Sell-Side Due Diligence

Why Now More Than Ever

by Terry Stidham, President of Target Search Group

Many sellers are told not to worry about doing their own due diligence because the buyer will be doing it instead. This can be a big and costly mistake. The right time to identify problems or issues to be addressed is before going to market.  Sell-side due diligence is best described as a self assessment of a seller’s own financial position plus anything else deemed material to the sale. It enables sellers to proactively identify matters impacting value, negotiating leverage and speed to close, while minimizing uncertainty in the sale process.   Note that sellers should also perform a level of due diligence on potential buyers to confirm their ability to purchase, as well as other items that could affect the purchased business or the seller after the sale.  I have seen many sellers spend a tremendous amount of time and emotional energy in what was thought to be a deal, to only find out that the buyer could not even buy a cup of coffee. There are other times where the "buyer" has no intention of buying but is only there to gather intelligence on the seller's business. At it's simplest level, sell-side due diligence is identical to buy-side due diligence; it’s just performed earlier in the sale process.  None of this is new to the sophisticated investment banking professional, who realizes sell-side due diligence can play a critical role in maximizing value from a deal.   Exit activity is expected to be robust in the near term and private equity groups have a large backlog of portfolio companies that are well past the typical three to five year hold time according to PitchBook.  A look at today’s deal environment emphasizes why sell-side due diligence is more important than ever:  Dry Powder – PitchBook reports that in 2012, 47% of all exits were secondary, private equity to private equity buyouts.  Three years ago, that figure was 25%.  This trend will be exacerbated by the current capital overhang from vintage 2007 and 2008 private equity funds.  These funds are reaching the end of their investment mandate, so investors may lose access to these funds after this year.  The incentive for private equity firms is to put this money (dry powder) to work.   Buyer Due Diligence Intensifies – Serial buyers are putting more capital to work in each deal as valuations are being pushed upward. They are not only accepting potentially lower returns but an equal or higher risk that a problem overlooked could become a much larger one.  An issue viewed as insignificant a year ago can delay or derail a deal today.  Buyer reaction is to intensify their due diligence, focusing harder on historical earnings (searching for negotiating leverage), forecast assumptions, working capital trends and operational drivers of the target company.  Return on Investment – Sell-side due diligence can uncover positive findings that improve the seller's financial results.  An EBITDA adjustment of $100,000 could increase purchase price by $700,000 (assuming a 7x EBITDA multiple as the purchase price). The buyers might discover the adjustment in their discovery but it is up to the seller to let them know that they know. Mutually Beneficial – Historically, a sell-side due diligence project culminates in a written report that can be provided to a select number of prospective buyers. Today, potential buyers are asking for more.  In addition to validating adjusted EBITDA (quality of earnings) and analyzing working capital trends, management teams need a partner to assist them in compiling and presenting data room materials, analyzing historical operating performance, creating/validating assumptions used in a forecast and defending information offered to prospective buyers. Sellers, management teams, investment bankers and buyers all benefit from sell-side due diligence. Contact Us To Discuss Your Next Steps If you have a quality business to sell, now may be the time to sell it.  The general consensus on the street is that there is too much capital chasing too few deals. The easiest way to jeopardize a deal is to raise concerns about the reliability of financial information, operating performance and forecast assumptions presented by the seller. Maximize returns, minimize uncertainty and improve your chances for completing a deal by doing sell-side due diligence.

What Is A Letter Of Intent and Why Do You Need It?

Letter of Intent

In mergers & acquisitions, a Letter of Intent (LOI) is a very vital document because, when it is signed, it spells out the preliminary agreement between a buyer and a seller. Simply stated, a LOI is a nonbinding document that outlines the key business terms the parties have agreed to, which will later become the basis for and part of the Definitive Purchase Agreement and other agreements and documents that memorialize a business sale. Letters of Intent vary in length and specificity. Sometimes they are called term sheets, but no matter what they are called, Letters of Intent should spell out the major deal points, deliverables, timelines and contingencies that become the basis for the legally binding agreements.

A LOI serves many purposes besides documenting the business deal, including the following:

• Serving as a record of the progress of the initial negotiations
• Identifying items that need resolution in order to reach a preliminary agreement prior to due diligence
• Defining (often) a “no shop” provision or standstill period during which the seller is precluded from negotiating with other parties
• Minimizing the waste of time and money by both parties, because if they cannot reach agreement on the key terms and conditions of the transaction in the letter, there is almost zero probability of negotiating the other definitive documents
• Acting as the basis for the buyer obtaining financing from a lender
• Defining time frames and deadlines so that the transaction can move toward a closing in a predictable manner, even though delays and extensions are common in merger & acquisition transactions due to the need for third-party consents, renegotiation of terms, the magnitude of work involved in gathering due diligence materials and supporting schedule information for the definitive agreement, or for other reasons

At a minimum, a LOI should address the following three items so that there is no misunderstanding between the buyer and seller at a later date:

  1. The Parties to and the Type of Transaction

These should be spelled out clearly. Who is the buyer? Who is the seller? What is the form of purchase (Asset, Stock, Recapitalization, Merger, etc.)? What is being purchased and what is being excluded (are all assets, liabilities and debts part of the purchase, or are specific assets, liabilities and debts part of the purchase)? How are these assets, liabilities and debts defined (cash; accounts receivable; inventory; furniture; machinery; customer and employee lists; seller's right, title and interest in the office lease and other contracts; trade names and trademarks; accounts payable; accrued payroll and payroll taxes; and capital lease obligations)? Which party is responsible for paying off bank loans?

What is the total purchase price? How much will be paid at closing? What is the method of payment (cash, the buyer’s stock, note, stock options, earn-out)? If other than cash or stock payable at closing, when and how will the other payments be made? Will part of the purchase price be retained by the buyer to secure representations, warranties and indemnifications? If so, how much and for how long? If the purchase price is adjustable based on finalized earnings or balance sheet deliverables (e.g., working capital peg), how will any adjustment be calculated?

  2. Employment

What is the agreement between the parties as to if and how long the seller will be employed by the buyer? What will be the initial salary, bonus, benefits, vacation days, etc.? If there is to be a bonus, how will it be determined? Will the salary be guaranteed? Are there termination obligations as far as salary continuation and benefits? What are the terms of the noncompete agreement?

  3. Transaction Contingencies and Conditions

Must the seller meet any thresholds to receive the purchase price? Is the transaction subject to the satisfactory completion of due diligence? How will due diligence be scheduled? Is there an “adverse change in the business condition” clause? What is the outside date for execution of the Purchase Agreement and closing? What information is to be considered confidential? Is the transaction subject to board of directors or lender approval? Is approval required by a legislative body? Is there an exclusivity period? If there is to be a press release, when will it be issued, and will what is said be subject to mutual agreement? Who will be responsible for the various costs of completing the transaction, including any audit, brokerage or consulting fees? How will the purchase price be allocated so that each party can understand the tax ramifications of the transaction? Is there an exclusivity period? Can the LOI be extended if deadlines are not met?

It is important to address all the above-mentioned issues so that there is true understanding between the parties prior to initiation of due diligence and the drafting of the Definitive Agreements, and so that the transaction has the maximum probability of being successfully completed with the minimum of misunderstanding and renegotiation between the parties.