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Vendor Due Diligence – Optimising your business for a successful exit


September 2019
Read time: 7 Minutes


Derek Neil is a transaction services partner specialising in helping tech companies execute transactions and maximise value.

Paul Morris is Head of Growth Advisory at BDO. His team work exclusively with growth businesses, helping them to prepare for and support them through private equity and venture capital fund raising.

Vendor due diligence is fast becoming common practice for tech businesses considering a sale. Paul and Derek talk us through the process, and explain how it can empower tech businesses looking to maximise their valuation… 


Every business owner who has ever contemplated selling will be aware of due diligence, that daunting process whereby a potential buyer commissions a third party to carry out an in-depth assessment of the business’ financial robustness and commercial potential in order to ensure that it is a good buy.

Increasingly, however, tech founders and other business owners are drawn to the idea of vendor due diligence. This practice – which has been growing in popularity in the UK and Europe over the last 10-15 years and is also on the increase in the US in a slightly different form – is where the company looking to sell proactively commissions an independent adviser to perform due diligence on its behalf, but for the benefit of an investor. This brings many benefits, such as surfacing issues that could impact on the potential sale price while there’s competitive tension in the process (and while they can be resolved), helping ensure that the business isn’t under-valued, and giving the seller much greater control and transparency over the whole selling process.

‘In the current climate, there's lots of competition for assets, so if you're a seller, you're in quite a strong position,’ says Derek Neil. ‘But as soon as you give someone else control over the due diligence process, the power shifts: you start to hear all about the problems they’ve found during the process and you don’t know what else is to come. Vendor due diligence gives you back the power. It’s a useful tool that can give you a fantastic advantage in the sale process.’

The difference that vendor due diligence makes

By carrying out its own vendor due diligence a business can control the flow of information to potential buyers. ‘If you give the same information to everyone, no specific party has to pay for diligence,’ says Neil. ‘This keeps a greater number of interested parties in the process for longer, and increases the competitive tension.’

To really understand the benefit of vendor due diligence, let’s start by looking at the traditional approach. ‘Traditionally, a buyer, whether corporate or private equity, will make an offer for a business based on the information that’s been fed into the company’s information memorandum. This tends to highlight selling points, results, projections and so on,’ says Neil. ‘Then they'll make an offer based on that information memorandum. Diligence is there to independently assess what’s in that information set. The potential buyer appoints third-party advisers to analyse all the data and talk to the management team to corroborate the story that's set out in the information memorandum.’

This period can be anxious and unsettling for the selling business as external advisers pore through records looking for irregularities and issues that might help drive down the valuation. ‘As a seller, you’re concerned that at some stage during that process, you’re going to be told that something has been found that means the deal won’t go ahead, or that the price will change,’ says Neil.

"With vendor due diligence, however, the business does away with a lot of this uncertainty by handling the initial part of the process itself, to its own timeline. "

Even though the financial due diligence report is from the business, the use of a third-party adviser maintains trust in the integrity of the diligence reporting.

Taking control of the conversation: tax, profit, value

A key advantage of vendor due diligence, then, is that it allows businesses to get an early view of potential weaknesses and risks, and to control the narrative. ‘If there are issues, you can either address them before the report goes out, or take steps to mitigate them,’ says Neil. ‘Even if there's nothing you can do about these issues, the buyer population can compete on who takes the most favorable view of the issue, based on the same information.’

Tax is a classic example, he says. ‘With tax, there tends to be an enormous number that could be crystallised if something goes wrong, but there might be a very low risk of it crystallising. You can mitigate the scale of this risk perception by completing vendor due diligence.’

Then, of course, there are the hotly disputed questions of profit and value. ‘Often the price for something might be based on a multiple of profit, or a multiple of revenue. However, though the accounts might say one thing, there’s a fair degree of judgment around accounting policies that can push profit up or down. You might have one-off items that can push profit either way.

‘Diligence gets underneath the skin of the numbers, to get to the underlying profit of the business and the quality of the profit, asking questions like: “Does the business rely on one big customer, or does it have a nice spread of customers?”, “Is the revenue contracted?” and so on. It also gives a view on future projections – you look at historical trends in the results to give you a guide as to whether the projected results look achievable.’ Having an adviser on board to help you position your view on potential profitability can have a big impact on valuation.

