Sell-Side Due Diligence – What Is Involved and Why it Makes Sense
By Barbara Israel
Historically when owners of closely held small and medium businesses or executives of larger corporate entities make the decision to sell all or a portion of the business, the sale process includes the preparation by an investment banker of a confidential memorandum circulated to prospective buyers and the establishment of a data-room by the seller containing pertinent historical financial and tax information, forecasts, key customer and vendor relationships, and contractual information, as well as employee salary and benefit data. Then the buyers send in their team of advisors (accounting, tax and legal) as well as management team to perform diligence.
The process of selling all or a portion of a business is complex and can draw the focus of key personnel away from the core operational activities. Businesses that either do not have an internal business development team or have not previously participated in a merger and acquisition process may underestimate the rigors and complexity of due diligence, as well as overlook a potential buyer’s concerns. As market multiples (the revenue to arrive at purchase price as contemplated by the prospective purchaser) have escalated and sellers expect to maximize return on investment, potential buyers seek to reduce the risk of making a bad investment decision, and thus, carefully analyze their targets.
The typical sell-side diligence should focus on those matters most likely to be of concern to the buyer. The procedures performed should focus on, but not be limited to:
- Quality of earnings analysis related to historical reported results including identification of non-recurring and normalization adjustments to reflect “adjusted” operating income of the business and for businesses which have not been audited, identification and quantification of accounting policies that deviate from generally accepted accounting principles;
- Identification of the impact of natural business cycle seasonality on operating income and working capital;
- Analysis of sales, identifying significant concentrations at a product and customer level, as well as year over year sales trend analysis showing impacts of new products and customers, discontinued products/lost customers and ongoing sales (product and customers);
- Key vendor relationships and third parties who market or distribute goods and services;
- Potential tax exposures related to state nexus matters (income and sales), documentation of transfer pricing policies, and support for the compensation of individuals as independent contractors vs. employees;
- Support for reasonableness of current year projections, with a particular focus on ability to achieve revenues based upon year to date actual, contracted business, sales pipeline and prospects, product introductions and discontinuance. Analysis of attainment of prior years’ projections and pacing of prior year monthly actuals compared to current year’s monthly projections;
- Cash flow historical and projected, identifying capital expenditures made and future required expenditures particularly for IT hardware, software and security;
- Impact of contractual commitments, including assignability, length of remaining commitment, and financial terms;
- Quantify impact of shared services when only a portion of a business is being sold.
The benefits of sell-side diligence include:
- Avoids surprises with the identification of potential concerns that could be raised by buyers and ability to provide well thought out and candid responses. In addition, this can provide an opportunity to consult with advisors in advance on potential downward price pressures which could result in changes in deal structure (fixed price vs. reduced price with an earn-out) or matters that could impact closing funds held in escrow ;
- Shortens the time between execution of letter of intent and date of sale signing/closing;
- Reduces time spent on satisfying information requests and questions raised by prospective purchasers, thus also reducing the distraction from managing the business during the sell-side diligence process;
- Opens a discussion on positive adjustments to operating income and thus a potential upside in price; purchasers focus on negative adjustments;
- Provides the opportunity to provide more detailed information to prospective interested parties as well as improving their “confidence” in the quality of data supplied. This could potentially stimulate more parties to actually submit bids in an auction process as well as potentially raise the price.
Selling a business is time-consuming and can be emotionally charged. Preparing properly can avoid the disappointment associated with either a reduced price or a blown deal. Mazars’ approach in providing sell-side diligence draws upon considering the buyer’s perspective and using a multi-disciplined transaction service team including industry, tax, IT and employee benefit expertise.
Please contact your Mazars USA LLP professional for additional information.