Diligence
Crystal described a seemingly never-ending back-and-forth with lawyers, focused on collecting various documents. This diligence phase is one of the most time-consuming and trying parts of the process; many designers seem to have an allergic reaction to spreadsheets, and this part of the process is all about contracts, estimates, forecasts, and the nuts and bolts of the business.
Before you go through a process like this, it’s hard to really internalize just how thorough, and time consuming, this part can be. I was warned it was all encompassing; it was, to the point of straining my marriage and personal relationships.
If you were methodical in how you ran the operations of your company, you’ll have nicely organized folders with MSAs, SOWs, and change orders. You’ll have your invoices sorted, your accounts payable detailed, and you’ll be able to find any part of your business at the drop of the hat. But for most of us, we weren’t that thoughtful and organized (particularly when we started). That employee you terminated years ago—can you find her I9? What about the lease agreement for your building? And that client that you invoiced by hand before you used Quickbooks, years ago; who was that again, and how much was it for?
It seems crazy, but that’s the level of detail you’ll need to provide during diligence. The hardest part of this process will be finding documentation related to anomalies, like contracts that ended prematurely or change orders that impacted revenue. But the sheer tedium of aggregating the documents that are produced in the normal course of business can feel overwhelming.
Here are some of the things that you’ll be expected to present during this due diligence process in a spreadsheet similar to the one Crystal described:
Contracts
The most time consuming part of preparing for diligence is aggregating your contracts. There are different types of acquisitions, but in an asset purchase, contracts are assigned to the buyer, so they’ll want to know what they are signing up for. This is every MSA, every SOW, every change order, every NDA—anything that a buyer may inherit as a liability, or that may be in conflict with their existing contracts. Some of the things they’ll look for include:
- Clauses related to assignment. Generally, contracts can be assigned to another party, unless there are terms that explicitly prohibit or limit this. When you assign the contract to the buyer, they take on all of the terms. If the contract limits assignment, you might see language like this:
This Agreement shall be binding upon and inure to the benefit of each Party and each of its applicable successors and assigns. This Agreement and the rights hereunder are personal to the Contractor and shall not be transferred, assigned, sub-contracted or sublicensed in any manner, pledged or otherwise encumbered by the Contractor, whether voluntarily, involuntarily, by operation of law or otherwise without Company’s prior written consent. Company may without restriction assign this Agreement and its rights and obligations hereunder.
Your sale terms may require you to go hunt down that assignment approval in writing, and that means you’ll have to let your clients know a deal is pending.
I found that, early in the history of my company, I ignored Assignment terms entirely in my contracts because it never occurred to me that I might want to turn the contract over to someone else. It’s worth creating a short spreadsheet that tracks requirements related to assignment.
- Clauses related to non-competes. Some contracts limit the companies you can work with, either by industry or by name. This may pose a problem for a buyer, particularly if they already have a contract with one of those named companies.
- Descriptions of how you invoice and bill. I’ve found that companies that are used to billing based on time and materials (strictly hourly) have a hard time understanding the mechanics of deliverable-based invoicing and its relationship to revenue recognition. Prepare yourself to explain, over and over and over, the nuances of how you know when a design is “done” and what “acceptance” means in our industry.
In diligence, a buyer will also look at your invoices, and will likely compare some of your historic invoices to the terms of your contracts. They are looking to see if you are buttoned-up in your operations, but also to understand if they are opening themselves to risk based on how closely you adhere to your contractual commitments.
Buyers will also look at your lease agreements, again for terms related to assignment, and also for commitments to duration and rent increases.
Finances
I found that preparing finances for diligence was actually one of the easiest parts of this process for me, and for many of the people I spoke with who managed small or mid-sized agencies, because design businesses are often pretty simple in structure. Our companies probably have cash on hand, some forms of credit and debt (typically carried on a credit card), and some basic equity structure. Beyond that, designers typically don’t poke around in more complex financial vehicles or investments.
One of the parts of the financial review process that has some unique aspects in the context of a design business relates to hourly rates and utilization rates. In a simple T&E model, an employee gets paid a certain amount and works a certain amount of hours. It’s easy to calculate their hourly rate, and it’s easy to calculate how much they are working and if they are fully utilized—working a full 40 hours a week.
