The Exit Engine Podcast Episode 5: Preparing for Due Diligence

Welcome to my ExitEngine Podcast, Episode 5.

Hey, John.

Joe, good morning to you.

How you doing, man?

I am doing wonderfully. And yourself?

Excellent. I'm doing very well. Thank you for asking. I was thinking about due diligence.

Fun, fun due diligence.

I had to do some of my own due diligence for another project over the weekend, and it got me thinking that, you know, due diligence is probably the biggest, scariest, you know, hard to— not hard to prepare for, but hard, hard, hard to handle when you're not prepared.

Yeah, and it— and that's a good point. It's— it can be overwhelming if you haven't prepared, right? If, if all of a sudden you've signed a deal, you're going into due diligence, and you get a checklist, you get a 2-page document of requests for information, specific questions, data that you don't have at your fingertips, and information at your fingertips, it can be daunting. Um, but what we're gonna do today is we're going to talk about anticipating that due diligence. Not only anticipating it, but preparing for the inevitable questions that will come from a buyer, the buyer of your business. And it encompasses everything from your financial statements to your corporate bylaws to your contracts with your customers. And it, and it's, uh, it's critical because the buyer is going to want to make sure that you have the contracts you say you do. You have the customers you say you do, you're buttoned up, and you can pull your financial statements so they can be analyzed and they can be looked at by this buyer who's gonna buy your business.

And it's not really— it's not the— I would liken it to, uh, if you've ever had a home inspection, right?

Yes. Yep.

So if you've ever had a home inspection where you're selling your house and you— or you're buying a house and you— let's just pretend you're the buyer because it's easier to be the buyer in that case sometimes because you're the one who's basically saying, look, I want to buy your house. But I want to make sure that the walls aren't going to fall down, that you don't have termite damage, and that— and if there's anything that basically that you know about, or maybe that you even don't know about, that could affect the price of the house or my enjoyment of it, I want to know what that stuff is ahead of time, right? It's simply that. So I'm going to do my due diligence. I'm going to hire a home inspector. I might hire a home inspector and a termite inspector, which sometimes are different.

Yeah.

I can get this stuff. And basically, I'm gonna go and I'm gonna have these people, professionals, come look through the house, your house. Um, sometimes you're there, sometimes you're not, whatever. But I'm gonna go through, have them look through everything, and they're gonna look through all the electrical, and they're gonna look through the roof, and they're gonna look at the heating plant, and they're gonna look at all the things they can see without opening up walls, without stuff like that. They're gonna look for water damage, they're gonna look for insects and bugs, they're gonna look for drainage problems, they're gonna look for all manner of things, right, that would basically— would— what you would want to know before you purchased. I want to say that in— because this is going to come up, but let's head it off at the pass. Yeah, uh, a home inspection is often used as in real estate by a buyer as a way of getting the price down.

Correct.

It is not dissimilar in the, uh, in the M&A world. Okay, um, Do they— your buyers are looking— remember, we keep talking about inefficiencies, and spotting inefficiencies is how these, uh, these buyers are going to make a profit on your company once they buy it. So the big one, big thing to remember here is that you being as buttoned up as possible. Back in the real estate days, John, when I was a real estate agent, I used to actually— I would ask my sellers to get a home inspection done ahead of time.

Yeah, good idea.

Have it done, have it done and in there and available to anyone who wanted to see it. Not to preclude someone from doing their own, they always want to do their own, but, but, but it was an indication of we are transparent, we have nothing to hide, and in fact we've gone in and done more than we have to in order to show you that we are buttoned up. And our approach has always to, uh, to diligence— due diligence in, uh, in the M&A world is no different, right?

Exactly. And that's exactly, you know, you can think of this, um, exercise, what we're talking about here, as providing the business— the home inspection report for your business to your potential buyers. Now, to Joe's point, they're going to want to do their own digging. They're going to want to ask their own questions. But if you have a package of information you can provide to them Well, okay, these are the contracts you have. Great. Maybe you just need to update a couple. So one, maybe one contract you have in your file is now— the customer is no longer a customer, or you have to update your financials so that it's up to, you know, through the current date. So when you give that information to the buyer, it's current. They're gonna want current information. They're gonna wanna walk through your books. They're gonna wanna look at your contracts. Just like you want to walk through your basement, they're going to walk through the basement, they're going to want to turn on the water and do all those things and complain about the roof's age even though it works. That always came up in any inspection I dealt with, like, oh, the roof's 25 years old. Well, right, still a roof.

It's working past its useful life, right?

Um, yeah. And, and so, you know, why don't we just dive right into it? Um, and just to start is, you know, Having your corporate bylaws and having your tax returns from the re— from the recent past is one of those things that is right off the bat they're gonna— they're gonna want. So you should have those things on hand in a physical document we were talking about earlier of like a 3-ring binder, or probably even better is to have it mimicked in the cloud or in an electronic file somewhere that can be shared. And the bylaws state that The name of your company is the name of your company. You own the company. You know, there's no dispute to that, or there's no other owners that are not on there. And then when you get into financial statements, right, you want to make sure that if there's debt on the business, what's going to happen to the debt after you sell the— most likely you're probably going to sell the assets to your company, right? Most acquisitions that are at this size between the, you know, let's call it A million bucks and $15 million are you're selling the assets of your company. You're not selling the whole company. And what that means is if you have liabilities, you'll want to get rid of those liabilities before you sell the company, or as, you know, make those sort of coterminous with the sale of your company at the same time, so that when you're selling your company to XYZ investor, you're retiring the liabilities that you used, the debts you have for that company. Those are critical. And being able to pull a financial report for the last 12 months, the last calendar year, with month-to-month changes. And that's really important to have that available so that if your business is seasonal— Joe mentioned real estate before. It's a very seasonal business. It's very bad in the first quarter. Usually it picks up in the second and third quarter and then slows down again in the fourth quarter. Investors will want to see that information and make sure that they have that.

So you have—

should have those, um, materials and those documents on hand for your buyer.

