For many sellers, withstanding the challenges of the due diligence phase depends on keeping their emotions in check and anticipating the buyer’s requests for information.
If you have been through a business purchase or sale, you have likely experienced the unique tension and strife common to that phase of the deal known as “due diligence.”
For first-time sellers who have just received a signed letter of intent, due diligence may seem like an interminable period during which the buyer mutates from a celebrated connoisseur nonpareil of business desirability and value to an insatiable hoarder of data and documents, whose capacity for annoying demands for minutiae and innuendos about the status of non-existent records is, in the mind of the seller, tantamount to calling his company an ugly child.
In reality, though, due diligence is simply a normal part of the business ownership transition, and most apprehensions leading into it stem from fear of the unknown.
The Value of an Intermediary. While due diligence may feel bewildering at first, part of what a top M&A advisor does is help their client prepare for, understand, and navigate the process – successfully and with the least possible disruption.
First-time sellers often assume that the main value of their M&A professional is in attracting potential buyers. After successfully navigating the due-diligence phase, they tend to have a broader appreciation for what their intermediary helped them achieve – especially in leveling the playing field with the buyer.
“In due diligence, the buyer and seller usually are not on equal footing,” says IBG partner Jim Afinowich (Arizona). “A professional buyer has been through the process before, probably multiple times, and has a checklist of due-diligence items. The professional buyer is also better equipped to make the deal ‘just business,’ and that’s an advantage over a first-time seller who built the company from nothing into something great and feels like they are giving up their first-born.”
Afinowich noted that a successful closing often hinges on whether the seller can adjust, sometimes in major ways, to the atmosphere of the deal.
“Many business owners are by nature self-sufficient and unaccustomed to relying too much on others. For some, the biggest adjustment they make during due diligence is to surrender control of the deal and start trusting their M&A professional to anticipate and respond to buyer requests and serve as a communication filter and emotional buffer between the parties.”
“When things get tense, our mission is to get the parties back on the same page, and we’re pretty good at it,” Afinowich concluded. “It isn’t always pretty, but when the parties are telling each other to go to hell at the same time, we know that they’re finally starting to think alike.”
Due Diligence Defined. In its simplest terms, due diligence is the process of ensuring that, before a deal is finalized, things actually are as they appear to be. While it takes work, due diligence helps squeeze risk out of a sale, protecting the buyer and the seller. It protects the buyer from buying something different than has been represented, and it helps the seller be thorough in material disclosures and avoid having a buyer assert that things were undisclosed as a claim for damages.
For someone considering a merger or the purchase of a business, document review and the answers to due-diligence questions are critical. It is a complex, time-consuming process, but with so much on the line with any merger or acquisition, neither buyer nor seller wants to make a major decision without a solid foundation of accurate information.
“A key goal of the due diligence process is to find potential problems, such as liabilities and contractual issues,” notes IBG partner Gary Papay (Pennsylvania and North Carolina). “The end result should be that the selling price of the business is justified and both parties walk away satisfied. It is very common for problems and issues to pop up during due diligence, so it’s important to stay proactive and be open to negotiation until the deal is finalized.”
While the types of information that a buyer (or seller) may request varies with the type and size of the business and the specifics of the transaction, here is a general list of issues and information requests that are likely to arise during due diligence.
- In-depth review of financials
- Income statements (actual and recast)
- Balance sheets (actual and recast)
- Quality of earnings review – more below
- Verification of all assets and liabilities
- Sales data
- Loan balances
- Accounts receivable aging
- Bad debts
- Legal issues
- All legal documents (entity documents, operating agreements, contracts, licenses, leases, employment contracts, obligations, etc.)
- Pending litigation
- Pre-litigation disputes
- Entity structure
- Government compliance
- Tax returns
- Payroll records and reports (1099s, W-2s, etc.)
- Company- and industry-specific issues (federal, state, local)
- Regulatory compliance (e.g., environmental reports)
- Customer lists
- Supplier lists and agreements
- Marketing materials
- Data security
- Intellectual property
- Trademarks, copyrights, patents
- Proprietary processes
- Operational and procedural manuals
- Product and service lines
- Insurance policies
- Inspection of capital equipment
- Organizational structure
- Employee census, including position, hire date, DOB, wages/salaries, benefits, pending retirement
- Can the buyer expect a turn-key transition? Will key employees stay? Are there employment agreements?
