Vendor due diligence: what business sellers need to know

Once your business goes to market, a buyer’s advisers will begin interpreting its figures for themselves. They will test the profits, question the forecasts and look for liabilities that could affect the price.

If they find something unexpected, they may ask you for further information, change the deal terms or reduce their offer. Financial due diligence is usually associated with buyers, but sellers can commission it too.

Vendor due diligence (VDD) examines the financial story before negotiations gather pace. It can identify difficult questions early, support the figures provided to bidders and give everyone a clearer understanding of the business you are selling.

Finding a problem does not in itself make the sale of your business easier. What matters is having enough time to establish the cause, calculate the effect and decide how to respond.

What is vendor due diligence?

Vendor due diligence, or VDD, is an objective investigation that you commission when preparing to sell your business. It is one form of sell-side due diligence.

Although you commission the work, your adviser prepares the analysis with prospective buyers and funders in mind. The review examines the financial areas they’re likely to investigate and explains the findings in a structured report.

The ICAEW financial due diligence guideline says VDD can give sellers greater control over the sale timetable. It may also reduce the disruption caused when several potential buyers request similar information from your management team.

Vendor due diligence isn’t an audit and doesn’t provide a formal opinion that every figure is accurate or complete. Instead, your advisers investigate an agreed range of issues that could affect the transaction.

The scope will therefore depend on your company, the proposed sale and the likely concerns of potential purchasers.

How does it differ from buyer due diligence?

A buyer normally arranges financial due diligence after identifying a possible acquisition. Its advisers investigate your company on that buyer’s behalf, asking what risks they might inherit and whether the proposed price is justified.

With vendor due diligence, you begin the process before or during the early stages of your sale. The review anticipates the financial questions that a credible buyer is likely to ask.

A purchaser may still commission further work. This is often called top-up due diligence because it concentrates on matters not fully covered in the original report, more recent trading or concerns specific to that buyer.

You may also choose vendor assistance. Here, an adviser helps you prepare financial information, analysis or a data pack for the sale. However, this work doesn’t provide the same independent view as vendor due diligence.

The most appropriate approach to take will depend on your transaction. A formal VDD report may suit you if you expect a competitive sale involving several bidders. A smaller or exclusive deal may need a more focused readiness review or vendor-assistance exercise.

Vendor due diligence can improve your sale process

An early financial review gives you more time to respond to problems. It might uncover inconsistent management accounts, weak supporting records or an exposure that hasn’t yet been quantified.

Depending on the finding, you may be able to correct the records, gather missing evidence, improve a process or explain the financial effect. The same discovery becomes harder to manage when it emerges during a buyer’s investigation and your transaction is already heading towards a deadline.

Vendor due diligence can also give bidders a shared set of financial analyses. Without it, several interested parties may ask you similar questions in different ways. You and your management team must then prepare repeated answers, increasing the chance of providing inconsistent information.

The process won’t prevent follow-up questions, but it should make them more focused. This can reduce the time you and your senior employees spend retrieving records and explaining the same figures while continuing to run the company.

Finally, the findings may support your valuation discussion. A buyer will want to understand whether the reported profit is sustainable, how much cash the company requires and which liabilities will remain after completion. VDD doesn’t determine your sale price, but it can provide evidence for the assumptions on which the valuation is based.

How much of your profit is likely to continue?

The reported profit may include income or costs that won’t continue under new ownership. A financial review therefore distinguishes normal trading from one-off events, unusual owner-related expenditure, discontinued contracts and changes in accounting treatment.

Advisers sometimes call this a quality-of-earnings review. It aims to establish how much of your company’s performance comes from ordinary, repeatable trading.

Imagine your company reports EBITDA of £900,000. EBITDA means earnings before interest, tax, depreciation and amortisation. It is a commonly used measure of operating performance.

You then add back £120,000 of remuneration and benefits that will stop after the sale. On that basis, you present adjusted EBITDA of £1.02 million.

However, suppose you also manage the sales team. A buyer may need to recruit someone on an £85,000 package to replace that work. After allowing for this cost, the supportable adjustment may be £35,000 rather than £120,000.

That analysis doesn’t alter the accounts. It does change the level of ongoing earnings that you can reasonably ask a buyer to accept.

You need to understand where the revenue comes from

The total sales figure becomes more useful when you divide it by customer, product, service, location or sales channel. You should also distinguish recurring income from one-off projects.

This analysis might reveal that a large part of your revenue depends on one customer, that an important contract is coming up for renewal, or that recent growth came from one-off work. It could also find unusual sales recorded near the year-end, or margins that have been weakened by discounts and refunds.

None of these findings automatically makes your company unattractive to a buyer. A concentrated customer relationship may be long-standing and profitable. However, you’ll need evidence of its history, contractual position and prospects before a buyer can judge the risk fairly.

Does your profit turn into cash?

Your company can report healthy earnings while waiting a long time for customers to pay. You may also need to hold large quantities of stock or invest heavily in equipment to maintain its performance.