And I think the, the good rule of thumb, everybody, is to think about how far it went, because a lot of questions we get are like, how— well, how far back? I've had this business for 30 years. How far back do I need to go on financial statements and stuff like that? And the answer is, you know, generally 3 to 5 years. 5 years would be best unless there was— and the only difference to that would be if there was anything, some kind of mitigating circumstances that where you'd need to show more than that. But the reality is nobody's concerned about your business from 30 years ago. What they're concerned about is how has the business performed and what is the trajectory or the, you know, how has the business been faring over time over the last 3 to 5 years. So Going back, tax returns, anything, any financial statement that you, that you, that, that is there. And, and we can, we will, uh, one, one thing to note is that we have this all obviously in a checklist.

Yeah.

So, you don't have to take notes right now. Um, you just go to myexitengine.com, and if you're subscribed, you will get access to this stuff for free. So, um, very, very simple checklist that just goes through everything, but it's a lot. Doesn't always apply to everybody. So, you're gonna have to use discernment. in figuring out what, what is that apply to you or not. There might be documents you don't have. That doesn't mean that you are supposed to have them. It just means that, you know, for instance, you may not have, uh, you know, you might not have any, uh, you may not have a loan. If you don't have a loan, then you're not going to have a loan agreement to show and that kind of thing. So that's, that's not something you have to include. But, but 3 to 5 years worth of any financial statement. So that means you want to show books, um, you know, year over year, Over the last 3 to, you know, 3 to 5 years. 5 years would be great.

Yeah, and the key thing with that is, as we get closer— as we get further away from the pandemic, what I've found in dealing with my buyers is we're still in that window, as Joe mentioned, of 5 years. But what you probably want to do is you want to keep— in the future, you want to keep that 2018 and 2019 financial statements so that people can tell what your business was before the pandemic, because I think that's going to be important for buyers. It's very important for buyers to find that out now. And they're always asking now because it's, again, it's within that 5-year window. But did your business change drastically during the pandemic? If so, that's even more reason to keep it. If it, if it's, if it hasn't changed at all, you still want to keep it. But businesses like, you know, real estate went crazy during the pandemic, and, and Amazon went crazy during the pandemic, and online sales, all those things went crazy during the pandemic. So you want to preserve those financial statements. So you can either say, Oh, the panic was— the pandemic was a blip and affected it during it, but doesn't affect it after. Look, my revenues from 2023 are pretty much the same or better than 2019, or my business got drastically better during the pandemic and we expect an upward trajectory. You want to make sure that the pandemic is still sort of part of our lives and it's something that people will ask about.

Yeah, as long as it stays in that 5-year window right now, you still are going to have to deal with that. And we've got a whole thing We've got a whole class just on dealing with the aftereffects of the pandemic. So that would be part of that. Understand that the one big takeaway is that your business may have done better, or it may have done worse, or it may have done the same. Okay? Pretty much all those things are possible. But buyers are going to be very— buyers want to know what happened during the pandemic, how you survived it. If it's a good story to tell, You're going to want to include it. If it's not that great a story to tell, you're going to want to downplay it. That doesn't mean you're going to ignore it, but it does mean that it's a matter of the emphasis and the stuff that you put on and what you highlight and things like that. So keep in mind that this is a sales job at the end of the day. All this information, all this due diligence is really important, but what you're trying to do ultimately is build a story. Yeah. Your exit, and that's, you know, that story is the story you're going to convey to the buyers that says, hey, look, this is the story of a guy who owned this company for 30 years, um, and built this thing. And the pandemic came, the pandemic was, you know, went, and the business suffered. But since the rebound of the pandemic is over, we've gone back to numbers that were even better than they were previously to the pandemic. And that's the story you want to tell, right? So just keep that in mind as we go through. So it's an excellent point, but we'll, we will talk, um, about the pandemic specifically, uh, in an upcoming episode, so don't miss that. But back to this. So you've got your legal, and basically you've got about 8 or 9 areas, right, of things that we need to concentrate on. You've got your legal and corporate stuff, you've got your financial, you've got your operations. What else have we got?

Yeah, I mean, one of the things that will come up is contracts with your customers. So, you know, you might have handshake agreements at certain points in your business. We totally understand that. But you need to put paper around those, especially the big contractual and really all the contractual ones that, that are tied to that revenue. So let's just make it easy and say you have a million bucks in revenue and you have whatever, 50 customers. Well, you very likely that those customers are different amounts of that million dollars in revenue and you're going to want to have contracts for those, for all that revenue, for all those customers. And if it's the fact that you maybe have 3 large customers, you wanna be able to disclose that and let your buyers know so that they know that you have a sort of relatively high revenue concentration. More importantly, what Jo's getting, or what Jo mentioned earlier, is have those contracts so you see that these are, let's say that it's an annual contract that has an evergreen clause that renews every year. Buyers love that. Buyers love subscription revenue. But really what they like is the documentation that you can provide to them that says, This company agrees to pay you X amount of dollars for these services over this time period. And when you have those, those are— that's gold. And especially if they're evergreen or they— or you can show a pattern of renewal. You know, we had at my— one of my old companies, we had a franchise renewal rate of, I think it was 95%. Now, we were a public company, but people love that because That's revenue that you can— those fees that are continuing to go. So that's a very big one. And again, those can be saved in a Drive, put in a physical file, and shared with any potential buyer who's, you know, in due diligence.

So think about anything that is contractual. So the customers one is an obvious one, but you have contracts with suppliers, you have contracts with vendors, you have contracts with partners. For whatever, maybe you have a revenue sharing deal or something, whatever. So the idea is that, and again, guys, this is why we bring this up now, okay? Because what you don't want to be doing, okay, is sitting in a situation where you have to sell the company and you start then thinking about things like, huh, I wonder if I have contracts. And it's funny, but the thing is it happens more often than anybody would care to admit. Okay? They've done handshake deals. Somebody has a— has an agreement with somebody. They've been doing it this way for 15 years, that, you know, whatever. So guys, it's not gonna fly.

Yeah.

Um, yeah, right. You, you have to have these contracts. If, if you, if you get nothing else from this due diligence thing, okay, because the financial things are easy to me. I, I think that's— these are no-brainer. The financial stuff is a no-brainer. That's what everybody focuses on. There are problems inherent with that too. And then there are people that don't do the books well. There's all kinds of issues that can pop up with that, but that's kind of like normal. Yeah. Meaning that's more typical. But another behavior that happens that we see constantly is people not having updated or fixed or adjusted or accurate contract recordkeeping.

