M&A deals have always been challenging to close, and all the more-so in recent years, when sale processes have become protracted and due diligence efforts have intensified. Deals – even good, mutually beneficial ones – can be easily derailed by “surprises” from the seller.
In this environment, sell-side due diligence is gaining broad acceptance. By doing their own internal homework and taking a critical introspective assessment in advance of providing buyers with due-diligence access, sellers can enhance deal value and improve negotiations. This is especially so given that buyer-identified issues can put a seller in a defensive negotiating position on price and transaction terms. Sell-side due diligence enables sellers and their advisers to proactively identify matters impacting value, negotiating leverage and speed and certainty to close, thereby minimizing uncertainty in the sale process and maximizing transaction value.
Sell-side due diligence, sometimes referred to as reverse due diligence, requires a seller to take a critical, introspective look at his own financial position and assess the opportunities and risks facing the company prior to sale. The focal points of sell-side due diligence mirror the typical objectives deployed by a buyer performing buy-side due diligence. Typically, these objectives revolve around analyzing the quality of the company’s historical earnings, the reasonableness of forecast assumptions, assessing working capital requirements, identifying tax risks and understanding the company’s customer, vendor and other key relationships. However, unlike buy-side due diligence, which is typically one of the final components of the M&A cycle, sell-side due diligence is commissioned early in the sale process.
Often, the transaction advisory practice of a public accounting firm is sought to assist management with the analysis and preparation of a sell-side report. These professionals are versed in taking a buyer’s view of an organization and will help the seller ask the tough questions in advance of the inevitable intense scrutiny of a buyer’s diligence team. In many cases, it may be desirable to provide the resulting report to a select number of potential buyers to assist them in understanding the business.
Driving value and reducing the risk of the M&A process is the underlying motivation in performing sell-side due diligence. These objectives are achieved through the following:
- Level playing field when soliciting bids. In situations when investment bankers are soliciting bids from a variety of interested parties, a sell-side due diligence report may be shared with interested third parties. A quality of earnings report produced by an accounting firm can provide potential buyers with additional information regarding the seller’s view on earnings before interest, taxes, depreciation and amortization (EBITDA) adjustments. All potential buyers will be able to confidently submit bids with a deeper knowledge about the significant matters impacting EBITDA. When all the cards are put on the table, the buyer has a reduced ability to renegotiate on price and terms at a later date, when other potentially interested buyers have typically exited the process.
- Minimize surprises. All companies have their blemishes. Failing to manage the discussions on these important issues in the hopes that they’ll be overlooked is a recipe for disaster. Sophisticated investment teams, along with their advisers, will leave nothing uncovered. Discovering surprises during due diligence can make a buyer skeptical of other unknowns, further impacting value and likelihood to close. Being upfront with issues enhances seller credibility and leads to a negotiation built on trust that prevails throughout the entire process.
- Be proactive by taking corrective measures. No one knows the company better than the owners. By first taking an introspective look, potential issues can be resolved before they escalate. Additionally, sellers can report to buyers that the necessary steps are already under way to rectify the situation. Unaddressed issues accumulate in a buyer’s mind and may distract from the positive accomplishments of the company or even escalate to a revaluation.
- Expedite the close. A comprehensive sell-side report will include all the requisite quality of earnings, income statement, balance sheet and working capital analyses common to a buy-side due diligence report. In addition, oftentimes sellers will want to include margin, customer and vendor data that address profitability and concentration risks. The objective is to be thorough in order to streamline the buyer’s own due diligence. The less uncertainty in a buyer’s mind, the fewer the hurdles before close.
There are a number of beneficiaries of sell-side due diligence.
- Stand-alone businesses. Well-run businesses typically prepare a wealth of internal information about their operations, customers and results of operations. Investment bankers often pull the critical pieces of this information into their information memoranda and other marketing information. However, there is often not a single document that will summarize relevant financial, tax and operational information in a manner to address matters most relevant during due diligence. A thorough sell-side due diligence effort can pull all the information into a single comprehensive document providing a roadmap through the financial analysis. It also allows management to build a more complete data room to support the due diligence effort and help resolve follow up questions from potential buyers. The exercise of developing such a document can also highlight areas where the seller’s management team should prepare to respond to important questions that will be raised through the sale process.
- Companies seeking a divestiture. Management may identify an underperforming division or a non-core product line that they wish to divest, which historically may not have complete, stand-alone financial information. Carve out transactions tend to be highly complex. Understanding and clearly articulating the basis for the financial information provided to potential buyers is critical to minimize the likelihood or basis for renegotiating on valuation later in the negotiation process. These situations often include analyzing cost structures, contribution margin, cost allocation and balance sheet carve out items.
- Investment bankers. The primary objective of investment banking firms is to maintain control of the sale process to maximize value and limit risk. By going to market with potential issues already vetted, corrective measures already implemented and a solid understanding of sustainable EBITDA, the entire deal process is poised to be more streamlined and effective.
- Buyers. Buyers benefit from sell-side due diligence as a result of having a better understanding of the seller’s financial information earlier in the process. This allows them to make more competitive bids with more assurance that there will be no surprises later in the process. Buyers are less likely to spend time on transactions that will not ultimately proceed to a closing, allowing them to focus their attention on only the most attractive opportunities.
In today’s economic environment, buyer scrutiny has intensified and there are no secrets after the due diligence cycle is complete. As such, sell-side due diligence allows the seller to get in front of potential issues and identify potential additional value drivers. Owners and their advisers can then make solid decisions about how to present these matters to prospective buyers. Increasingly, sellers are recognizing that having the ability to clearly articulate their financial information can be critical to demonstrating the value proposition to potential buyers. We expect an increasing number of sellers will turn to sell-side due diligence in an effort to drive value, efficiency and certainty in their transactions.
Jeff Bradford is a partner and Brian Lambrecht is a manager on the transaction advisory services team at Grant Thornton LLP.
