Insights 2022: How to Prepare for Due Diligence/Maximize Value Pre-Transaction

Current State of the Market

World economic activity typically moves in cycles, and M&A activity is no exception. Recent economic turmoil reminds us that peaks and valleys are simply inevitable. 2021 was the best year on record for global M&A, with more than 60,000 publicly disclosed deals and an average deal value exceeding $5 trillion. In contrast, the first half of 2022 saw a decrease in the activity of 20 percent, which is likely to continue.

Geopolitical turmoil, increasing inflation, increasing interest rates, supply chain issues, labor force issues, increasing regulatory enforcement, environmental impacts, and bearish sentiment on Wall Street as fears of a recession are verbalized – these all contribute to uncertainty in the markets. Uncertainty means buyer sensitivity to risk is heightened, and there is a focused effort to mitigate that risk when navigating through a transaction. However, there will still be an appetite for deals as there remains significant liquidity in the market, which arguably provides the potential for lower market valuations providing opportunities to generate higher returns. The bottom line is buyers will still be looking for deals, albeit they will be picky, spending more time and effort ensuring that the perceived benefits are attainable.

What This Means for Sellers

The slowdown in the market comes with more cautious buyers, who will more likely take more time to perform their due diligence, seek additional warranties and seek post-closing price adjustments. However, a depressed market does not change the fact that almost all M&A deals are completed by experienced buyers who can take advantage of the one-time seller. The vast majority of deals will also continue to be in the middle and lower middle market, and full or limited auctions will continue to be the most common method for sellers to go to market.

Finding the right advisor is a crucial piece of engaging in any M&A deal and should include of an investment banker, accountant, attorney, and wealth manager. Deals can take six months or longer to complete, so you and your management team should ensure there is a good fit and chemistry with the advisory team. Remember, they are to be considered your trusted advisors, and they work for you.

Steps to Prepare for a Sale

Preparation can take a minimum of six months and can last much longer. Good preparation can make the difference between a successful sale and a failed attempt. The goal is to paint a picture that gives the buyer confidence in the management team, the business potential and the numbers being presented. This process usually includes the following steps:

1. Setting Your Goals – Develop a clear understanding of why you are selling the business and be prepared to give a clear and concise answer to buyers who ask this question. You’ll also want to establish what a successful transaction looks like to you, including factors such as maximizing value, minimizing tax and purchase contract terms, managing outcomes for employees, and even community support.
2. General Rules – Continue to run your business, as the sales process can be draining and distracting. Maintain confidentiality regarding the transaction and its subsequent communication. Take time to prepare without shortcuts, as this is likely to be the largest liquidity event in the careers of you, your stockholders, and your management teams.
3. Financial Statements and Forecasts – In most cases, audited financial statements fail to highlight how the company makes money. Obtain a sell-side Quality of Earning (QoE) report from an independent expert, which should be designed to tell the company story in a clear and concise manner. The QoE should include revenue and earnings, trending monthly income and cashflows, customer metrics, product descriptions, intellectual property analysis, and the balance sheet. Additionally, you should have a three to five-year forecast reflecting growth based on sound and clearly documented assumptions.
4. Developing the Story – A well-prepared Confidential Information Memorandum (CIM) gives confidence to potential buyers regarding the investment opportunity, showing that the company is prepared for the diligence process and that a successful outcome is possible. The CIM should anticipate the needs of the professional buyer in order to entice them to maximize the selling price. In many cases, companies cannot readily articulate or quantify what makes them successful, which leaves the investor confused. Being able to clearly articulate competitive advantages can make a big difference in successfully closing a deal. The basic structure of a CIM should tell the company story in terms of customers, operations, employee relationships, and financial results/outlook.
5. Management Presentations – The hard work invested in preparing a well-constructed CIM can be negated when the core management team is not prepared to present to a sophisticated buyer. Take the time to prepare the management team for such a presentation.
6. Negotiate the Contract – This can be very stressful, but a good M&A attorney can help you navigate through all the issues.

Be Watchful During the Sales Process

• Buyers can play games, especially when attempting to drive a hard bargain – remember, their job is to buy the company at the lowest price on their most favorable terms. This is why having a second bidder willing to step into the breach becomes very important for your ability to control the deal outcome and move to close.
• Remember that negotiations around seller representations and warranties are designed to protect the buyer and are normal to all transactions. Sellers should have an exclusion that excludes damages that either individually or in the aggregate do not have a material and adverse effect – defining this can be addressed by your legal advisor.
• Baskets are set at levels that avoid having to deal with items that do not represent significant dollars. However, in many cases, once the aggregate reaches the threshold set, every item is then included. Such negotiated baskets can reflect between 10 and 15 percent of the purchase price. Once these baskets are set, an escrow or holdback is negotiated to give comfort to the buyer that there will be money available in case losses are incurred. Therefore, it must be clearly defined what is included to protect your purchase price.
• Escrows and holdbacks are established to deal with losses incurred by the buyer. They can amount to up to 10 percent of the purchase price, so it is important to limit them as much as possible.
• All companies need a certain amount of working capital, so this amount is set at closing by the seller and agreed to by the buyer. Post-transaction, the seller will prepare the opening balance sheet to establish the actual working capital at close. Then adjustments are paid by either the buyer or seller to constitute the difference. In some cases, the seller may require an escrow.
• Negotiating the terms of an earn-out payment is critical and often difficult. Many buyers require earn-outs when there is a difference between what the buyer wants to pay and what the seller expects to receive. Where an earn-out is established, it is important that the buyer lay out how this is to be calculated and agrees to manage the business in a way where there is a high probability that the projections can be achieved. It is then incumbent on the buyer to keep sufficiently detailed records in order to measure whether the earn-out has been achieved.
• Perhaps most important, be wary of the wrong buyer. Remember that the right buyer reflects the goals you set for sale in the beginning.

For more information, reach out to Laura Berry.