Yeah.

And Right. Yeah.

Yeah. And just one other thing to add to that, you know, you can have a contract management system, you can have a document management system, which is great. The other one that I didn't mention specifically was leases. And if you have locations like real estate offices or any place where you have a number of leases, those can be tough to negotiate with the landlord. Some— we had— I negotiated with landlords who did not want to change. They had had a relationship with my old company for 25 years. They didn't want to change the entity name when the company got bought, or when we bought a company. And they had— they literally had a handshake deal. We bought a company 2 years ago that had a handshake deal with a landlord that never had a lease. They had to write up the lease for the acquisition that we were making.

Just for due diligence purposes, right?

Just for due diligence. It was exactly, Joe, it was just for due diligence. So the lease is really important. Because you have to change the name of the lease into the new company. They might change the name of your company. So that's something really, you know, Jo's point is exactly right. Customer contracts, vendor contracts, revenue shares, leases, anything where you've signed saying, I, John Kniff, have agreed to do this, that needs to transfer to the buyer.

So employee contracts or agreements. Okay, so there's basically anything that falls in that. If you have shareholders, if you have other owners of the company that get revenue somehow, even if it's just a like a on a sale, you know, on a sale basis where somebody's going to get you know two percent of the sale of the company because it did something for you ten years ago, whatever those things are. So keep in mind that you don't want like anything else, right? We don't want surprises. So what we don't want is to be in a situation where a buyer goes, whoa, who, who is this other owner that comes out of the woodwork? Or that, right? Because what'll happen is someone will be able to make a claim on this later on. Just like in a house, when you do the title search and you're going through to make sure that you actually own the house so that nobody else has claim to it and things like that, and there aren't any liens, that the buyer's getting a clean title. The same thing, they want the same thing that happens. The buyer wants the same thing when they're buying a company. They want to understand what they want to be as clean as possible. They want to know exactly what they're getting, exactly what the numbers are, everything down to the thing. And any deviation from what they're expecting could be a deal breaker, right?

Yeah, absolutely. Um, and, and things like that where, you know, you have, you, you have the ability to do it up front, that you want to get that buttoned up up front because there'll always be a curveball question on due diligence that you didn't prepare for, and you want to make those the ones you spend your time on, not the ones you could have prepared for before. Like Joe was saying, financial statements, those are table stakes. Contracts, those are table stakes. The out-of-the-blue weirdo question— we— I think I have a bunch of them, but we're not going to get into them. But it's just, they're just wacky questions like, oh gosh, I didn't, I didn't, I didn't anticipate that. I don't have that document available. That'll take me some time to get.

Right. And making sure— look, there may be stuff that pops up like that, and there may be— look, Part of what we're going to be able to do too in teaching you how to do this is to, is to give you all the things that are possible. Doesn't mean that you're going to use all of them, but, um, but it will get you thinking into things and go, oh wait, you mean, uh, I need my confidentiality agreements? Yeah, like you should have those if, if your business dictates that confidentiality or non-competes or whatever are signed by the parties or things like that. That's the stuff you want buttoned up. And, and again, another reason why you want the stuff buttoned up, guys, isn't just because it's good to have it buttoned up, but it's also because you're showing the buyer that you're buttoned up.

Yes.

Right. As much of this is showing that I've got all my stuff together, okay, and I'm not gonna let you— A, I'm not gonna let you derail this. I know what my inefficiency is, okay, and I'm, and I'm okay with that, but I'm not gonna let you spot another one. Okay, and try to use it as leverage to either walk away from the deal or to, or to, you know, try to get them negotiate the price down based on missing some obscure document that doesn't matter. There's documentation that matters and there's documentation that doesn't, and you will know the difference, okay, after spending some time with us. And, and that's an important thing to know because what you don't want is someone coming up and going, where's your confidentiality agreements? And you're like, I don't have, you know, confidentiality agreements. I don't have anything confidential. We're a, you know, we're a sub shop or whatever, you know what I mean? So, you know, you don't need that stuff. Right. So if someone tries to come and tell you that they do and are trying to, you know, to negotiate your price down as a result of that, you can just— you can call BS and go, no, I have everything here that you could possibly need. It's all in one location. Everybody can go access it whenever they want. Once you're under NDA, here you have at it. You're allowed to look at all the stuff that you want. And, and it's all right there. And that's what we want to make sure— that's your goal, trying to make sure that you've got all the stuff that matters and it's all buttoned up. If there is something that you do not have that is actually something that's a viable, necessary document, there's nothing wrong with saying, I don't have that, but let me get— let me get that to you. Put a timeline on it with the negotiation and say, give me until Thursday or whatever to get back to you. That's why Due diligence timelines and timelines for closing on transactions and all these things is an estimate at best in terms of the time it's going to take to get through this stuff. But you can mitigate the length of it. You can make sure that everything comes out in your favor if you, if you are proactive about it and have all the stuff in one place. Please do not wait to the day that it's asked for to start worrying about contracts or employee contracts or your financial statements or that kind of stuff, guys.

Yeah, and never be afraid, um, to push back on the timeline, right?

All—

every buyer you deal with wants things yesterday, um, and it does take some time. You have to— hey, you have to continue to run your business, um. You, you know, as you know, you probably are going to be gathering all this information because you don't want this data to come out. I mean, I had one instance where the owner had to go into the um, the, the QuickBooks to get, and to get all the financial information because he couldn't go to her, his accountant, because, um, the accountant was internal and she didn't— he didn't want to disclose that he was selling the company. Um, so like a lot of times you're gonna have to go and run all these things. So, so that, that's just the reality of it is we've gone through these and, and sometimes it's, it's 2 weeks, sometimes it's 3 weeks of, of time to gather all this information. And also what you want to disclose is not only the financial information, but Um, like litigation. And litigation can be slip and fall things, right? If you're— if you're— if you have a number of locations, if you have one location, if you have employee, um, you know, maybe an employee claim or anything like that, uh, you can, um— you want to disclose that too. Past, uh, issues and pending and ones you anticipate in the future, right? There's all sorts of things that are in the news about real estate. I'm not going to get into those. But there's all sorts of other specific business-specific litigations. Someone fell down in front of your sub shop and they're suing you. Like, not going to kill the deal, but it's something that the seller or the buyer needs to know and needs to be able to put like a dollar figure and understand more about it.