Smaller consultancies break this model. Designers often work on many projects at once, or casually help out with a program through collaborative sketching and brainstorming. They may not track time diligently, and may not even track it at all. Designers “just want to do the work” and so it becomes very difficult to claim a studio-wide utilization rate with a strong degree of confidence. But a buyer wants to know how hard people are working, and without a utilization rate, it’s hard to know how optimized your studio is. Optimized isn’t typically something we think about, but it’s something a buyer will think about.
But a part of the process that is truly confounding is the Quality of Earnings evaluation. I’m not sure every company goes through this process, but it’s a very foreign way of thinking for many designers. The QofE report looks at, among other things, how you recognize the revenue you take in. You run your company on a cash or accrual basis, but there’s more to it than that. Consider if you can answer these questions:
- Do you feel that you’ve earned your revenue when you finish a whole project, or a deliverable? What constitutes “finishing” a deliverable?
- Do you invoice for a percentage of the project before you start, as a form of good-will on signature? When can you claim that you’ve earned that money?
- Do you have sufficient money in the bank to pay back all of those upon-signature payments if the clients back out?
These aren’t things I ever cared about when I ran my company, but an acquirer will care about them a lot. I’m not sure there’s anything to do to prepare for a Quality of Earnings investigation ahead of time, except to have given these topics some thought so you have a thoughtful answer (even if the answer is, “I have no idea”).
Employees
The diligence process will get into the details of your employees. At the minimum, a buyer will want to understand how many people you employ, if they are full or part time, how long they’ve been at the company, and how much you pay them. They’ll also probably want to understand titles and the way titles relate to experience, if there’s a reporting structure, and how many of your employees are utilized at any given time (people who are actually doing the work).
You’ll be asked to provide a list of key players, and to describe who would be most likely to take over for you and your leadership team over time. And you’ll likely be asked to provide employee records for the last three years, including start date, end date, salaries, titles, and any anomalous behavior (like a performance plan).
Customers
At some point, your buyer will want to talk with your clients. This is a reference check, and once your client knows about your sale, the “cat is out of the bag.” Secrets don’t stay secret very long, and designers gossip. I would assume that once you get to a customer reference check, the circle of people who know about your sale will widen; this means that, around this time, you’ll need to have a solid talk track in place to explain the sale to your employees and clients (even those who aren’t interviewed as part of the diligence process).
There’s a risk of the customer reference check; your customers may become scared. Will they continue to get the hands-on support they’ve grown accustomed to? Will their main contacts at your company change? What about pricing? Phil described that after Deloitte bought his company, “The rate increase was astronomical… a doubling or a tripling of our rates.”
There’s also a risk, although hopefully a small one, that your customer won’t say supportive things about you and your business. I always pre-game my conversation with that contact and ask them what they’ll talk about, and I trust that they’ll be honest, but you never know, and not knowing is risky.
Getting ahead of diligence
Even if you aren’t actually interested in selling your company, this might be a good time to do some reflecting on your organizational process. If your feet were held to the fire right now, could you go track down a specific invoice for a specific client? Could you identify how much money you made 14, 20, or 26 months ago? Could you see if, upon acquisition, you are legally allowed to assign an MSA you have with your biggest client? This is a good thought exercise to try prior to beginning an acquisition process, so you can really get a feel for what you might be diving into.
A quick checklist of improvements you might make to get ready for a process like this includes:
- Contract organization. Put all executed contracts in one place, with each client in a unique folder. Create a spreadsheet going back at least 3 years that lists each one, executed dates, and pricing. Identify which have clauses about assignability, and document those contracts in the spreadsheet.
- Employee history. Create a list of active and previous employees, including their start date, end date, salary, and title. Identify any performance issues.
- Revenue history. Produce a detailed historic view of revenue by client by month, revenue by project per month, and revenue attributed to a specific employee. Write a brief description of how you recognize revenue and how you bill.
- Employee utilization. Create a historic view of how many hours each team member worked, their bill rate, and the overall company utilization rates.
You can find a more comprehensive list of documents in the Appendix.
