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M&As: Seal the Deal with Vendor Due Diligence

19/10/2015


Acquisition due diligence has long been an expected and valuable information-gathering process for purchasers investigating a planned acquisition. Vendor due diligence on the other hand, is a relatively recent newcomer to the negotiating table, yet it is already exerting a strong influence on the ability to successfully close sales transactions.

​With complexity the norm in today’s business, regulatory and accounting environments, acquiring an understanding of the risks of a deal has become intensely challenging. Banks, private equity investors and other lenders and purchasers are therefore more focused than ever on evaluating prospective acquisitions for potential future problems and liabilities.

Defensive Due Diligence has Become Mainstream

With an increased focus on understanding the full business picture on both sides of the table, vendor due diligence is becoming more mainstream among mergers and acquisitions. Also referred to as defensive due diligence, it is a systematic review of the current state of the business a vendor proposes to sell. The vendor commissions this review prior to preparing sales materials. By presenting all material information in order to facilitate a focused and efficient transaction, vendor due diligence aims to pre-empt the discovery of deal-breaking issues, assists in sustaining value from the Letter of Intent up to closing and helps to reduce the time involved in the transaction process.

"Defensive due diligence identifies gaps that a prospective purchaser would find when evaluating an M&A transaction," says Aleem Bandali, MBA, Senior Vice President & Director, Corporate Finance in MNP's Vancouver office. "The more gaps a purchaser finds, the more it will discount the company’s enterprise value. But if the seller finds and addresses these gaps before the purchaser does, the vendor is able to present a significantly more appealing investment."

Defensive due diligence is intended to provide a balanced analysis of a company, its market, competitive environment and future prospects in order to anticipate questions, alleviate concerns and facilitate a speedy and successful transaction. This review also informs the seller of any issues that could be problematic in negotiating a sale, thereby providing an opportunity to build enterprise value before entering into discussions with potential buyers. In fact, vendors gain the following advantages by initiating due diligence prior to launching the sales process:

  • Control over the sale process – by addressing any serious issues that could derail a deal
  • Credibility for facts and figures – by providing a thorough analysis
  • Ability to focus on running the business – saves management time and resources by eliminating duplication of responses to questions from multiple potential buyers
  • Enhanced company productivity and profitability – by identifying solutions that optimize business performance
  • Reduced risk of bid withdrawals and price chipping – by addressing issues that may concern potential purchasers
  • Facilitate acquisition financing needed to close the deal – by providing lenders with clearer insight into the business

The Benefit of a Review

Ultimately, this type of review supports a higher sales price. "One of our clients commissioned a due diligence review a year prior to presenting the company to the marketplace," says John Caggianiello, CPA, CA, Senior Vice President & Director, Transaction Advisory Services, who is based in MNP’s Toronto office. "Our professionals estimated the current value of the business at $25-$30 million. They also estimated the potential sale value at $35-40 million – provided the owner addressed certain aggressive tax and accounting transactions with significant risk of tax reassessment as well as incomplete financial procedures they believed would raise red flags among potential purchasers." The owner adopted the recommendations and "within months, the operation was turnkey for potential purchasers," says John. "The sale was completed soon afterward and the vendor realized $10 million in additional enterprise value above the original sale estimate."

The process of conducting due diligence, which typically takes two to four weeks, is customized to the needs of the seller, the proposed transaction and the size and scope of the business. "Relying on our experience with hundreds of transactions, our professionals use a knowledgeable, risk-based approach to identify and focus on the issues that are critical to the proposed transaction," says John. "This approach facilitates a targeted, efficient and cost-effective review."

The end result is a detailed report that provides interested buyers and lenders with a clear, comprehensive picture of the business, which they can use to determine a fair price for their expected return on investment. From the vendor's perspective, this means a higher probability of closing the deal.

Vendor due diligence: the process

  • Discussions with management to understand the business and the vendor's needs and expectations
  • Identify critical issues and risks related to the proposed transaction
  • Agree on terms of reference
  • Observe operating practices at the facilities
  • Request relevant documents such as those related to: corporate, employees, financials, sales and accounts receivable, purchases and accounts payable, taxes, inventory, fixed assets, debt
  • Review revenue and expense cycles and transaction flows
  • Interview individuals involved in transactions
  • Investigate critical success factors such as those related to financials, earnings, taxes, operations, environmental, legal, information technology
  • Review and analyze data and conduct tests to verify information
  • Prepare report with findings related to all factors relevant to the transaction, such as financial highlights, any material issues and analyses of operations, EBIDTA, cash flow, balance sheet
  • Provide management with an opinion related to the risks and implications for the deal, plus strategy recommendations as necessary
  • Respond to queries from parties involved
  • Update report as needed until transaction is finalized

A Proactive Approach Saves You Time and Money​​

​​Within today's M&A marketplace there are an increasing number of international purchasers and investors, and they often present letters of intent with high valuation multiples. John cautions, ​"​It's important to understand that in many competitive auction processes, potential buyers are putting forward offers that assume a ‘perfect’ business in order to win the auction process and get the vendor under exclusive terms. After a prospective purchaser begins its own due diligence, the offer typically falls in value and the transaction can stall or even stop because of 'surprises' that arise and for which the seller is unprepared."

In contrast, when the vendor initiates due diligence at an earlier stage, the seller is able to view the company from the perspective of a third party. This prepares the vendor with an understanding of potentially problematic issues, what can be done to address these challenges and what price range is reasonable to expect.

If you are contemplating the sale of your business at some point in the future, consider undertaking defensive due diligence early. "Ideally one to two years prior to starting the sales process," suggests Aleem Bandali. "This will allow time to address any problems, undertake appropriate structuring and tax planning and to plan the optimal timing to take your business to market." Moreover, early vendor due diligence will increase the probability of hearing those golden words, "You've got a deal!"

For more information on this topic or other business due diligence questions, contact John Caggianiello, CPA, CA, 416. 513.4177, [email protected] ​or Aleem Bandali, MBA, JD, 778.374.2140, [email protected]​ or your local MNP Advisor.