How Sellers Can Avoid Unwanted Surprises During Due Diligence
Potential buyers frequently uncover unwanted surprises during due diligence — resulting in downward purchase price negotiations, lower valuation multiples, lenders getting scared off, or the deal falling through.
In today’s economic climate, potential buyers are willing to search long and hard to identify the best acquisition candidate. Transparent financial and operating information is more important than ever.
For companies anticipating sale, sell-side due diligence can identify and quantify issues and exposures that could negatively impact a deal.
How Sell-Side Due Diligence Helps Sellers
According to a recent survey commissioned by BKD, 66% of closely held/family-owned businesses anticipate a change in ownership in the next 10 years. For would-be sellers looking to maximize value, it is prudent to begin preparing now.
Sell-side due diligence is a process in which a company hires a third-party expert to conduct a dry run diligence assessment. It usually covers areas such as financial statements, taxation, information systems, and operations.
The sell-side diligence process will assist companies in resolving or managing potential issues before potential buyers discover the problems on their own. To best position a company for a successful sale, we recommend beginning the sell-side diligence process one to three years in advance of the anticipated sale.
Here are a few specific ways in which sell-side due diligence can expose potential issues in advance of a transaction.
- Make sure EBITDA addbacks are appropriate
To reduce the likelihood of purchase price disputes, sellers should take caution to make sure adjustments to restated EBITDA are appropriate and supported through proper documentation. For instance, a manufacturer who has leveraged process changes or purchasing practices to drive EBITDA growth needs to depict or model the actual run rate improvements that they should get full credit for. This should be supported by data that demonstrates throughput rate increases and purchase price decreases.
- Avoid disputes around net working capital
Unless clearly defined early in the process, target net working capital is another area commonly disputed during transaction negotiations. Purchase agreements frequently define closing net working capital computations as “consistently applied and in accordance with generally accepted accounting principles (GAAP).” Costly disputes can arise when a company consistently applies certain accounting policies that are not in accordance with GAAP, particularly at interim period-ends.
If as the seller, you haven’t followed GAAP “to the letter,” it’s often beneficial to address this with the buyer early in the process. For example, in a recent manufacturing deal we assisted on, the seller proactively defined the accounting methods he had used around valuation of inventory. With some effort, the buyer was able to get comfortable with inventory and the deal proceeded to close. Sell-side due diligence can identify GAAP departures early on to help ensure net working capital computations are clearly defined prior to the purchase agreement.
- Develop meaningful analytical information to support valuation
Sell-side due diligence can help a company produce meaningful analytical information from its accounting system (i.e., gross margin by customer, product line, market segment, etc.). This supporting detail can help substantiate changes in historical EBITDA as well as model future performance (given varying assumptions).
In one recent deal, a manufacturer combined invoice details, purchasing data, and bill of materials to illustrate material margins at a customer and product level. Even before conducting due diligence, the buyer had a clear view to the drivers of changes in performance, and was able to focus on future opportunities among customers and products.
- Uncover liability issues and exposures
In nearly every buy-side due diligence engagement, we have uncovered liability issues and exposures related to state tax compliance and nexus, many of which surprised the seller. These types of exposures are common in privately held companies and can frequently be addressed and mitigated in advance of going to market. State and local tax (SALT) due diligence can also identify savings opportunities by identifying potential tax reductions. Savings generated through reduced SALT payments effectively increase EBITDA, which can lead to increased company valuations.
- Identify technology improvements to increase EBITDA
Information systems sell-side diligence focuses on identifying current technology capabilities, suggested improvement opportunities and internal controls while balancing investment demands and priorities. Operations sell-side diligence is a fact-based and metric-driven analysis to provide a company with potential improvement opportunities and cost saving suggestions, both of which could generate increased EBITDA.
Other situations where sell-side due diligence in advance of a sale process are beneficial include:
- When the company has made one or more recent acquisitions and is presenting financial information on a pro forma basis, as if the acquisition(s) had occurred at the beginning of the period, and wants to present meaningful trend analysis
- When the company is unaudited and complex GAAP accounting requirements (i.e., multiple deliverable revenue recognition) apply to its financial information
- When the company records its financial statements on the cash basis of accounting, while buyers would require GAAP basis accrual financial information
In summary, sell-side due diligence provides companies with an objective third-party view from the buyer’s perspective and helps companies resolve issues before potential buyers discover them on their own. By engaging in sell-side due diligence several years out from a transaction, companies can avoid unwanted surprises and ensure a transaction runs as smoothly as possible.
Considering a sale? We’d welcome the opportunity to confidentially review your situation, offer a free valuation of your business and offer a game plan to help you maximize your return in a sale.
Grimes, McGovern & Associates provides expert advice during all phases of a transaction. Contact us today for a confidential consultation: John McGovern, CEO, email@example.com, (917) 881-6563.
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