Selling Your Agency? Be Prepared for Pre-LOI Due Diligence

Selling your agency is an exciting milestone, but the process is far from simple. One of the most critical stages is due diligence, where potential buyers evaluate your agency’s financials, contracts, operations, and risks. If you are in the market to sell your agency, understanding the difference between these two stages can help you be prepared to navigate the process quickly and easily.

Two Stages of Diligence

There are typically two stages of due diligence. The first stage is before the letter of intent is signed and the second stage is after the letter of intent is signed. The former is generally more summary in nature. It is used to confirm some key facts that are necessary to come up with a proposed price and other summary terms for the letter of intent. 

The latter is generally quite comprehensive. This stage of diligence is to further confirm what was learned in the initial stage and to find any latent risks or other skeletons in the closet that need to be addressed in the full transaction documents. This more comprehensive diligence phase also helps identify the operational aspects of the business that will need to be transitioned to the buyer.

A key step in preparing to sell is to get organized. Having your business documents available and organized can save you time and money while working through the acquisition process. Also, being able to respond to diligence requests quickly, cleanly, and fully communicates that your agency is properly managing its risks and is worthy of a solid purchase price. Disorganized and incomplete due diligence signals risk to a buyer which can lead to a lower purchase price.

We recommend that agencies looking to sell have the following materials organized and ready to respond to potential buyers:

• Confidentiality Agreement. Of course, no business information should be shared without first putting a confidentiality agreement in place. Don’t simply recycle your employee vendor confidentiality agreement. An acquisition confidentiality agreement has some special considerations. In many situations, this should also contain an employee and customer nonsolicitation agreement prohibiting the potential buyer from learning (and then stealing) your team and clients if the deal doesn’t go through. 
• Corporate Information. Prepare a short narrative summarizing the form of entity your agency was organized as (e.g., LLC or corporation), the date and type of any change in form of organization over the years (if you have converted), your tax status (e.g., partnership, S‑corporation, C‑corporation, other), the date and previous type of any change in your tax status over the years, and a list of the states where you have employees or offices.
• Capitalization. Summarize who the current owners of the business are and their respective ownership interests in the company. 
• Financial Information. A buyer will typically want to see the balance sheets and profit and loss statements for the last three years plus the same for the current year-to-date. These can be summary financial statements in many cases, though it is often helpful to break out key revenue and expense areas. If you have good financial information, it can often save disclosing tax returns until after the LOI is signed.
• Accounting Policies. If you have any unique accounting policies that a person needs to know to understand your financial statements, those should be summarized. Also be sure to list any expense or revenue items that likely will not continue after the acquisition. For example, if the business employs kids of the owners who won’t continue in the business or if the agency leases cars for certain key employee-owners as a perk, call those out separately.
• Assets. Assemble a list of key assets of the business. This might be software that your agency has developed internally that it uses to operate or licenses to clients. You should also list any copyrights, trademarks, or patents that your business holds (and whether those have been registered).
• Liabilities and Liens. While your liabilities should be called out in your financial statement, you should prepare a summary of any liens or security interests that encumber the assets of the business. For example, if your agency has a line of credit, very likely the bank is using all of your agency’s assets as collateral. Very likely all those liens will need to be released prior to closing.
• Employee Census. You should have an employee census with job titles, annual compensation, and years of service. This census should NOT include employee names. Be sure to summarize any special compensation arrangements if they apply to certain employees.
• Employee Benefits. Assemble a list of all your employee benefits. This includes plans like a 401(k) and also informal benefits that might just be explained in your employee handbook. This should include a summary of any change-of-control bonus plans. 
• Customers. Prepare a list of the top 10 customers for each of the past two years ranked by revenue. This should be anonymized, simply referring to category rather than actual business name. If there have been any material changes in customers in the last two years (losing or gaining a major customer, major changes in revenue mix), those should be identified. Ideally, you should also be able to call out any key statistics like retention rate. Also be sure to identify what percentage of your revenue is recurring (retainer, long term contracts) vs project.
• Litigation. If your agency is pursuing or the subject of any litigation, prepare a summary of those cases including the amount at issue, the basic facts of the matter, whether insurance is involved, and the agency’s assessment of the case.

With this type of information, a buyer should be well equipped to assemble a meaningful offer and draft a letter of intent. Once the LOI is signed, the buyer has signaled serious interest, and it is appropriate for both parties to invest in more comprehensive due diligence. But having a core set of pre-LOI diligence materials ready ensures that you aren’t wasting time with buyers who are merely kicking tires.

We recommend that potential sellers assemble these materials in a shareable Dropbox folder so access can be controlled and monitored. If you have multiple potential buyers, you’ll likely want to create separate instances of the data room with different access. Keep your ​“gold master” diligence set separate and make copies to share with potential suitors in case the diligence set for each potential buyer ends up being customized. 

Diligence is a balance between telling a compelling story about your business to generate a high price while also laying everything out on the table (including the negative facts). Every agency has warts and the best time to deal with them are prior to closing. You should assume that any warts your agency has will be found and in many cases you’d rather handle that prior to closing than through a messy indemnification claim. Assume the buyer will find out all your warts (because they generally will). So best is to address them head on. 

Need help in getting your agency prepared for an acquisition? Contact us.