Vendor Due Diligence: Pros and Cons

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The process of preparing a business for a future sale or researching a target business often is made smoother by accessing vendor due diligence. However, each transaction is unique and should be evaluated on it own individual merit.

Auction Processes – While auction processes can facilitate superior transaction valuations, potential drawbacks include:

• Potential purchasers often put forward high valuations to be selected as the preferred bidder, and then look to every opportunity to grind the purchase price once exclusive;
• Can be extremely time consuming for management over an elongated period of time.

Vendor due diligence can be highly effective in providing relief to these issues. With a vendor due diligence report, potential buyers are forced to price in earnings normalizations and other valuation issues upfront. Providing access to such a report allows vendors to limit pre-exclusivity financial due diligence to review and discussion of that report (potentially together with other select financial information), deferring more detailed “top-up” buyer due diligence to the exclusivity phase.

Businesses of Scale – Vendor due diligence increases the seller’s transaction costs. For smaller businesses, the relative benefit may well be lower. Vendor assistance can be a pragmatic alternative if the seller acknowledges that limitations with the quality or depth of readily available financial information may be a roadblock to maximizing value on a timely basis.

Multiple Unconsolidated Entities – If a business being sold has multiple unconsolidated entities, buyers can find it difficult to understand the size and makeup of the earnings stream being bought. Vendor due diligence or vendor assistance will include an exercise to consolidate or combine the financial information into a digestible format.

Poor Quality Financial Records – Poor quality financial records can quickly erode enterprise value and confidence in management, even if it is primarily because the company has deliberately prioritized managing sales and operations over financial metrics. Similar to the above, vendor due diligence or vendor assistance will tidy up and reconcile records, enabling buyers to spend their time analyzing the business rather than trying to “audit” the numbers.

Company is Unaudited – A buyer will typically place less confidence in financial statements which are not audited. For example, accounting practices which deviate from GAAP are commonplace and can drive significant variability in numbers which drive valuation (e.g. revenue recognition practices). At the uglier end of the spectrum, fraud is less likely to be detected. Larger private companies which have “review” or “compilation” engagements performed by external accountants will often benefit from the upfront work of vendor due diligence or vendor assistance support.

Start Early

It is generally best to start a vendor due diligence process early on and before a company is brought to market. If very significant issues are identified, the seller can take the time to address such issues before the formal sale process starts. Further, it can help the seller in framing its valuation expectations.

The processes are then most effective if the vendor due diligence report contains information which is relatively current and does not become outdated due to the preparation and review process taking longer than expected. If that happens, buyers will wish to perform their due diligence to more recent periods and/or the seller will feel obliged to issue an update to the VDD Report to, for example, the latest quarter.

Commissioning a vendor due diligence process is not necessary for all sale processes and the benefits need to be weighed against the additional upfront costs. However, in the right situation, the likely benefits include a higher probability of a deal being realized, an enhanced deal value, and the deal being completed on a timelier basis. For many sellers, ultimately the benefits will far outweigh the costs.

Contact Johnny Earl, Managing Director, Corporate Finance, at 604.685.8408 or [email protected]