By Matt Bartholomew

As we continue through a mature stage of this economic boom, sellers are entering the market to ensure their company can attain a perceived value while buyers are increasingly methodical and careful. A critical step to provide validity and credibility to the historical performance of these businesses is sell-side due diligence. It has become increasingly popular as a key component of a structured, well-run sales process. The overarching purposes of sell-side financial due diligence include:

  • Buyers, and the internal or external diligence teams, gain confidence in the financial data (i.e. EBITDA, cash flows, balance sheets, etc.) which these buyers use to form a view on valuation
  • The perceived risk of surprises during buyer due diligence is greatly reduced
  • There is a higher likelihood of increased speed and certainty of the contemplated transaction closing

What is sell-side diligence and why should I consider yet another workstream?
Often referred to as ‘Sell-side Quality of Earnings’, this consists of a seller engaging an independent third-party (usually an accounting firm with professionals specializing in transactions) in order to undergo rigorous due diligence analyzing the business as if it were from a buyer’s perspective. The goal is to explain the “story” of the business through the financial results. These analyses and conclusions are put into a user-friendly report that can be shared with potential buyers, designed to share the strengths and opportunities as well as deal-closing, negotiating points.

Akin to a high-quality buy-side financial due diligence report, a worthwhile sell-side due diligence report should cover a range of valuation related topics, including: (i) A Quality of Earnings analysis, (ii) Net working capital trends, adjustments and considerations and (iii) an analysis of debt and debt-like items that may or may not be on the business’ balance sheet.

The sell-side due diligence should also cover other areas to succinctly convey to potential buyers that are likely already familiar with the business; however, it affirms what they know about the business in a balanced, third-party report, including (i) customer concentration, (ii) product or project revenue and margin performance or (iii) key performance indicators that support telling the ‘story’ of the business in a succinct, supportable report.

What’s the upside here for the seller? Won’t buyers insist on their own due diligence process?
Credible value affirmation for the seller: Sell-side due diligence should be performed by a team of seasoned professionals who have the experience of preparing businesses for sale in a way that: (i) is credible for buyers, and (ii) optimizes the value for sellers. As an example, the identification, analysis and detailed presentation of quality of earnings adjustments (“add-backs”) to historical reported financials may increase the EBITDA. Since buyers use EBITDA as the basis for their valuation of the business, these actions could unlock value for the seller.

Reducing surprises for buyers: Potential issues should be identified and proactively addressed before investment bankers launch the sale process. This minimizes surprises during buyer due diligence and, in doing so, significantly reduces a buyer’s ability to seek price discounts during the sale negotiation process.

Expediting the sale process: One goal of sell-side due diligence is for potential buyers to read the sell-side report and be left with a few areas of focus for their own due diligence. This shortens the time that buyers are “in the business”. The buyer derives confidence in the quality of earnings from the quality of the report and in the solid responses in interviews with its authors and management.

‘Dry’ diligence run: The sell-side process allows management to be better prepared to address the buyer’s diligence questions related to the financial performance of the business.

Signaling to buyers: Buyers view this kind of preparation by the seller as allowing a potential buyer a clearer path to better understand the financial performance of a business before starting to incur its own buy-side financial due diligence costs.

Isn’t it duplicative if we already have an audit?
Audited financials do not reflect “deal financials”. It is the deal financials upon which buyers base their valuation. If a seller merely shares GAAP basis financial information with a buyer, the seller is likely to experience a significant loss of value from not conveying the “noise” that doesn’t properly convey the business being sold.

Investment bankers are hired, so is this necessary?
A quality sell-side due diligence report supports the sales process the investment bankers are managing. Sell-side financial due diligence reporting bridges the gap between the deal financials included in the Information Memorandum and the financial records of the business. Sell-side financial due diligence builds this bridge in a credible and objective manner; it should not be seen as a replacement for the Information Memorandum. Rather, sell-side due diligence is quality support for the Information Memorandum and complementary to it.

About Matt Bartholomew
Matt is a Managing Director and leads BDO’s Transaction Advisory team in Utah with over 10 years of deal experience, including Quality of Earnings processes as well as net working capital and purchase agreement negotiations pertaining to financial and tax matters.