Article

Vendor and reverse due diligence: Opportunities and advantages

Preparing your business for sale

Once a business owner has made the decision to exit their business, they should treat that decision just like any other strategic initiative. They need to identify concrete goals and objectives, outline the strategy designed to meet those goals and objectives, and implement the various tactics that are needed to support the strategy.

In addition to the obvious issues of identifying the goals, such as what is the acceptable purchase price and structure, legacy issues, care of loyal employees, etc., the seller needs to identify his internal and external support team and objectively assess the current condition of the company. Unfortunately, this last issue is frequently overlooked and without question weakens the seller’s negotiation position, which could cost them in terms of a favorable price and structure. However, ownership can address the issue of preparedness though reverse or vendor due diligence, that is, having a third party assess the company the same way a buyer would, prior to taking the company to market. The difference between vendor due diligence and reverse due diligence is that in vendor due diligence the results are presented in a report that is provided to prospective buyers where in reverse due diligence the results are kept confidential by the seller.

A comprehensive vendor or reverse due diligence will include a quality of earnings, quality of assets, tax due diligence, commercial due diligence (especially if the future revenue stream of the company is critical to the sale), and operational (if the operations are proprietary or otherwise critical to the value of the company). This will allow the seller to prepare for the issues that frequently arise in the sale process. While this article discusses the advantages of vendor and reverse due diligence related to preparation for a near-term sale of a business, due diligence could also be performed well ahead of a sale process to provide owners the appropriate amount of time to correct or modify any identified concerns prior to an exit.

Vendor or reverse due diligence provides the following advantages to the seller and their investment banker.

  • Provides the seller an opportunity to fully explain issues or circumstances that could be perceived as flaws of the company by prospective buyers
  • Assists the seller in preparing for the questions and document requests that are invariably part of the buyers vetting of the company
  • By identifying potential deal issues for the investment banker, the seller’s representation can anticipate buyers questions and concerns and develop the appropriate negotiation strategies
  • Provides the investment banker with now vetted data to include in a Confidential Memorandum (and data room), which can assist keeping any "re-trading" to a minimum
  • Minimizes the potential for surprises from the buyer’s due diligence

There are additional benefits of vendor due diligence.

  • By answering many of the questions or concerns that a buyer might have, a vendor due diligence can keep a prospective purchaser in the process longer and extend the "competitive tension" thus helping the investment banker maximize the price and structure for the seller
  • If the vendor due diligence is comprehensive enough, it can help minimize the exclusivity period as the buyer need only roll forward the data required to validate their investment thesis

A seller should consider utilizing vendor or reverse due diligence in the following circumstances:

  • When the seller’s systems are less sophisticated or cumbersome making it difficult or time consuming to extract the required data and documents
  • In a complex transactions such as a "carve-out" where identifying the operations economic earnings may be difficult due to shared costs, pro-forma standalone costs, etc.
  • When there is a lack of seller resources to properly prepare for sale
  • The seller is not audited, leaving the company vulnerable to potentially complex accounting issues such as appropriate revenue recognition

The following examples highlight some of the benefits of a vendor due diligence.

Example 1

The seller had previously entered into a very complex tax advantaged financing structure—a New Markets Tax Credit (NMTC). The structure is unique and involves several parties, in this case a bank, the purchaser of the credit, the community development company, and the borrower (seller). Under the correct circumstances, NMTC can be a very effective financing tool. However, if the credit needs to be "unwound" as could be the case in the sale of the company, there would be unanticipated penalties, fees, interest, and legal costs. In this case, it would be in the interests of almost any buyer to continue the complex structure, but first they would have to understand it. The vendor due diligence dedicated a section to this structure, the benefits, risks, and the inexpensive nature of the capital. By providing a complete and concise explanation of the NTMC, prospective buyers were not scared away by the complexity, and did not dismiss the structure but instead embraced it, which avoided the costs that would have fallen to the seller to satisfy.

Example 2

The client was just beginning to recover from a very difficult period. Management needed to re-capitalize the business but recognized several issues needed to be addressed up front to solicit prospective lenders/investors. Many one-time and non-recurring expenses needed to be validated to demonstrate the sustainability of the company’s cash flows. In addition, the complex nature of the company’s operations required an equally complex revenue recognition policy to comply with generally accepted accounting principles in the United States of America (US GAAP). The vendor due diligence helped to substantiate both issues. However, the vendor due diligence also uncovered an additional debt-like item that would have undoubtedly been a difficult point of negotiation. By identifying the issue in the vendor due diligence, the borrower was able to get out in front of it and was prepared to present explanations for the liability. This expedited the process that would have otherwise dragged on.

The vendor or reverse due diligence process can add a substantial amount of value to the sale process. Business owners contemplating the sale of their business should consider one of these services as a first step toward a successful transaction.