.
3) Set realistic expectations for the time it will take to reach closing. Buying a business is a big decision for a buyer, just as selling your business is a big decision for you. Proper diligence takes time and will likely require many rounds of communication and data requests. The diligence process itself requires a significant investment of time, energy, and money for a buyer so the fact that they have reached this point in the process with you inherently means that they are serious about making a purchase.