Right. And the reason is that you don't want that person to come back having heard that the business changed hands, to come back to the new buyer claiming that they had an issue that was never resolved with the former buyer and things like that. So Again, disclosing that stuff. If you have, you should just just be buttoned up. There's nothing to hide. Everything was you know if every if it's done with and it's over and you know and there was a judgment on it or whatever it was whatever has happened it's closed. If it's open, then obviously it's open and and you have to you're gonna have to deal with that no matter what. So being again being able to disclose what is going on, what is the litigation that's currently pending, why is it happening, what's the situation? Obviously. And that may not— that may— that alone might make it not the best time to be actively trying to pursue a sale of a company as well. So keeping in mind that if you have active, you know, pending litigation against you, or it doesn't even have to be against you, the reality is you could be the— you could be the, you know, the person who is actually suing somebody else and that thing is open. That's, that's going to be a red flag for any buyer at that point in time.

Yeah, but it's red flag, but, but, but it happens, right? Unfortunately, we're a sort of litigious society. And, uh, and I, I bought companies with pending litigation. I bought companies where I required them to get just to resolve it. Um, and, uh, and both things can be, can be dealt with. It's just what was— Joe mentioned earlier, what buyers don't like is surprises, especially surprises that are either at or near the closing table. Never, never good.

That's right. So current, past litigation of any kind, right? Any kind of legal opinions that were served up or whatever, any, any kind of judgment or whatever. And by the way, any, any kind of intellectual property. Okay.

Good one. Yep.

This is a big one. Intellectual property is— I mean, we see this happen all the time, that people are kind of forgetting that they've got research, R&D potentially. They've got intellectual property documents. They may have patents and trademarks, stuff like that. Any kind of litigation that's going on with that stuff is obviously all gonna be important as well. So same thing, just like with all your contracts, your IP should be in this file too, and, and, and should, should be very clear in terms of what are— what is your IP? What, what do you own? What do you license from somebody else?

Yep.

What are the— what, what are you spending? What are you doing in terms of research and development? Where are you headed in your R&D next? What, you know, a good clear understanding of everything intellectual property kind of is just as important as understanding the litigation that's involved in, or in the other legal stuff that's there as well.

Yeah. And just one thing to back up about, and I mentioned tax stuff before, but this was particularly helpful from my experience in buying companies is, yes, you get the financial information, you get the litigation, you get all these things, When you get a tax return, that's a different level of— and it won't match up to your financial statements.

So, Right.

Meaning that they don't break out the cost of goods sold and all the components of the financial statement in your tax return, but the numbers should, should sort of be in, in the ballpark. If you have a financial statement and a fina— and a, um, and a tax return that are wildly divergent, you need to explain that. I mean, there's a couple of reasons for that. We're not going to get into those details now, but But if you do have those sort of differences, you're going to want to explain those differences to the buyer because they're going to certainly ask you when they look at the documents that you provide to them.

No question. So keep in mind too, we have a— we get a blog post on it and we will do a podcast more specifically on the financial, all the financial things for sure. Probably a couple of episodes dedicated towards that. But just to understand, just in general, understand that The, uh, the, the, the, the depth of the numbers and the, and the, the, your tax. Here's one thing to keep in mind that trips us up all the time. Everybody gets worried about their tax returns and about the stuff that they're doing to the books that might be a gray area as far as the IRS is concerned. I want to tell you this right now, okay? There is the IRS, with the exception of capital gains tax, the IRS has nothing to do with you selling your company. Okay, very little. There is nothing there. They have no jurisdiction over anything. There is nothing that they're doing. They don't check stuff. There's nothing there that the IRS does that is directly related to you, to the deal that you do with yourself and another individual and the sale of your company. Okay. You do want to make sure happens, okay, is that, as John said, is that that your tax returns aren't so wildly divergent from the rest of your financial statements that it makes a business that it makes a buyer potentially question your you know you know what's it called you know yeah ethics you know in general right you don't want somebody nobody wants to You know, it's the thing, oh, we all do it, but nobody wants to be called on the hook for actually, you know, for, for, you know, for trying to, you know, hide money from the IRS. There is nothing here, just so everybody knows, okay, that's going to get that— that's going to trip that wire.

Yeah, and you, and you are— it is well within your, um, rights and legal rights to pay yourself whatever compensation you want, be it, you know, if you're paying yourself excess compensation, it's your company, you can do whatever you want. As long as you do that by the books and you don't only do that, you pay your taxes to the IRS, that's fine. But just those divergences between a tax return and the financial statement, all you gotta do is explain it. You know, that's all you have to do.

Right. Yeah, just an explanation. And I want this, the add-backs thing and all that stuff, which we'll get into as well, that's what triggered this in my brain was just knowing that there is, there are a lot of, there's a lot of money potentially that you can take out of the company on a regular basis that would be actually, you would be advised to put back into your— to readjust your earnings to show that that money was taken out and could be put back. And when put back into the company, makes the company more valuable at a multiple. So understand that if you're taking an extra $100,000— here's a great example, this happens all the time. You have a, uh, you're paying your son who doesn't really work there, right? But basically you give them, uh, let's just say you give them $50 grand a year And, and it's easy enough for you to do to make it look— you give him a, uh, you know, you give him enough, make him an employee, you give him $50,000, uh, you know, $50,000 a year, and he comes in and spends, uh, you know, whatever, a couple of, a couple of vacations a year hanging around the office. Okay, so this happens more than you realize. So you pay that kid $50,000, he gets that cash, whatever, but there's really no record of it, of where that $50,000 goes often in the books. Okay. And that's because you're taking essentially your discretionary income, the profit that's left over in the company, and you're essentially using that and $50,000 of that to pay your kid. Perfectly fine. The thing that happens now is that you're saying, well, look, that employee is no longer here. Obviously we're not, you know, where did that $50,000 go? Well, now you can take that $50,000, add it back into your books After the fact and go, right, and readjust it. And by the way, that $50,000 is gonna get— is gonna net you 4, 3, 4, 5x that, right, in the value of that company. So that $50,000 is really worth $150,000, $200,000 in actual, you know, value of your company.

