Why sell-side due diligence is a win-win
The issues that are uncovered during a sell-side due diligence process, from concerns with financial controls to reporting differences from U.S. GAAP and tax compliance risks, are likely to be the same issues that are uncovered by buyers during a sale process. Waiting until buy-side teams uncover these issues can lead to purchase price adjustments, delays in timing, unwanted stress on leadership teams, and possibly a failed transaction. Identifying potential areas of risk prior to going to market can, in many cases, give you time to remediate the issue or position it in the best possible light as solvable — before there’s a deal on the table.
For the seller, sell-side due diligence provides an accurate idea of the business’s true cash flows on a normalized basis. That credible metric for valuation helps establish trust with the buyer and prospective lenders. Sell-side diligence also accelerates the buyer’s diligence process since the seller is prepared and already has an independent, third-party presentation of the company’s financial performance and tax situation at the ready. The benefits add up to fewer delays and headaches and, often, an expedited close.
What’s involved in sell-side due diligence?
Sell-side due diligence can uncover details that directly impact business valuation in multiple areas: normalized quality of earnings, GAAP reporting of operating results and financial position, insights into revenue and margin growth opportunities, potential unrecorded liabilities, and tax exposure.
Sell-side diligence is useful in presenting the expected go-forward operations of a business to garner the best possible valuation and mitigate perceived exposure by buyers. The process has much more creative liberty than audited financial statements in presenting “normalized” earnings over a long-time horizon. This process can include showing the expected impact of pricing increases or cost reductions, depicting the financial impact of significant changes in operations, and projecting new products or customer arrangements, while eliminating the noise caused by non-recurring or personal expenses.
Buy side vs. sell side
In a transaction, due diligence relies on proof. It confirms the numbers, tests assumptions, and identifies risks that could alter value.
On the buy side, diligence is investigative. Equity sponsors and strategic buyers examine financial performance, operational stability, customer relationships, market position, and compliance records. The objective is to confirm that margins are consistent, that growth isn’t overly dependent on a similar client, and that no hidden liabilities will change the structure of the deal. In the middle market, this process often reveals vulnerabilities ties to customer concentration, undocumented processes, or family ownership dynamics.
On the sell side, diligence is anticipatory. Business owners and their advisors prepare by assembling reliable financial statements, documenting customer contracts, and resolving compliance issues before buyers begin their review. This preparation reduces the risk of late-stage renegotiation, advances the review process, and helps preserve valuation. Investment bankers frequently play a role in guiding the process to ensure the narrative of the business is both consistent and defensible.
Ultimately, buyers want to protect capital, and sellers want to protect valuation. The earlier both sides prepare for diligence, the smoother the transaction and the fewer surprises during negotiation.
One of the first major tasks in a sell-side diligence process is assessing how a company’s accounting policies and procedures compare to those that are required under U.S. GAAP. In nearly all situations, buyers will be required by their investors or financing sources to report financials on a fully accrual basis that is GAAP compliant, regardless of the buyer type. Given this requirement, as well as the complexities of ever-changing accounting guidelines, it’s worthwhile ensuring that the monthly financials that are shown to buyers have been analyzed and adjusted for potential GAAP-reporting risks. Some of the most common areas for adjustments include the timing of revenue recognition, improper cost accounting, and differences in monthly versus annual accounting processes. Addressing this before going to market could mitigate significant accounting adjustments during buy-side diligence that directly led to purchase price adjustments and transaction complexities.
An often overlooked benefit of a sell-side process is the chance to highlight strengths about your business that can lead to potential growth opportunities post-close while reinforcing your understanding of the drivers of performance. Buyers place a very strong emphasis on being able to understand the specifics of (1) what drives profit and (2) where the opportunities are to improve in the future. A full sell-side assessment can provide invaluable insight into the customers, products, or services that drive performance and tell the story of a business.
Working with a sell-side provider can often lead to uncovering potential liabilities that lead to reducing value in a transaction negotiation. Some of the most common liabilities that are often unreported on a company’s financials include warranty accruals, earned (but unpaid) employee benefits, and purchase commitments. Analyzing these exposure areas and presenting them in a sell-side deliverable to a buyer can often mitigate unexpected purchase price adjustments, either through working capital true-ups or removing potential debt-like items.
Ensuring federal, state, and local tax compliance under the ever-changing rules is increasingly difficult. The financial exposures and risks created by unreported taxes often lead to significant holdbacks and escrows in a transaction, as well as hefty penalties and interest if tax filings are required. Engaging a sell-side tax provider to assess a company’s tax exposure for improper filings or issues with tax elections could allow a company to address risks before it’s too late. Or, at a minimum, they could provide a roadmap to buyers to address the exposures moving forward.
Understanding the full picture puts sellers in a better position to maximize the value they’re going to get for the company. This holistic view is especially important when selling carve-outs or divisions of larger companies that may not have separately reported financial statements.
Start the process early
If you’re considering selling, begin the sell-side diligence process early — long before going to market. Think in terms of years, rather than months. Conducting sell-side due diligence early gives you valuable opportunities — not only to resolve issues that might give a prospective buyer pause, but also to learn the best ways to maximize the value of your investment.
Understanding which buyer types best align with your goals helps focus limited time, resources, and effort on areas that are most valued by them, ultimately increasing the potential purchase price. Building a qualified team of advisors is also critical in ensuring you have the proper representatives looking out for your best interests. These include an M&A attorney, investment banker, tax/estate planning and wealth advisor, in addition to the sell-side diligence team.
