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The Fundamentals of Sell-Side Due Diligence

Posted by John Nicklas on Sep 16, 2021 10:00:00 AM

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This lite paper addresses how a business can conduct financial due diligence on itself, with an eye on understanding and enhancing value to prospective buyers. It is designed to be a general overview of the sell-side due diligence process. We recommend that you conduct further evaluation, with a professional advisor, to apply these concepts to the specific circumstances of your company.

What is sell-side due diligence?

“Due diligence” typically describes a series of examinations undertaken by a potential buyer of a company to clearly and objectively evaluate its target’s financial position and operational health.

Sellers, however, are becoming increasingly aware of the value of similarly evaluating their own companies before giving buyers the chance.

When commissioned early in the sale process, or even years before an owner is ready to sell, this practice of “sell-side due diligence” gives sellers a critical, introspective look at their own company, and the opportunity to make value-enhancing adjustments.

Sell-side due diligence allows a seller to assess the organization’s financial position as well as any factors that buyers may see as risks, prior to sale. It objectively analyzes the quality of the company’s historical earnings, the reasonableness of forecast assumptions, the quality of assets and working capital requirements, tax positioning and various operational aspects of the company, such as customer and vendor relationships.

Sellers have found that sell-side due diligence can reduce the risk of the M&A process.

It helps the seller to prepare, mitigate and even avoid potential issues that can arise in the sale process. Ideally, the examination will be an eye-opener revealing more than one value-enhancement opportunity. When conducted far enough ahead of sale, owners can leverage such opportunities – and of course correct or modify any identified concerns – prior to their planned exit.

How does a company conduct sell-side due diligence?

In sell-side due diligence, the seller turns the tables on typical M&A negotiations. The owner engages professional valuators and transaction specialists from a CPA firm to perform due diligence on its business in the same manner as if they were representing a prospective buyer evaluating the company as an acquisition target.

This gives owners the same information that a buyer would expect to see in a buy-side due diligence report.

It should include quality of earnings and related revenue – profitability, and cash flow analysis; analysis of the organization’s balance sheet, including analysis of working capital requirements and indebtedness; identification of related parties, contingent and off-balance sheet liabilities; overviews of significant accounting policies, controls, and financial management processes; and evaluation of tax compliance and potential exposure.

When a CPA firm performs sell-side due diligence it is not an attest function. The report presents findings and recommendations that the seller can act on but doesn’t issue an opinion. Prospective buyers view reverse due diligence reports to be objective because the CPA firm does not have a stake in the transaction’s outcome.

Sellers are increasingly recognizing that being in the power position when it comes to sharing their financial information allows them to craft their value proposition to buyers.

Sell-side due diligence is becoming more common because it can diminish surprises, shine a light on hidden value, reduce the buyers’ negotiating power, and ease the transaction process.

It diminishes unwelcome surprises.

It’s common that owners may want to ignore a known company issue (and every company has some kind of issue), in the hopes a buyer just might not notice it. But the reality is that the buyer’s CPAs will leave nothing uncovered when they do their due diligence. And that means the seller will be in a defensive position – not a power position– when explaining any surprises uncovered by the buyer.

It’s counterintuitive to some but being transparent about any unfavorable company situation makes an owner more credible and trustworthy, and this goes a long way in the negotiation process. Conducting sell-side due diligence allows you to acknowledge - or even eliminate - an existing issue before the sale. This gives you strength in negotiating the transaction, and that often leads to greater value in the sale.

It can enhance value.

A buyer’s assessment of the value of your company will be based on both the quality of recurring earnings, and their perception of risk. Conducting sell-side due diligence will shine a light on how to improve both sides of the value equation.

No one knows your company better than you, the owner.

So when you engage a firm to conduct sell-side due diligence, you’ll have a unique perspective on the findings in the report, and may be able to resolve any issues before they are truly a problem. In fact, owners are commonly engaging sell-side due diligence services well before they are ready to exit, giving them time to move the needle on value before entering the sale process.

If they cannot fully resolve an issue, at least sellers can report to buyers that the necessary steps are already under way to rectify the situation. Even this small step can help sellers attain higher valuations.

By demonstrating that there are corrective action plans in place to mitigate risks, sellers increase their believability and legitimacy.

 This can make your company a more attractive target, improving your value in the market.

It strengthens bids.

If you have a variety of interested parties, a sell-side due diligence report can be shared with all of them, providing the information they need to be confident about your financials and operations. Buyers’ bids will then be based on a deeper knowledge about the significant matters of your company. That forces them to put all their cards on the table early, reducing their ability to further negotiate terms at a later date, when other prospective buyers have exited the process.

It facilitates a smoother transaction.

A sell-side due diligence report will include all the information that a buy-side due diligence report should contain, and that means that it will streamline the buyer’s own examination.

Once a letter of intent is in place, the potential buyer will still want to conduct its own due diligence. But rather than the buyer’s due diligence exercise being a nail biting, cross-your-fingers-they-don’t-uncover-a-surprise experience, as it often can be for sellers, the buyer’s analysis will become akin to a mere technicality.

Conducting sell-side due diligences is a smart investment.

By introspectively taking a good, hard look at your company the way a buyer would, sellers can enhance deal value and improve negotiations. This is particularly true because a sell-side due diligence report can move you from the defensive position to the power position at the negotiating table. Sell-side due diligence enables sellers and their advisers to identify value, minimize uncertainty and speed the transaction process.

Please contact me if you have any questions.

Topics: Talent and Leadership Development Resource, Strategic Leadership

John Nicklas

John Nicklas

John Nicklas is a Vice President of the Assurance Service Group. He has 20+ years of experience serving accounting and business advisory needs.

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