And yeah, and this, as Joe mentioned, this will be— we're gonna go through all these details in a further podcast where you really break down And so where we take your financial statements, what your profit, what you showed your profit was to be on your tax statement and your financial statement, and how you can gross that profit up in the event when you're selling your business.

So, but I think a lot of what— and we'll spend more time on that later. But one thing I just want to close this out, this thought out, is because it just, this comes up so much. Everybody is so afraid that I've been doing this thing wrong, or I've been doing this thing that they think is like, you know, under the radar that the IRS doesn't know about. Right? And now they go to sell. Now that it got it, then now they're in this weird, weird situation of, wait, do I disclose this? Do I not? Whatever. Do I always disclose it? Get it out in the open. Let it out there because chances are it actually will be to your advantage. You'll be able to add it back potentially. And we're not in a situation where anybody is calling the IRS about this stuff at this point. Now, you don't pay your taxes. That's on you. And that will have nothing to do with the new owner of the company or any of that stuff. So they're not on the hook for that. That is a personal thing between you and the federal government. And the same thing happens after the fact with what you ever— what you do with the proceeds and the way that you're taxed that way too. And we will spend many, many episodes on what to do with that money after you sell the company as well, and the way you go about that, and the financial and the tax implications, of course, of all that stuff. It's a big deal. But Understand that you're not going to get— there's nothing that's going to happen in this transaction, um, that the buyer is going to pull a trigger that's going to alert the IRS of anything. No.

Um, okay, so moving along to operations. I think we've covered the banking and financial and tax documents. So operations. So operational things that, that, that a buyer wants are plans and strategy documents. What are— what have you done? What is your— what is your business Consist of what products or services do you sell, and any sort of research and development, and frankly, what also works and also what hasn't worked, right? People appreciate the things you've tried that haven't worked out just as much as the things you try and you make your money on.

It's true. It's an excellent point. It's an excellent point that goes on because remember, what the buyer is looking for too is also like, is the first question I'm gonna ask is, And often, often this is actually in the promotional documents that we put together, is what are the, what are the ways in which you would grow the business if you were sticking around and had all the money in the world to do it, right? Because you are the expert in that. Excuse me. Um, you have spent a lot of time obviously in the business. You were considered, probably if you're, if you've made money and done well, especially over a period of time, you've probably got an industry following. You're probably someone who's known for what they're doing and doing well. So what they're going to want to know from you first is, well, what would you do? Um, and, you know, in looking for ideas to grow the business, and sometimes the documentation that you have in your operational documents could be those old strategic documents or old ideas or things like that that maybe never got implemented, you know, but are there as well. So all that stuff could be valuable to the buyer, um, even for stuff that wasn't executed.

Yeah, and things like lists of— again, we went through the contracts, but a list of the key supplier and vendors, a list of customer lists and contracts. Again, this is all post-NDA, so this is all protected. Supplier and customer contract agreements, a list of your fixed assets and any sort of machines. If you're a die tooling machine or company, excuse me, or you have a number of very expensive machines to do steel fabrication, or whatever you happen to do, they're going to want those along with depreciation schedules and maintenance reports, right? Those are the big things in fixed assets and asset-heavy businesses is, are you depreciating them, the non-cash expense? And then are you maintaining them, right?

What—

it's just like Joe mentioned about the home inspection. Are you doing these Basically, are you getting your car inspected? Are you getting your boiler and your furnace inspected? Are you getting those business assets that generate your revenue, are you getting them maintained? Are you maintaining them with a frequency that is industry standard?

One of the things to keep in mind is that, especially around documentation, is that if you don't have documentation around process, if you don't have documentation around The, you know, again, the way that you, you know, do you have an onboarding thing with new customers? Do you have a way of handling, you know, certain complaints about customer complaints? Or do you— whatever those documents are, if you may have a process, but if you don't have those documents, the process documented, right, that's potentially a red flag too. All right. If I'm a buyer and I come and I go, wow, you got all this process going on, how do I know what you do when? And what are the decisions? Well, it's okay. You know, Bob in accounting, we've been here forever. He just knows what to do. You know, it's like, well, that's great, but Bob's leaving with you. So I need to know, right, as the new buyer, what to do and how to do this. So again, anytime you see a hole in these places, it's the, the opportunity is, all right, I got to create this documentation to make sure that I have everything buttoned up for due diligence.

Yeah. And, and the best person to do that example of when Joe mentioned about Bob in accounting is Bob in accounting, right? Bob in accounting is the best person to document what Bob in accounting does. Like, you, right, as the owner of the business, you might know a little bit about it. I'll speak for myself, I would know a little bit about it, but I don't know all the things that he does. And that's something that you need Bob in accounting to, uh, to document so that he— so that the buyer knows what, what he's doing and, um, and what he does and what— how he closes the books every month, every quarter.

So, and speaking of Bob from accounting, he's just one of your employees, right? So you've got an HR A mountain of HR materials potentially that need to be in place for due diligence, right?

I mean, simply an organizational chart, right? That, that's something that's a visual thing that is really, really helpful. It helps sort of— it helps the buyer visualize the, the, the business units or the, the groupings underneath your group if you're a small business, is who's reporting to whom, who are the key employees, who's the VP of marketing, who's Who's the person that is the head of distribution? Whatever it happens to be, who, you know, who makes the candy? That was always a big one back in the day when I was, when I, when we were in the candy business is, are there contracts with these people? Are there special salary arrangements? Are there job descriptions of what they do? The job descriptions is a sneakily important one because one person's VP of marketing can be another person's, you know, It really depends. It's company by company about these job descriptions. So a VP of marketing at one company can be, you know, could be a director at a big company, and they could do different, different items and different job things. So having that documentation of what each person does and what— not only what a person does, but what the role does— there's something that sometimes those things can be different.

And there's obviously— there are legal components to HR, right? So there could be There's— we talked about a little bit about employee contracts, potentially kind of any litigation or anything else that's going on with employees in terms of, you know, suing you over something or any, you know, any kind of, you know, employee benefits, any of your insurance policies, any of the stuff that basically goes along with the EHR, anything that you give them as perks, you know, on top of their salaries or whatever. So the pension retirement stuff, everything needs to be out in the open. Now, some of this will come up in the books. Okay, we'll see. You'll see there will be a line item in terms of how much you're paying for employee healthcare and things like that. But the document— documentation on what the actual plan is, who is the insurance provider that's doing it, all those things obviously are, are gonna be important things to have, to have in there. What if you have, uh, do you have, uh, do you have union employees? All right.

