In the world of mergers and acquisitions (M&A), the process of financial due diligence is an essential step in evaluating the value, risks and potential of a target company. While much emphasis is often placed on the buyer's side of due diligence, the role of the seller in preparing for this process is equally critical. In fact, proactive seller preparation can not only streamline the due diligence process and enhance transparency; it can also add tangible value through presentation of the company’s earnings and growth potential, and through efficient tax planning.

UNDERSTANDING THE DYNAMICS OF DUE DILIGENCE

In an M&A transaction, due diligence is the comprehensive investigation to evaluate the target company's financial, legal, tax, operational and strategic environment.

It is an in-depth examination aimed at identifying risks, understanding and validating the business model and earnings profile and other factors that may impact a proposed valuation.

THE SELLER'S ROLE IN PREPARATION

While a buyer will always conduct their own due diligence process, sellers who take proactive steps to prepare can significantly influence outcomes. There are several reasons why seller preparation is of huge importance:

Value Optimization: Seller preparation is not just about minimizing risks and preparing for questions, it is also about maximizing value. By presenting the company and its earnings in the most favorable light, sellers can showcase their strengths, growth prospects and competitive advantages. This can lead to increased value in the eyes of potential buyers. In particular, earnings adjustments can often be included, which take out the privately held nature of many owners' income statements and reflect the business potential in a buyer's hands (see Quality of Earnings below).

Streamlined Process: Thorough preparation allows sellers to organize their financial records and other pertinent documents in advance. This includes ensuring that financial information is accurate and up to date, and that supporting data is readily available with pre-emptive commentary to provide clarity and insight. As a result, the financial due diligence process becomes more streamlined, saving time and minimizing disruptions to management and daily operations.

Identification of Issues: Conducting internal reviews prior to engaging in due diligence enables sellers to identify and address potential issues or discrepancies. Any such items can then be resolved and/or disclosed upfront, prior to having to negotiate them with a buyer. This process also allows the seller to assess whether they have the appropriate team in place (e.g., CFO, controller, accounting staff) to support the end-to-end transaction process and the ability to continue to operate the businesses effectively under new ownership.

Enhanced Transparency: By proactively preparing for due diligence, sellers demonstrate transparency and a commitment to facilitating a smooth transaction. This openness can instill trust between the parties involved and set a positive tone for negotiations.

HOW SELLERS CAN PREPARE

To demonstrate a strong data environment and an informed management team to buyers, a seller should understand and be able to discuss their key performance metrics and the associated impact on earnings. This includes revenue growth, profitability and customer-specific profiles such as size, margin, churn and opportunity as well as channels, competition, unit economics and other company-specific metrics.

Pre-emptive seller diligence enhances the company's ability to articulate these competitive advantages and growth drivers, which can be highly valuable to buyers during a deal process.

Pre-emptive seller diligence enhances the company's ability to articulate these competitive advantages and growth drivers, which can be highly valuable to buyers during a deal process.

Quality of Earnings: Many of the metrics mentioned above can be uncovered through a sell-side quality of earnings (QofE) analysis. Conducting a QofE before selling a business arms the seller with several advantages:

1. A QofE focuses on EBITDA, one of the most important drivers of value, as well as other performance indicators. EBITDA is not a simple calculation, and adjustments are made for historical items that may not be relevant to a prospective buyer or items that have a background that requires explanation and interpretation that is not otherwise evident. These EBITDA adjustments can significantly increase the value of a business given the importance of EBITDA and the multiples placed on them in private company valuations. For example, the privately held nature of many businesses often distorts the true underlying earnings of the company.
2. A QofE provides a comprehensive understanding of the company's financial performance that allows sellers to identify and address any discrepancies or anomalies that may arise during due diligence. By proactively addressing these issues before a potential buyer performs their own diligence, sellers can enhance transparency and credibility, instill confidence in potential buyers and ultimately maximize the value of their business. For example, if the company’s financial statements are not maintained on a GAAP accrual basis, then there may be uncertainty from buyers as to the “true” earnings. Whereas a QofE will address this and present earnings on a GAAP basis upfront.
3. A thorough QofE analysis enables sellers to present their financial information in a clear, organized manner, which facilitates smoother negotiations and expedites the transaction process. It helps sellers anticipate and prepare for the types of questions and concerns that buyers may raise and enables sellers to provide informed answers and mitigate any potential obstacles to closing the deal.

Investing time and resources into a sell-side QofE analysis can significantly enhance the likelihood of a successful and value-added sale of the business and serve as a strategic mechanism to shield management from the intense scrutiny during buyer diligence — GHJ’s philosophy is to support the company beyond the QofE and to assist all the way through counterparty diligence, through to a successful closing.

Tax Considerations: Effective tax structuring allows sellers to optimize the transaction's tax structure, which potentially reduces tax liabilities and enhances after-tax proceeds and sets the stage so after-tax proceeds can be efficiently used depending on the individual’s goals. Whether through entity restructuring, tax-efficient structures or other tax deferral strategies, thoughtful tax planning can significantly impact the overall economics of the transaction for sellers. Ultimately, pre-emptive tax structuring and modeling empowers sellers to navigate the complexities of M&A transactions with confidence and ensure that they maximize value and minimize tax exposure throughout the process.

M&A Experience in Professional Advisors: Given the complexities surrounding M&A, sellers should consider engaging professional advisors who specialize in mergers and acquisitions to guide them through the due diligence process. Advisors who specialize in M&A can provide market commentary, foresee risks and provide solutions to guide clients through the intense process involved in selling a company.

To learn more about how sellers can prepare for a merger or acquisition, please contact GHJ’s Transaction Advisory Services Practice.