Industry Insights

Preparing a Company for Sale – Reverse Due Diligence

February 2010
Author:  Monte McKee

Monte McKee

Managing Director

Consulting

Manufacturing & Distribution

1201 Walnut Street
Suite 1700
Kansas City, MO 64106-2246

Kansas City
816.221.6300

Merger and acquisition activity in 2010 is beginning to show signs of improvement, and many analysts are forecasting a slow, but steady, economic recovery. If this outlook is correct, we can expect companies’ financial condition to stabilize as overall market conditions improve. In addition, we could assume the recent depressed level of mergers and acquisitions resulted in a surplus of portfolio companies held by private equity groups. These will need to be sold for the fund to create investor returns. Consequently, many companies may begin to consider preparing for a sale. However, the troubled economy has resulted in more risk-averse buyers and advance preparation is necessary to meet the increasingly stringent diligence requirements.

In the current economic climate, potential buyers are more willing to search longer and harder to identify the best acquisition candidate. As a result, transparent financial and operating information is more important than ever. Sell-side, or reverse, due diligence, is a process in which a company hires a third-party due diligence expert to conduct a dry run diligence assessment. This will identify and quantify issues and exposures that could have an adverse impact on a deal. Reverse due diligence usually covers areas such as financial statements, taxation, information systems and operations.

Areas of focus with respect to financial statement reverse diligence include pro forma earnings before interest, taxes, depreciation and amortization (EBITDA) and net working capital. To reduce the likelihood of purchase price disputes, sellers should take caution to make sure EBITDA addbacks are reasonable and justifiably supported through proper documentation. In addition, unless clearly defined early in the process, target net working capital is another area commonly disputed during transaction negotiations. Purchase agreements frequently define closing net working capital computations as “consistently applied and in accordance with generally accepted accounting principles (GAAP).” Costly disputes can easily arise when a company consistently applies certain accounting policies that are not in accordance with GAAP, particularly at interim period-ends. Reverse due diligence can identify GAAP departures early on to help ensure net working capital computations are clearly defined in the letter of intent and purchase agreement.

In nearly every buy-side due diligence engagement, we have uncovered liability issues and exposures related to state tax compliance and nexus, many of which surprised the seller. These types of exposures are common in privately held companies and can frequently be addressed and mitigated in advance of going to market. State and local tax (SALT) reverse due diligence can also identify savings opportunities by identifying potential tax reductions. Savings generated through reduced SALT payments effectively increase EBITDA, which can lead to increased company valuations.

Information systems reverse due diligence focuses on identifying current technology capabilities, suggested improvement opportunities and internal controls while balancing investment demands and priorities. Operations reverse due diligence is a fact-based and metric-driven analysis to provide a company with potential improvement opportunities and cost-saving suggestions, both of which generate increased EBITDA.

In summary, reverse due diligence provides companies with an objective third-party view from the buyer’s perspective. Unwanted surprises uncovered during buy-side due diligence often result in downward purchase price negotiations, lower valuation multiples or scaring off lenders and/or potential buyers. The reverse diligence process will assist companies in resolving or managing these issues before potential buyers discover the problems on their own. To best position a company for a successful sale, we recommend beginning the reverse due diligence process one to three years in advance of the anticipated sale.

For more information on this issue or related matters, please consult your BKD advisor.