Vendor due diligence compares the reported profit with the cash generated by your operations. Your advisers may investigate overdue invoices, bad debts, stock movements, supplier payment patterns, capital expenditure and seasonal changes in cash flow.

A buyer needs to know how much cash the company normally produces and how much it requires to keep trading. Reported profit provides part of that answer, but not all of it.

How much working capital does your business need?

Working capital is the short-term funding tied up in everyday trading. It usually includes stock and amounts owed by customers, less money owed to suppliers and certain other current liabilities.

Buyers often expect you to deliver the company with a normal level of working capital. You might improve the apparent cash position before completion by reducing stock, collecting customer debts unusually quickly or delaying supplier payments. However, this changes the balance on a particular day without necessarily making your underlying business more valuable.

Examining working-capital movements over several months helps establish the normal requirement. You and the buyer may then use that figure when calculating the final purchase price.

Which obligations could affect what you receive?

Bank borrowing forms only one part of the company’s financial obligations. A buyer may also need to understand overdrafts, leases, hire-purchase agreements, director loan accounts, overdue tax, customer deposits and commitments to future expenditure.

Some of these balances may be treated as debt-like when the value of your shares is calculated. Others could require funding after completion even though they don’t appear within the headline profit figure.

Vendor due diligence helps you identify these items before the transaction documents are finalised. You can then explain the balances and allow for their likely effect on the proposed deal.

Can you support your forecasts?

A spreadsheet can calculate rapid growth without proving that your company can deliver it. The forecast assumptions should therefore be compared with previous forecasts, actual results, confirmed orders, the sales pipeline and available capacity.

The review may also consider whether you need more employees, equipment or working capital to support the projected increase in sales. A forecast that ignores these costs may overstate both future profit and cash generation.

You don’t need to present the most cautious forecast possible. You do need to show where the numbers came from and what must happen for you to achieve them.

What can you do if the review finds a problem?

You and your advisers first need to establish the cause and financial effect of the issue.

You may need to correct inaccurate records, gather better evidence for a disputed adjustment or revise an unsupported forecast. You might be able to resolve a tax or compliance matter before marketing begins. Other findings may need explaining in the sale documents or reflecting in the valuation and deal terms.

If the figures don’t support a claim, VDD can’t make it convincing. A genuine liability may also reduce your asking price. However, the review can establish the scale of the problem, helping you and the buyer decide how it should affect the deal.

A purchaser may accept a known issue when you can explain its scale and propose a reasonable treatment. A late-discovered problem is more likely to raise questions about what else may have been missed.

What information will you need to provide?

The initial information request should be tailored to your company and transaction. In most cases, your advisers are likely to need:

• Statutory accounts and recent management accounts.
• Detailed profit and loss, balance-sheet and cash-flow information.
• Budgets, forecasts and evidence supporting their assumptions.
• Revenue and margin analysis by relevant customer, product, service or division.
• Aged debtor, creditor and stock reports.
• Bank statements, borrowing agreements, leases and other financial commitments.
• Tax returns, computations and relevant HMRC correspondence.
• Details of related-party transactions and proposed adjustments to profit.
• Access to the members of your management team who understand the figures.

Gaps in the information don’t necessarily prevent a transaction. They may, however, restrict the conclusions your advisers can reach and create more work when bidders begin their own investigations.

When should you begin vendor due diligence?

You should start the review before marketing your business, while you still have time to act on its findings.

The ICAEW financial due diligence guideline notes that sell-side advisers are typically engaged early in the deal cycle, often before marketing materials are released. You can then use the relevant analysis when preparing your information memorandum, management presentations and other documents for bidders.

You may be able to correct some problems quickly. Others require a longer record of improved reporting or trading performance. If your proposed sale remains several years away, THP’s guide to increasing the value of your business explains why early preparation can matter.

If you treat VDD as a final check before the buyer arrives, you’ll have little time to improve the evidence on which the report depends.

Will buyers still carry out their own investigations?

Financial VDD concentrates on financial performance, cash flow, assets and liabilities. It doesn’t replace legal, commercial, operational, employment, tax or technology due diligence.

These different reviews should inform one another. The revenue analysis may show that a customer is particularly valuable, for example, while the legal investigation reveals that its contract can end when ownership changes.

A buyer may also request updated figures or further analysis of risks that matter specifically to them. Done well, vendor due diligence should make that work more targeted.

Prepare for the buyer’s questions

A buyer’s advisers will examine your figures. Vendor due diligence gives you the opportunity to identify and investigate the difficult points before negotiations limit your choices.

THP offers vendor due diligence for business owners preparing for a sale. We can review your financial performance, identify matters likely to concern a purchaser and help you prepare clear evidence and explanations.

We can also work alongside your legal and mergers and acquisitions advisers so that our financial findings inform your wider transaction.

If you’re considering selling your business, contact THP’s financial due diligence team to discuss the work you may need.

This article provides general information only. The appropriate scope and form of due diligence will depend on your business, buyer and proposed transaction. Take professional advice before acting.