This article is a continuation of the article titled “Transitioning ‘Tails’: A Veterinarian’s Journey,” that was published in Issue Number 9, 2024, regarding a veterinarian’s exit strategy, and is the second in a continuing series that guides the reader through the sale process. This installment will briefly address the due diligence process.
Whether you sell to a veterinary consolidator/private equity or an associate veterinarian, the buyer will want to conduct “due diligence.” This process is the same for any kind of buyer, but is generally more sophisticated with a veterinary consolidator or private equity buyer. In that scenario, there is usually a third-party “virtual diligence room,” diligence tracker, and regularly scheduled diligence conferences to discuss the buyer’s diligence questions. In any event, as previously outlined, there are two broad buckets of due diligence – “financial due diligence” and “legal due diligence.”
Due Diligence: Financial Due Diligence
Financial due diligence is a review of the seller’s financial health and usually starts during the letter of intent phase. Some private equity backed buyers will instruct their counsel to not distribute the transaction documents until financial due diligence is completed, while others are more willing to run the two work streams simultaneously to expedite the process.
During financial due diligence, the buyer will ask for copies of tax returns, the seller’s books and records (including financial statements such as a profit and loss/income statements and balance sheets), “point of sale” (or “POS”) data/access, and other items which will reveal and substantiate the seller’s financial circumstance. The buyer will then calculate the “earnings before interest, taxes, depreciation, and amortization” (more commonly known as “EBITDA”) and will pay a multiple of such EBITDA as the purchase price.
Prior to marketing or offering your practice for sale, it is important to have your accountant review and gather your financial diligence in order to streamline the process and be as efficient as possible.
We advise our clients to tell their accountant to review any “addbacks,” which are items that are “added back” into the EBITDA calculation because the financial item will not continue going forward. For example, a lot of veterinarian owners will expense items to the business that will not be continued by the buyer (perhaps a vehicle or entertainment expenses). Adding these expenses back raises the EBITDA.
It is better to have a grasp on the EBITDA early on so any variations in EBITDA or financial due diligence do not become a surprise or roadblock closer to closing. If the business does better than the financial records indicate, we have seen buyers increase offers. Similarly, if the financials are overinflated, buyers have reduced their offers, and if the buyer is a veterinary consolidator/private equity backed buyer, the buyer may ask the seller to take less cash and more equity (whether it be topco equity or more equity in the joint venture).
Legal Due Diligence
Legal due diligence is the review of all of the other information concerning the operations of your business. In legal due diligence, the buyer will ask for, among other things, the seller’s corporate documents (i.e., the formation document and the related governing documents), contracts, debt documents, employee information and handbook, insurance, intellectual property (i.e., whether the seller owns any trademarks or copyrights, domain information, social media accounts, etc.), permits, vendor information, inventory and equipment lists, and pending or threatened litigation.
In addition, the buyer will order “lien and litigation searches” which reveal whether any of the assets the buyer is purchasing is presently encumbered. If an asset is encumbered, it will need to paid off either prior to or at the closing.
Legal due diligence is important because it helps the buyer understand the business and what obligations it will take on post-closing. Buyers want as little disruption to the business and generally want to keep the business operating the same way as it was operating prior to the purchase.
Providing legal due diligence is also important for the seller because sellers need to provide a disclosure schedule to the purchase agreement which identifies any supplements or qualifications to a representation and warranty made in a purchase agreement (we will explain what a representation and warranty is in a future article). Without a full picture of the business, it is difficult to make such qualifications. Failing to adequately make disclosures may lead to future damages for breaching a representation and warranty.
The next article will provide an in-depth discussion of the components of a purchase agreement and the fourth article will discuss ancillary documents.