Vendor due diligence can also help businesses avoid buyers trying to push profits down. ‘If you do profit prep work and take a look at underlying profits, it gives you a better argument against any challenge,’ says Paul Morris. ‘You can demonstrate that you’ve put investment into your business, such as building sales teams. Even if you haven’t generated a lot of revenue with the sales team as yet because they haven’t reached maturity in the business, you can justify the add-back to your profit, as they should generate profit in future for your company.’

‘This happens quite often with tech businesses, as they scale so quickly. With a tech company, for example, you might start selling in the US, but US sales tax is a nightmare at the moment, meaning there’s a big focus on buyers and due diligence. Small problems can become big issues quite quickly, so thinking about them in advance can help you nip problems in the bud that might severely impact your value later,’ says Neil.

Then there is the distinction between equity value and enterprise value. If companies have cash in them or debt in them, that can change the valuation, but these assessments are not cut and dry. ‘For your average entrepreneur, there's no text book they can turn to that gives them the unarguable definition of debt or working capital,’ says Neil. ‘Having an adviser on your side doing vendor diligence helps to address these questions on your behalf. It’s closing a knowledge gap between the buyer and the seller.’

"All of this shows how vendor due diligence helps to shift the balance of power from buyer to seller in what is effectively a seller’s market. "

‘Because there's so much capital out there, vendor due diligence is a great way to reclaim value during a process,’ says Morris. ‘We surveyed private equity people a while ago and asked them whether they liked vendor due diligence. Interestingly, although about 75% of them said they didn’t like it, but when asked if they would use it when selling a business, 90% said they would!’

Business as usual

Another benefit of vendor due diligence is the control its gives a selling business over the process, without distracting the management team during the pivotal period of courtship with potential buyers.

‘The management team is put under enormous pressure during a diligence process,’ says Morris. ‘If you have due diligence performed on your company two or three times by different potential buyers, you’re inevitably going to get distracted from running the business as usual. As a result, current trading can often suffer, right at the time when you're trying to build confidence in the buyer community that your business is great and that your management team is solid.  It is important to remember that profit performance underpins the value of the business.

‘Being able to do this diligence in a timely and more controlled manner allows the management team to perform much better through the process,’ he says. ‘That’s why vendor due diligence is now used on the majority of transactions above a certain size.’

The changing face of diligence

Our experts agree that the rise of vendor due diligence coincides with a much greater level of depth and granularity in the process generally.

‘Over the last 20 years or so, due diligence has become much more refined and focused, says Neil. ‘It used to be more of a scatter-gun, try-to-cover-everything approach, whereas these days it’s a more focused product. These days, the diligence that is done typically covers areas such as: financial diligence, tax diligence, market diligence, management diligence, IT diligence and more. Buyers want to de-risk their purchase as much as possible, leading to a much more intense vetting process.’

With a tech business, vendor due diligence isn’t just financial; it’s also technical. ‘With sales of tech or tech-enabled businesses I’ve been involved in, we often brought a consultancy in to look at issues such as licensing, the right IP protection, the right resilience, disaster recovery etc,’ says Morris. ‘What we didn’t want was for someone, such as a corporate buyer or a PE house, to come in and find gaps in the tech plan, which would impact value.

‘We made those businesses exit-ready in advance. To do that, you need an expert to test the claim that the IP is genuinely disruptive, as well as whether it can scale.’

Starting early

Both our experts emphasise the importance of starting the vendor due diligence process as early as possible. ‘The earlier you start, the better,’ says Neil. ‘For example, for the tax aspect, sometimes you might need a year to get it together. You should always have exit-readiness on the board agenda; thinking about your vendor diligence well in advance will help to make it go more smoothly in the end. By planning early, you can start to mitigate and downsize risks, and you can also find evidence of value.

‘For example, if your business has a low churn rate of customers, you should start tracking churn as a KPI, and if you can get to the point where you've got a year’s track record of showing low churn, that's fantastic. If you can't show it in your numbers, then it's just a management assertion that can't be proved. That's not as compelling as having the data in the vendor due diligence report.’

For tech businesses, there are also specific benefits of advance preparation, says Morris. ‘Let’s say you've got a lot of IP in your software, with a range of R&D tax credits that you can claim within a two year period. If you haven't done this prep work with an experienced adviser, you could actually be handing this value to the buyer, rather than you taking advantage of those credits before you sell.’

Have further questions about vendor due diligence? Email [email protected] with your queries.

 

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