- Employee manuals and personnel policies
- Benefit plans
- Retirement plans, pension plans and funding condition
For an even longer list, see a 2019 Forbes article, “A Comprehensive Guide To Due Diligence Issues In Mergers And Acquisitions.”
“One of the things you have to do as the seller of a company is put together a mountain of information for the buyer,” recalls Doug Padgett, an IBG client who recently sold his company, Pendergraph Systems. “This is stuff that you’ve accumulated, in my case, over 25 years. IBG’s help in that effort was immense; we couldn’t have done it without them.”
While the scope of information required by the buyer is typically very broad, in most deals the central focus is on the subject company’s financials. That should come as no surprise; because the purchase price is largely based on some multiple of the company’s net revenues and adjusted earning capacity, the buyer wants to know that he’s getting what he’s paying for. But the financials also serve as a roadmap to the subject company’s operations, which will lead to questions. The answers will spark more questions, and that back-and-forth, rooted in the financial records, is a major contributor to the length of the due-diligence phase.
With the help of their M&A advisor, sellers can prepare themselves for that process, both emotionally and in gathering the information sought by the buyer.
Financial Scrutiny. In recent years, the financial focus of buyers has risen to new heights by the growing use of a “quality of earnings” (QofE) review, which we referenced above. Such reports are increasingly common in larger transactions, especially where the buyer is a private equity firm.
“A quality of earnings report is a deep dive on the seller’s financials,” said Matt Frye, a partner in IBG Business’s Oklahoma office. “It shows a buyer the business’s true profitability by adjusting EBITDA to reflect any non-recurring revenues and expenses. Likewise, a QofE identifies liabilities and how they might be factored into the working capital calculations.”
Investopedia puts it less delicately, noting that a QofE report reveals a clearer picture of earnings “by dismissing any anomalies, accounting tricks, or one-time events that may skew the real bottom-line numbers.”
When the “real bottom line” deviates too much from the financials offered up by the seller, the QofE report can drive a wedge between the parties, injecting new challenges to due diligence and putting the deal at risk.
As threatening as that may seem to a seller, IBG’s M&A professionals view a QofE review as consistent with one of their standard practices in packaging a business for sale.
“We routinely recast the business’s financial statements to show its true earnings in a form that buyers expect,” said Frye. “While it doesn’t rise to the level of a QoE review, our in-depth recasting, before the company goes on the market, can strengthen the package we present to buyers and possibly lessen the need for the buyer to initiate its own review.”
Frye’s IBG colleague, John Johnson, adds: “We pave the way and anticipate issues. A top M&A intermediary will have prepared the client to sail through the QoE part of due diligence. Much of the advance process is routinely handled by the client’s M&A advisor, whose analysis minimizes the ‘surprises or difficulties’ arising from the buyer’s subsequent QoE work in due diligence.”
In some deals, a recasting will not meet the buyer’s needs, and the buyer might commission its own QofE review, absorbing all of the cost or asking the seller to share in it. If the seller and their M&A advisor anticipate that the buyer will require a review, there are instances in which it’s in the seller’s interest to have it done in advance. That can make a good impression on the buyer, reduce buyer requests for financial information, and shorten the due-diligence phase.
The benefits to the seller may not end there, Frye noted. He cited a white paper by Whitley Penn that contends that “every nickel spent on a QofE turns into a dollar”:
“A sell-side Quality of Earnings often results in a higher sales price for the company. Because M&A transactions are valued as a multiple of earnings, the higher the earnings the higher the value. The sell-side QofE team will likely uncover certain expense adjustments that would be considered addbacks to EBITDA to increase profitability which will then be multiplied by a market-based multiplier to calculate the transaction value.”
“Because QofE reviews are more the rule than the exception in the upper echelons of deals,” said Johnson, “we expect them to become more commonplace in mid-market transactions as well. Sellers need to be prepared for buyers to initiate the review, which can extend the due diligence phase.
“Under certain circumstances, sellers might consider the possible benefits of commissioning a review on their own, but the reality in most deals is that neither the buyer nor its bankers and investors are likely to accept seller-commissioned work commissioned as a substitute for their own review.”