Yeah.

What's the union contracts? Labor agreements?

What due diligence is, right? In a lot of ways, what due diligence is, is tying the costs that are, that they know are in the financial statement with the contract that you provided them about HR. So to Joe's point about the insurance is a really good one, is you have, you have a healthcare premium, uh, for insurance on your books, in your, in your income statement. Well, they're going to want to make sure that Whatever you're paying for that health insurance premium is documented in the contract for that. So those are how they're tying these things to say, wait a second, like the rent payments you have, like, is the rent payment that you have, is that tied to your— where are the leases that tie to that rent payment? Um, that they're making— that, that's what really due diligence is, is do these things make sense, right? Do the— why are they paying this person more money? What's the market rate for these things? Are they— was this business negotiated? Did they do— did they negotiate? these expenses properly.

So, and then of course what goes on top of that is the regulatory and compliance issues, some of which are related to HR in terms of, you know, do your employees have to be licensed to do something? Is it a license that you— a master license that you hold where you're— so your employees don't have to have licenses? Is that stuff kept up to date? When does it renew? Is that a requirement to doing business in certain places? Is it, you know, are there larger federal regulatory things? Do I get inspected twice a year? Do my facilities come looked at? All that stuff is basically, you know, that compliance thing is another huge area depending on the industry that you're in. And then you've got things like workman's comp, right? Are you offering that stuff? How many claims have been taken out on there? How about unemployment claims?

Yep.

So the reality is all that stuff kind of gets, gets buttoned up and should be— again, you would think, okay, would be something that would be, you know, built as you go, right? And as you— each one over time, you— every time you had somebody, whatever, you added a document to this file or whatever. But as we know, many times things could fall through the cracks, things get missed, things— people forget about it. An emergency happened and everybody forgot about making sure that Bob from accounting's employee contract got signed. And so now he's not, you know, technically there'll be a mismatch there when a buyer goes to look between, you know, look at the numbers of employees and missing a contract. So, um, and they'll— and look, that's an easy fix, by the way. So it's not that, not that big a deal either. But at the end of the day, it's about, like we said before, everything. I've— if I've— if I— it seems like I've thought of everything.

Right.

That, that puts the buyer immediately at ease. Right. Immediately they're like, okay, this is, this is a quality outfit because this guy has spent time making sure this stuff is here. Yeah.

Right.

Um, I'm saying guy, obviously gal, whatever. The idea is that we're making sure that whoever the business owner obviously knows that this is important to them. Um, they've done all the homework, they put everything, everything is in this business, looks like it's run well. It's, it's, you know, in that it's maintained, it's like a well-oiled machine, and this is a very attractive company that I want to buy.

Yeah, another thing to go along with some of the compliance thing that Joe just mentioned, um, and like the licensing and permits, is internal controls. Like, so, so sometimes, you know, big companies, large companies have internal controls and they have audit reports. Maybe you don't have those, maybe you have an outside accountant, but one thing you can do is something is document Who's a company officer? Who can spend money on the company's behalf, right? Because that's something that a big company wants to know. And, and who is the one that can sign contracts? If it's just you, that's fine. They just want to know if there's 4 people that can do it, okay, are those 4 people competent? You might want— because they're going to want to interview those people, right, a lot of times. So you're going to want to have a document that says John can spend $50,000, Joe can spend $75,000, but Marianne can spend $100,000. And what they can spend this money on, it can be a simple document, but you adhere to it. And, uh, and, and you let— you give them that document, the buyer's list document, to say, oh, here's our internal controls for payment outside the company.

As just one example. And there could be, there could be so much, you know, so many other kind of controls in there and the whole thing, customer stuff, all kinds of things. So again, you know your business. Nobody knows your business better than you, right? But the idea is that what you're trying to convey here is that you're trying to get somebody who doesn't know your business at all, okay, except for a couple of sentences on a blind profile somewhere out there on some, you know, listing, you know, business listing website, okay? That's all they know.

Yeah.

So what you're trying to do is essentially build the story around what you are and show everybody that what, you know, that what you have and you, this information needs to be conveyed sometimes at a glance, right? Or very, very quickly. So keep in mind that the reason that we like this file structure and this cloud idea for keeping this stuff, and by the way, we haven't even gotten into the AI and the things that you can do in terms of keeping this stuff. There are so many ways of organizing this information and keeping it there. That's a whole week we could spend. Well, we probably will in the future spend a couple of different podcasts on the, Just on the technology that helps you keep this stuff in order and can remind you to check and things like that. But keep in mind that the entire thing here is to say is that you want to be able to you need to prove to somebody else that your company is good, right? We we're on your side. We know your company's great, okay? But you want you need complete strangers who have no idea who you are to be able to get that same feeling, and they can get that because you. instantly when you give them a single link where they go to and then everything is here and everything is organized and everything is done in the way in which we're recommending, and it's all right there and nobody has to go anywhere else. And by the way, it makes it— makes due diligence easier, it makes it faster, and it gets you to the end faster, quicker. It just—

it just—

that's— it's just simple. So keeping this stuff up, it's okay. And so by the way, big shout out, no shame for anybody who doesn't have this yet. It's okay. Keep in mind that the reason that you're here at ExitEngine is to, A, understand this stuff, learn about it, know what you don't know. That's the whole point. And so there's nothing wrong with— there's no shame here in not knowing this stuff or not having done a good job keeping contracts. You're not alone, okay? There are people who are not— who do— don't keep up the books. There are people that don't keep up their contracts. There are people that don't know, you know, that have, uh, you know, agreements with employees that are on the back of a napkin, whatever that is, okay? It all happens to all of us. It's perfectly okay, but we're here to help you fix it before it's too late.

Yeah. Okay. So I think we can move along to, like, IT, information technology.

So IT, that's the one people forget a lot. Yep.

