Lies, Damned Lies, and Honest Mistakes: Misrepresentations in Due Diligence
Depending on the day, attitudes on conducting due diligence range from a skeptical “Trust, but verify” to a Mulder-esque “I want to believe.” In any event, the purpose of due diligence remains consistent. It’s getting a satisfactory answer to three questions:
What have you told us that we can verify? What can’t be verified and why? And what isn’t true?
What haven’t you told us that we need to know?
What don’t you know that we should know?
Or, to paraphrase anthropologist Margaret Mead, “There’s what people say, what people do, and what people say they do.”
There are some other valuable types of information that comes from due diligence that we get into elsewhere, but this is the crux of it. And the essence of these questions is, “What’s verifiable reality, and how does that line up with what you told me about your business?”
And that framing begs the question of misrepresentation.
Who Me? No Way.
Our experience is that the vast majority of people that we work with fall closer to the innocent mistake end of the spectrum than the malicious and/or fraudulent misrepresentation end. Most of the time, most missing documentation is missing because a seller simply didn’t know we really meant “all” or didn’t fully understand what we were asking for.
But, people do try to gussy up the numbers sometimes. And the intent and nature of that extra shine can make all the difference. And, here’s the other thing about misrepresentation: Once somebody’s caught in one lie (or half truth, or suspected omission, or gussying up of information) everything else becomes… a little more suspect.
Let’s start with the basics. A misrepresentation is a false statement of a material fact made by a party that then affects the other party’s decision in agreeing to a contract. There are three overarching types of misrepresentation:
Innocent misrepresentation: You make a statement of fact that is untrue, but you’re unaware that it’s untrue.
Negligent misrepresentation: You’re violating the idea of “reasonable care” by not trying to verify if a statement is true before executing a contract.
Fraudulent misrepresentation: You knowingly or recklessly make a false statement.
What, Why & How
Then, we’re left with three more questions (due diligence is nothing if not an exercise in asking questions):
What might someone misrepresent?
Why might someone be motivated to do that?
How might someone protect themselves against misrepresentation (or incentivize different behavior from the beginning)?
First, the what. And, quite honestly, the list of what people misrepresent is seemingly endless (and, remember, not all misrepresentation is intentional). A short and wildly incomplete list of possibilities includes gross margin (you can move things to operating expenses to make your gross margin look better), sales numbers (if you don’t include refunds or discounts, or book future sales as current, your sales can look drastically different), EBITDA (don’t get us started on the sheer creativity available in adjustments), unrealistic budgets (if you’ve got the right inputs, you can make a forecast say anything you want it to), working capital needs…
The “what” of misrepresentation is why so many diligence checklists, including ours, ask the same question in many different ways – and for the documentation to back it up.
Then there’s the why. In fraud examiner circles, there’s what’s called the Fraud Triangle. Here, people misrepresent things or withhold information because of the confluence of pressure, rationalization, and opportunity. And, even in innocent misrepresentations, it’s easy to see how these three forces can create an environment where an omission seems reasonable or a slightly shinier number feels better.
For a small business owner, this might look like: “I need to retire and sell the business because of a health situation. I’ve worked really hard and deserve this. And I’m the only one who has this information, so no one will be able to easily find it out.” Other options might be simply wanting a quick close or a higher price, wanting to make a boring business look more exciting or shinier, or wanting to avoid disclosing information that might be embarrassing (whatever that means to you).
Then, finally, there’s the how, as in how to prevent misrepresentations. Due diligence is meant to cast a net both wide and deep to capture information and piece together a picture of a business that’s as close to reality as possible. Like putting together a puzzle, you can sort through pieces that have migrated over from different boxes and other pictures (“I think that’s a nose? But this is a picture of a castle?”). And if you discover something’s missing, you can probably approximate what should go there (“Okay, that piece was definitely part of the ocean.”) But how much easier would it be to just… start with the right pieces in the first place?
Avoiding Misrepresentation
How does that happen? Trust and transparency. The key lies in fostering relationships, working with good partners, discussing the process, and providing clarity around what’s being asked in the diligence process and why.
And the work isn’t all on the seller’s side. For buyers, it means doing the work to get what we think we’re getting in the diligence process – asking for information and stories and projections and numbers and trends and explanations in different ways, and then asking for the documentation to back that information up.
Finally, it’s about developing a process that aligns incentives from jump. At Permanent Equity, that means setting the tone at the top, ensuring that everyone has skin in the game (and stakes on the table if misrepresentations and misstatements become material), and leading with the expectation that everyone wants to keep the game going. It doesn’t mean that we never get burned, but it decreases the motivation for misrepresentation and provides everyone a common language and direction when it does happen to (hopefully) move forward.