While M&A transactions can be daunting tasks for both buyers and sellers, generally the management of the seller (i.e., the “Target”) faces the most stressful phase of the process: the initial financial due diligence.
This phase can be challenging for three reasons:
- Potential transactions are often not disclosed outside of a select group of key executives, leaving accounting teams in the dark until the related due diligence is scheduled. Though those accountants will be responsible for preparing and providing most of the due diligence requests, they have no way to prepare beforehand.
- Timelines for diligence completion can be very tight.
- Except for larger entities with a dedicated M&A/Business Development team, companies do not generally have internal resources with prior M&A experience.
To make the experience a little less disruptive, let’s go over some insights and best practices for Target entities regarding the financial due diligence process.
First, let’s address some key high-level questions regarding the financial due diligence process.
1. What is the main deliverable produced during a financial due diligence process?
At a minimum, a financial due diligence report will discuss the Target’s:
- Quality of Earnings (Q of E)
- Net Working Capital
- Net Debt
- Analysis of Key Metrics (e.g., sales, gross margin, etc.)
However, the deliverable can vary depending on the scope of the transaction.
2. What type of information will be requested by the buyers?
Generally, due diligence teams will produce these reports from a review of pertinent financial records, starting with an analysis of detailed financial information. For example, they might look at monthly trial balance reports outlining account balances in relevant groupings, such as by business unit, product type, and geography. They’ll ask for the latest historical periods, generally three years’ worth, and the stub period of the current year. They will also likely meet with management to obtain an understanding of the Target’s financial accounting and reporting function, discuss unusual items and significant variances on account balances, and to get a better feel for the performance of the business, such as analyzing sales trends, costs, key products, personnel, suppliers and customers.
The information request list will include obvious transaction-related documents (e.g., Purchase/Sale Agreement), financial forecasts, supporting documentation for adjustments and assumptions, and support for certain balances. Some of the items they’ll request appear to be similar to those requested by auditors, but generally, the diligence team needs a greater level of detail. In most cases, requested items are provided through an online dataroom, ideally managed by the seller or a seller-representative, which can include investment bankers, third-party due diligence advisors, and internal project managers.
3. How long will the diligence process take?
The turnaround time for a diligence report is typically much shorter than an audit. It typically takes three to four weeks. However, in some cases (for example, where carve-outs are performed), the diligence period can last several months. In cases with multiple potential buyers, the process will be longer and generally divided into phases:
- Limited diligence will be allowed to a larger group.
- The top contenders (typically up to three) will continue due diligence.
- The selected bidder will complete the process.
Now let’s discuss critical best practices in sell-side due diligence for Target companies to consider and potential issues to watch out for.
Project Management and Communication
It is important that the buyer and seller side assign individuals as project managers for the due diligence process. The project manager could be an internal party like the CFO, Controller, VP-Finance, or an M&A Analyst; or it could be an outside party working for the Target, like an investment banker or Financial Due Diligence professional.
The project manager must have enough authority to warrant the attention of the Target’s management team, and s/he must be given unrestricted access to information. Also, keeping in mind the sensitive information that will be handled, it is a good idea to consider limiting your candidates to members of the executive team or trusted mid-level managers or outside consultants.
The Target determines the level of detail to be shared with the various potential buyers, and it usually does so based on the phase of diligence and credibility of the buyer’s interest in completing the transaction. In preparing financial/accounting analyses, always drill down into the lowest level of detail available, and always by month at a minimum, although daily/weekly level analyses are appropriate if relevant to the entity.
One of the greatest pitfalls in sell-side due diligence is having to re-perform analyses for each phase of the process and/or for multiple buyers. It is much easier to perform a highly detailed analysis from the beginning, with the content and format that will ultimately be provided to the winning bidder, and then edit it as necessary. As noted above, due diligence is typically performed at a more detailed level compared to an audit, so do not rely on your audit schedules or internal financial reporting packages unless they were prepared with enough granularity such that no further drill-downs can be performed.
Also, keep in mind system limitations do not always exempt a Target from providing requested information, so consider the availability of information outside of your accounting system. That information might come from sources like sales databases or operational reports.
Clarity and Support for Management Adjustments
A common frustration for due diligence teams is the generality of management’s adjustments, as it often results in buyer adjustments. Always produce supporting schedules for any historical or due diligence adjustments and provide backup for any assumptions. Consider engaging an outside advisor to produce or review a schedule of adjustments to ensure your rationale is sound and the calculated figure accurate.
It is common for Targets to have differences in historical information above and beyond those that may have a consequential accounting impact and may have already been adjusted for auditors or management. These can include new profit centers, departments, or business units; differences in reports due to system upgrades or conversions; and/or the use of multiple systems for different segments. In these cases, to the extent possible, schedules should be reconciled so that data provided is comparable.
Forward-looking information, such as budgets, forecasts, and other pro-forma data are often vague and can result in several follow up questions and adjustments that can have a significant impact on key financial metrics—and ultimately the transaction price. Solid support should be provided for all significant forecasts, particularly when they are not consistent with historical data and may be perceived as overly aggressive. In such cases, consider engaging an outside advisor to validate your forecasts and run-rate adjustments.
Quality matters in sell-side due diligence.
Financial due diligence is critical to the success of an M&A transaction, and particularly for a seller, experienced professionals and high-quality reports can have a significant impact on the final structure and price of the sale.
The above insights and guidance can help you and your accounting and finance teams prepare for what will undoubtedly be a stressful process—and possibly one of the most difficult projects of their careers. In the interest of everyone involved, you should always evaluate the experience, workload, and competence of your internal resources and consider involving outside consultants to supplement your team’s efforts. They can assist at various levels of involvement – from project management, to dataroom maintenance, to the preparation of a company data pack, and to the issuance of a full branded sell-side due diligence report.
If you’re interested in speaking to 8020 Consulting about a financial due diligence project, we’d love to talk. We have a deep bench of consultants at the ready, who can jump in to provide the M&A and due diligence support you need.
You can also download our sell-side due diligence decision tree to learn more about fielding diligence requests during the process:
About the Author
Jorge Lopez has over 18 years of finance and accounting experience across the real estate, financial services, consumer products, telecom and high-tech industries in both private and public companies. Jorge started his career with KPMG’s audit practice, where he progressed through the senior manager level before leaving to join one of his clients in a financial accounting and reporting oversight role. Most recently, Jorge was a Transaction Advisory Services Director at KPMG and PwC, where he advised companies on M&A transactions, providing sell-side and buy-side due diligence and pre/post transaction accounting support. Jorge has performed or overseen all accounting and financial reporting processes (including SEC filings), participated on several stages of acquisitions and divestitures, and tackled a host of complex technical accounting issues, including GAAP conversions. Jorge holds a BA in Accounting and Finance from the University of Texas at El Paso and is a CPA licensed in Texas and Florida.
Categorized in: M&A Due Diligence & Transaction Support