Because you forget sometimes, you know, I'll speak for myself. I would have an IT person and we had an IT person, and they sort of took care of everything, and I didn't have a lot of interaction with them. But what they do, especially now with all these crazy ransomware things is what they do is critical. They are, they're the gatekeepers to keep all this stuff safe. All the stuff we're talking about, oh, you put it in the cloud, they're the ones putting security on it. Or you either have someone internally who you trust to do this stuff, or you've contracted out with a contractor to buy their software and tools and services so that you can keep all your customer lists, your vendors, all those things secret. And keep them safe. All the companies that they're using, the infrastructure you're having, the suites you're using. Are you using Google Suite? Are you using Microsoft? Are you using freeware? I'm blanking on the name, but any open-source technology, using that.

Right. What's your tech stack, basically? What's the tech stack, and how much money do you spend on that tech stack? And how much should you be spending and where, where would your future investments be? You know, things like that are all, all good things to have there. And, and John's point is right. If you have— if you're a, if you're a very small business and you don't have a lot of people and you're doing this, this, this, you know, technical stuff yourself, that, that's going to feel a little bit overwhelming to document the stuff and have those things there. But if you are large enough to be able to have somebody either in-house or an outsourced person help you with these things, then you should be paying them to be able to supply this information to you. Just so keep in mind that, you know, you're gonna wanna double-check it. You're gonna stay— you're ultimately, you're the one on the hook for it, not them. You know, when it comes to something being wrong, but being able to get somebody to say, hey, look, putting an operational process in place in your own business that says, hey, every time we get a new piece of software, that we use for the business, I need to have that software licensed, documented, stored, approved, budgeted, and lined up with a budget item. Otherwise, it doesn't move forward. You know, it's a good, pretty good policy to have in place, especially when it comes— so you'll be ready, you know, for when due diligence comes.

Yeah. And this one, I'll contend, I'll make a confession that this was the one where I missed some things in a couple of the acquisitions that I was working on. And not only I missed it, but I was just surprised at how much spend was taking place at some of these companies at the small— on the smaller side of this. And it made me think of, wow, if this small company is doing this, we should probably be doing this too. And that's more data protection and malware protection. And some of these smaller companies realized and got the message that it was very important. I learned from them that I should be doing the same projections that they were doing. And I was like, wow, this is a pretty hefty investment they're making. But they were right, and frankly, I was wrong in doing that.

So yeah, no question. So, you know, obviously, if you guys aren't out there, there is the malware, the ability for people to hack into databases to get customer information, to be able to get the credit cards. You guys know this, right? I mean, it's a serious, you know, battle out there, you know, to try to protect yourself on a regular basis, and it's a constant You know, the game is constantly changing. There are people out there who are, you know, who are just— have very bad intent and are very good at being able to steal this stuff. So having these protections in place is going to be key. And by the way, the reality is, if you don't have those things in place right now, any buyer worth their salt is going to say, yeah, look, I can't— you're unprotected here unless you're willing to protect this. Right now, we can't move forward. So, this is something that's going to be— and with AI and the way that it's rolling right now, it's only going to become more important as we move forward.

Yep.

So, that IT stuff is often forgotten, but very, very, very, very important. We're running out of time, but we talked about real estate and, you know, what are the properties? Are they leased? Are they owned? What are they? There might be property tax things that go on those things as well, especially if the property is owned by the business. Again, this is business stuff. Nobody cares about your own personal property in this stuff. It's just a matter of what is running through the business.

Yeah. And if you're selling the business along with real estate, right? Sometimes those 2 things are sort of inextricably linked. You got to realize that if you're selling a building or you're selling real estate along with that, that has a valuation separate from the business too. So, especially in the way that real estate's appreciated, you got to break those 2 things apart. But yeah, Joe's right about all those maintenance and lease agreements we talked about previously.

So, here's another one, environmental. So, lots of times you may be in a situation where, you know, I'm trying to think of— so, I helped sell an independent gas station. Talk about regulatory nightmare.

Holy Toledo.

Yeah, I mean, you're talking about old tanks that were moved and replaced at one point 15 years ago. The documentation they had to have from the DEP about whether— how those underground tanks were filled and stored and replaced and cleaned and all the things that kind of go out, you know, all that stuff. This is one example. I mean, the environmental thing can be A big deal if you, especially if you're in any kind of manufacturing, you know, any kind of manufacturing or dealing with any kind of substance that is obviously, you know, potentially harmful to the environment.

Yeah, agreed. I have to say I haven't had that much experience in doing the environmental things, but environmental reports or anything, but in certain types of businesses, to your point, Joe, about a gas station or any sort of manufacturing, you got to make sure that you have the disposal if you're disposing of something that's that's hazardous, if you're disposing of something that's, that's a result of your product or your service, got to have those records to make sure that you understand and the buyer understands that they're the byproduct of this product will be or could be hazardous and how you get rid of it.

No question. And one more, we have time for about one more. We got, we got to split on this. But, and there's going to be odds and ends, guys, some things are going to pop up, you know, do I have to share my Do I have to share my CRM tool or something like, you know, customer relationship management stuff with the bot? You know, probably yes. You know, those are the kinds of things that you're going to want to— you know, there's going to be stuff that's going to pop up. It's going to be a question. And anything that you question, the answer should probably be, look, look, let's put it in there to make sure. And unless it's going to— unless something's going to be completely detrimental or throw something completely off it or open up a can of worms that doesn't need to be opened, Yeah, our general sentiment is like, yeah, throw it in there, man. There's nothing wrong with an extra document or 2 that are floating around that basically are just better backup. But one thing we should bring up that is not often thought about here is your sales and marketing information. As we have gotten more electronic-based, more digital, more digitized, many— much of our record and stuff, as we've already talked about, is kept in the cloud somewhere. And the cloud is a generic term for basically keeping it on a remote server. Okay, when you just— in case we don't know this, the cloud is not an actual place. It's just a matter of having it be on a server that is not your local computer. Okay, within your— the confines of your property right now, where the location you are right now. So your sales data that those— you've got reports on sales data that are not necessarily just financial things, but you're talking about The way that you go to market. You may have info— we talked about the CRM a second ago. You might have customer information of people that aren't yet customers, but people that you've been talking to on a regular basis that are in a certain stage in the pipeline, right? That pipeline information is gonna be imperative for the new buyer to know.

Yep.

You might also—

Yeah, I was just gonna say, going along the lines of that, is what we were surprised by one time was Search engine marketing, right? Related to search engine marketing dollars is what this small company was spending on search engine marketing and how good they were at it and how well they had defined their market and what— and the data that they were buying ads on Google, they were really, really good at it. And that can— that's a competitive advantage. That's something that—

No question.

