Forward thinking

In today's challenging economic environment, companies attempting to attract and retain qualified buyers must anticipate the buyer's due diligence. Credit markets have tightened dramatically, and, in turn, transactions are subject to heightened scrutiny. If a seller's accounting and reporting capabilities are not positioned to withstand rigorous buy-side due diligence, the likelihood of successfully executing the transaction drops significantly. Performing sell-side due diligence in advance, however, can help reduce the risk of unwelcome surprises that could derail a deal.

Unfortunately, sellers often are unprepared and lack the resources to address critical transaction pressures. A report, prepared by the seller's accounting staff, on the company's financial results is not sufficient. The key financial issues affecting the quality of those results must be addressed thoroughly to promote confidence that the report represents the company's ongoing operations.

But many owner-operator companies, for example, do not have an adequate financial and accounting infrastructure to produce the information a buyer expects. A lean accounting staff that typically focuses on daily operations and the year-end close might have trouble providing reconciled, pro forma financial information for interim periods and the most recent trailing 12 months. Buyers also require analyses of the quality of assets and earnings, pro forma monthly working capital levels, comparative income-statement trends, business issues, commitments and contingencies and other accounting issues. Smaller companies might not track this data routinely.

Similarly, larger public companies might not regularly produce standalone financial statements for subsidiaries or divisions that aren't material to the company's performance. In carve-out situations, though, the buyer requires detailed financial analyses of the entity for sale. If standalone financial statements are not audited separately or do not exist, due diligence can become more complicated on both sides.

When financial reporting issues arise today, they create bigger hurdles to completing the transaction than in the past. Private equity groups are under increasing pressure to improve investment decisions. Buyers are very willing to delay or walk away from deals.

Even when buyers remain interested despite financial reporting issues, they must deal with the realities of the contracted credit markets' limited options and terms. A slightly material change in the earnings the seller originally reported may in the past have prompted the buyer to renegotiate. Today that change could blow up the deal.

Sellers can counter such risks by engaging independent accountants to conduct sell-side due diligence, taking a proactive approach that seeks to mitigate issues related to the accounting due diligence. Few sellers actually engage a firm to perform due diligence in advance, instead leaving the buyer to take charge; however, providing buyers and lenders a comprehensive due diligence report in addition to the offering memorandums inspires confidence in the financial results.

Performing due diligence up front also empowers sellers and their investment bankers to seize control of any deal issues related to the accounting due diligence. Generally, when such issues are communicated early on, they prove easier to resolve, thereby facilitating a smoother transaction process. Further, sell-side due diligence could identify positive Ebitda adjustments and other factors that might drive up the price.

Sell-side due diligence is especially useful in multiple-bid scenarios where sellers prefer to avoid multiple potential buyers performing a full-scope due diligence. A seller can limit the due diligence period by providing a single report to each bidder. When a company has no audited historical or clean interim financial statements, a sell-side due diligence report allows the seller to provide a substitute deliverable to potential buyers and their lenders. In carve-out situations, a due diligence report can address typical risks and concerns that a buyer might have used to leverage valuation if they had not been communicated up front.

Performing sell-side due diligence can be a cost-effective approach to mitigating potential issues, controlling the transaction timing and sale process, and generating confidence in the financial results and sustainability of earnings. Making this proactive investment up front may well produce an easier process and a higher purchase price.

Michael Lux is a partner with Crowe Horwath LLP in the Chicago office. Barret Bloenk is a senior manager in the Grand Rapids, Mich., office.