Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / The Due Diligence Request List That Almost Sank a Deal
Transcript
- Lucas: So there's a moment in almost every private business sale where the seller opens an email from the buyer's attorney and sees an attachment that's, like, forty pages long. It's the due diligence request list. Luna: And their stomach drops because it's a list of every document the business has ever touched. Lucas: Exactly. I mean, I worked with a seller last year — a mid-sized industrial coatings company, about twelve million in revenue — and the buyer sent a hundred and forty-seven separate line items. The seller's first reaction was to say forget it. But the thing is, most of those items are noise. The deal lives or dies on maybe ten documents. Luna: Alright, that is a good opener. And if this conversation saves you even a few hours of stress, honestly, it's worth the price of a coffee. We keep this show ad-free, and listener support is what makes that possible. If today was worth a coffee to you, the link is buy me a coffee dot com slash fexingo. Lucas: Yeah, and we mean it. No pressure, but if you get value, we'd appreciate it. So back to that hundred-and-forty-seven-item list — I've seen this pattern over and over. Buyers use the request list as a fishing expedition, but the real work happens in three buckets. Luna: Let's hear them. What are the three things that actually matter? Lucas: First bucket: financial statements. But not just any statements. The buyer wants three years of annual audited or reviewed financials, plus interim period statements. And they want the trial balance, the general ledger, and sales journals. The quality of earnings report is the single most scrutinized document in the whole process. Luna: Because that's where they find out if the EBITDA is real or if it's been padded with one-time adjustments. Lucas: Right. I saw a deal fall apart because the seller had been capitalizing routine maintenance as an asset. The buyer's accountant caught it in the fixed asset schedule, and suddenly the EBITDA dropped by fifteen percent. The seller hadn't even realized it was a problem. Luna: So bucket one is financials. What's bucket two? Lucas: Customer and revenue concentration. Buyers want a list of the top twenty customers by revenue for the last three years, with contract terms, renewal rates, and any correspondence about disputes. They're looking for dependency. If one customer is thirty percent of revenue and that customer's contract expires in six months, the buyer sees that as risk. Luna: And they'll either discount the price or demand an earnout tied to retention. Lucas: Exactly. In that coatings deal, the top customer was only twelve percent, so that wasn't an issue. But they had a second bucket issue: supplier concentration. One chemical supplier provided a key raw material, and their contract had a change of control clause that let them terminate if the business was sold. Luna: Ouch. That's a deal breaker if the buyer can't secure supply. Lucas: It almost was. The seller had to negotiate a waiver from the supplier before the buyer would sign the LOI. That took three weeks and cost them a small advisory fee. But if they'd flagged it earlier, they could have handled it before the buyer ever saw it. Luna: So what's bucket three? Lucas: Legal and regulatory. This is where sellers get sloppy. The buyer wants articles of incorporation, bylaws, board meeting minutes, stock ledger, all material contracts, intellectual property assignments, licenses, permits, and any litigation history. The mistake sellers make is they wait until the request comes in to gather this stuff. They should have a data room ready before they ever talk to a buyer. Luna: Because once the buyer starts waiting for documents, they get nervous. Lucas: Nervous, and they start assuming the worst. In a different deal — a software company I advised — the seller couldn't find the IP assignment agreements for two of their early developers. The buyer's attorney flagged it, the seller spent four weeks tracking down signatures, and the buyer used that delay to reopen the price negotiation. They got a five percent discount just for the inconvenience. Luna: And that's five percent of the purchase price, not five percent of revenue. Lucas: Exactly. On a ten million dollar deal, that's half a million dollars because someone didn't file a signed agreement. So the lesson is: pre-assemble your data room. Have three folders. Folder one: financials — audited statements, tax returns, quality of earnings. Folder two: commercial — top customers, top suppliers, contracts. Folder three: legal — incorporation docs, IP, licenses, material contracts. Luna: And then when the buyer sends that forty-page list, you can respond in twenty-four hours with ninety percent of what they need. That builds trust. Lucas: It does. And it shifts the power dynamic. The seller looks organized and transparent. The buyer's team thinks, 'These people have their act together, we don't need to dig as hard.' That can shorten the due diligence period by weeks. Luna: But what about the stuff that isn't on the standard list but still kills deals? I've heard of buyers asking for personal tax returns of the owner, or for social media passwords. Lucas: Yeah, that's a real thing. Sometimes buyers push beyond reasonable boundaries. The rule of thumb is: anything that affects the business's ability to generate cash flow is fair game. Personal tax returns? Only if the owner is a key employee and they're trying to verify compensation. Social media passwords? Hard no — that's a red flag about the buyer's intent. Luna: So how do you push back without looking like you're hiding something? Lucas: You say, 'We're happy to provide anything that's directly relevant to the business's operations and value. That request falls outside normal due diligence. Can you explain how it relates to the purchase?' That forces the buyer to justify it. Most of the time, they'll drop it. Luna: Good. I want to come back to something you said earlier about the quality of earnings report. Can you walk us through what that actually contains? Lucas: Sure. A quality of earnings report, or q of e, is prepared by an independent accountant. They take the seller's financial statements and adjust them to show what the true sustainable cash flow is. They add back one-time expenses like owner perks, legal settlements, moving costs. They subtract non-recurring revenue like a big contract that won't repeat. Luna: And the buyer uses that adjusted number to set the multiple. Lucas: Exactly. I saw a q of e that adjusted EBITDA from two point one million down to one point six million because the owner had been paying himself a below-market salary and taking distributions instead. The buyer said, 'If we have to pay a market-rate CEO, that's the real cash flow.' The seller was furious, but the adjustments were legitimate. Luna: So sellers should do their own q of e before they go to market. That way they know what the buyer is going to see. Lucas: One hundred percent. And it costs maybe ten to fifteen thousand dollars for a middle-market company. But if it prevents a price adjustment, it pays for itself a hundred times over. Luna: Alright, so the big takeaways: pre-build your data room, focus on the three buckets, and run your own quality of earnings. Anything else sellers should know about the due diligence process? Lucas: One more thing: the timeline. A typical due diligence period is sixty to ninety days. But if the seller is prepared, they can push to close in forty-five. That's a negotiation advantage. Buyers who take longer often get cold feet. The faster you move, the less time they have to think of reasons to walk. Luna: Speed as a deal-closing tool. I like that. Lucas: And if you're a seller listening, start today. Even if you're not selling for two years, start organizing those three folders. The cost is low, the option value is enormous. Luna: Good advice. Next episode, we're going to look at what happens after the data room — the purchase agreement and the reps and warranties. That's where the fine print can cost you. Lucas: It's a good one. See you then.