The buyer will want to buy, like, wow, they were really doing doing a really good job of spending the money. So it was a good return on investment. So that's something that the buyer will definitely want to know and understand how that works.

Absolutely. And if you're currently running, let's just say if you, you know, whatever marketing that you do on a regular basis, if you've got advertising that's running, you've got creative that supports that advertising, you've got media spend, you've got all those. So your advertising budget, all that stuff is going to be a line item. your financials. But again, we're talking about matching things up. Okay, I see you spend $4 million a year on advertising. I'd like to see the materials that you're doing, uh, you know, and the promotional materials that you're using to be able to, you know, and, and where are you spending this money specifically? Because it's going to make a difference to me in terms of what I do moving forward as the buyer. I'm taking this stuff on. I might decide, hey, look, this has been working great. Like you mentioned, your SEO is top-notch. I want to keep that going. I want to keep that vendor on who's doing that stuff. I don't want to change that. But you might tell me, hey, look, we've been spending a lot of money here and we're seeing, uh, we're seeing— I've got a marketing document that wouldn't be in my financials that shows a downward trend of my advertising dollars.

Wait a second. Yeah.

Yeah, that's something that's important to know. Oh, maybe because something has shifted and now, you know, we need to, you know, and you might even say, hey, look, uh, if I was continuing to own the company, I would change my marketing strategy to include X, Y, and Z. You know, or do that, or at least there's a hint to the next buyer who's got their own marketing people or whatever that, you know, that there's some things here that were working and some things that weren't, but here's a documentation of all of it.

Yeah, and one thing I do want to mention is like any sort of analysis you've done, right? We talked about sales data, but getting to like a SWOT analysis or anything like that, it's one of those things where as Joe mentioned previously, is the private equity firm or the buyer who's buying you is looking to exploit that weakness or that opportunity. And an opportunity can be, you know, if I had money, I would have expanded to another county or another state. That can be something that the buyer will want. They might not want to do that, but they want to understand your thinking. And sometimes a document that's a SWOT analysis where you've sat down and you've taken the time to go through and done the strengths, weaknesses, opportunities, and threats, That's something they want to look at and they'll be like, oh, they can find value in it. You never know what things you've maybe put down on paper 6 months to a year ago, how that can sort of dovetail and jive with what a buyer wants to know about the business going forward.

Any kind of— look, any kind of strategic document, okay, is going to be really, really imperative to share with the new owner. It may have been one that— and look, it may have been one that, you know, your initial strategy from 15 years ago might not be relevant today, okay? But what other things that you've done along the way or whatever, or the things that you're doing now, or the things you've done in the recent past, all of those things are potentially good information for the buyer to have. Your SWOT analysis, don't worry about that, guys, because if you don't have a SWOT analysis, you will have one by the time that you're done with ExitEdge, okay? It's one of the first things that we make you do. It's an incredibly important exercise to have, and And by the way, it's something that has to be done on a regular basis. It's a major part, a major kind of plug-in component of your overall exit plan. Because understanding yourself, your business, the competition, the landscape around you, and the whole thing on an ongoing basis is imperative, you know, you know, to do that stuff. So yeah, all those strategic plans. Any other M&A histories that you've had?

Yep, good point.

Maybe you purchased a company from somebody else. Uh, years ago. Here's what I've done since then. Here's where it was when I took it over, etc., etc. Showing that story, showing that move— movement from point A to point B tells a great story to the new buyer and that kind of thing. So I think we've hit just about everything, John. Do you think— can you think of anything else that we haven't hit on right now?

Um, no, I think— no, I think we— I think we've done a good job of hitting as much as we can. And you know, There's obviously a checklist that we're going to provide too.

So there's a lot of this stuff. So again, at any point in time, if you're a member of Exit— My Exit Engine, you know where to go to get this material. You maybe have already done a class on it or whatever. If you're new to Exit Engine, understand that with a subscription, you're going to have access to all this information for free, or as part of your subscription rather, and including this entirely very extensive checklist due diligence items, things that, things that hopefully there's things on here that you will, uh, will make you realize. And again, one of the, one of the things that we do with these documents, John, to remind everybody is that looking at this document today ought to spark some things and go, oh, do I have that? And that's a good thing. Okay.

Yes.

Because we want you to think, we want you to think about whether or not you have it. We want you to think about whether or not you need it. Not everything you are gonna need or want. That's fine. We try to give you a list of everything that's possible out there. I think it's a very comprehensive list, so check that out. Guys, please, thank you so much for listening to this episode or joining us on this one. I hope this was, was, you know, you got some information out of this. Love to hear your comments below. Let us know how we're doing, what you want to see more of. If you've got specific questions, we're happy to try to answer them. We try— we do try to answer everything that comes Comes on here. Visit myexitengine.com for subscription information and becoming a member of the community, right, John? And you know, just let's keep it going. Oh, by the way, want to point out as well that if you're not yet a member of the Exit Engine community, there's two ways to do this to become one. The first is obviously that you can go to myexitengine.com, look about it there. But what we would like you to do is we want you to take our assessment. And the reason we want you to do that is just like what we're talking about today, you're going to find some things that you're going to discover, some things that you don't know that you should know as you're starting to think about the exit planning process, the need for the exit planning process, and how to go about it. So, follow us there for that. And then the other thing is that once a month, John, we do what we call Exit 101. And Exit 101 is a free webinar that anybody can come to, just got to register for it. You can find it on myexitengine.com or on any of the social media sites that we have, LinkedIn, um, and go and, and sign up for that way. That's a great entry point, right, into Exit Engine and what we're all about and gives you some very, very important information right off the bat.

Yes, absolutely. It— we talk about some of the things we talked about here, but we talk about all sorts of other things that are non-due diligence related that are key when you're planning and building that plan to sell your business.

Exactly right. So check that out again, which we do that once a month. It's a great way to kind of get started. Uh, but again, myexitengine.com, read all about everything there. We hope you become a member. So please subscribe and like this podcast. We really appreciate your time today. And John, we will, uh, we'll keep going at it this week, and we will see you next week.

See you, Joe. Thanks.