Vendor Due Diligence

In essence this is an exercise to make your business ready for a sale. It is an essential part of your pre-sale planning. If should be executed by an independent person. It should allow your business to withstand a robust due diligence exercise by a purchaser when your business is sold.

The exercise, if conducted properly, should facilitate the completion of the transaction. Furthermore, where there is more than one interested party, the exercise will push them a long way up the learning curve in a brief period of time thus facilitating the transaction once exclusivity is entered into and you, the seller, lose control of the process.

A pre-due diligence exercise is all part of preparing for the transition from your business. It should include a review of the following areas:

• Financial, including taxation;
• Legal Review; and
• Operational matters, including a review of the management team.

These are the key areas a purchaser will evaluate as part of their due diligence process. Any weaknesses can be used by the purchaser, and indeed I have done this myself, to reduce the price or even stop the process altogether. Moreover, if these issues come out in due diligence they can increase the timetable, adding to the costs of both parties.

Accordingly, you must identify these weaknesses, if any, at an early stage. This will give you either the time to rectify them or have a credible plan to do so. Another benefit is the ability to limit the time period for due diligence by the buyer on the grounds that part of the exercise has been conducted already.

The decision to conduct the exercise should be taken well before starting the marketing and sales process of your business.

Financial, including taxation.

Review of taxation

• This review covers all taxes PAYE, NIC, VAT and Corporation tax to name but three.
• Research and Development claims have been properly made.
• Capital Allowance claims are correct in relation to the underlying asset.
• All returns to be up to date.
• What is the position of the tax losses, including the tax relief on the exercise of Enterprise Management Incentive Schemes.
• Avoid aggressive tax planning schemes – the buyer will not wish to be associated with such schemes for risk of prejudicing its reputation.
• Ensure the outcome of any investigations are available and that the outstanding tax and penalties have been paid.

Pension schemes

• All returns are up to date.
• Any final salary schemes subject to any regulations and the rules governing the scheme should be closed.

Financial matters

These are best dealt with by someone who is familiar with finance. If you do not have a financial director, then you need to bring someone in to do this for you. Additional resources may be needed and whoever conducts the exercise these are the areas which should be covered:

Review of Assets

• Remove any surplus assets or those not included in the sale
• Review working capital with a view to reducing this to a minimum. That way you can take out any surplus cash taxed under the current rules at 10%.
• Identify hidden or undervalued assets. If the business owns freehold property, this ought to be carried in the accounts at an independently revalued amount prior to the sale. Fully depreciated assets which are still in use should be identified at current market value. Tangible assets no longer in use should be removed from the asset register.
• The asset register should be up to date, where the total figure for cost, accumulated depreciation and net book values being reconciled to the year-end accounts.

Accounting policies

It is tempting to adopt policies which inflate profits and which under scrutiny by the purchaser will result in a downward adjustment to profits.

• Undertake a review of all the policies to ensure they are consistent and properly state underlying earnings.
• Recognition of profit, especially on contract related operations.
• Depreciation policies: are these consistent and reasonable in relation to the nature of the assets and the policies of similar businesses.
• Provisions against bad debts and slow-moving, redundant stock are common – avoid using these as a way of manipulating profits and or managing the corporation tax liabilities.
• Research and Development expenditure identify clearly where these costs are situated in the accounts i.e., capitalised as part of fixed assets or written off against profits. Either way they should be consistent and be supported by evidence in the Research and Development claims.

The issue faced by life-style businesses is that some expenses are not genuine business expenses. While they may be accurately reflected on forms P11d and the Corporation Tax Return, they still impact upon the profits of the business.

In my experience, buyers are always suspicious of adjustments to profits to present a greater figure than that reported in the statutory accounts. Avoid these where possible and minimise the number of adjustments.

Accounting systems

The sale of a business can takes a long time. The period between producing the information for marketing the business and completion can be many months. So, buyers will be curious and so ask for management accounts. It is essential these are accurate, reliable and timely. With modern systems it should be possible to produce these within hours of the period end and a review needs to be made of the procedures to ensure this can happen.

Likewise, there are usually adjustments made by the accountants between the management accounts and the final accounts. Ideally these adjustments should only be for taxation provisions.

Where forecasts or budgets are produced, then the buyer will wish to see these. Again, they should be reliable, and the management accounts should be compared to these. It is not a clever idea just to produce forecasts for the sale as these may lack credibility. It is not easy to produce forecast. While costs can be estimated, it is turnover where the issues lie. This is another topic altogether. So, being able to demonstrate a history of forecasting against actual results will improve the chances of receiving an offer for the business.

Legal Review

I come across issues regarding leases, trading contracts, shareholder agreements and outstanding litigation which can either delay a transaction or stop it altogether.

Leases: there can be an issue locating the leases, title deeds, share certificates and key contracts. The vendor due diligence exercise will ensure all these are located and put to one side to be available to the buyer at short notice.

The key point about trading contracts is the ability of the other party to terminate the contract on a sale of the shares of a company. Should this happen and the contract be renegotiated, then this puts you in an invidious position.

Where there is more than one shareholder is there a shareholders’ agreement. Together with the articles of association these need to be looked at to ascertain if there are any provisions regarding the sale of the shares in the company and the effects, if any, thereon.

Where there is outstanding litigation including slow paying customers, then these issues ought to be resolved before the business is marketed. Any major litigation or dispute will be a deterrent to the purchaser.

Keep it simple: Buyers, especially those in the US, do not like complicated share structures. Even where there are minority shareholders if these can be bought out in the absence of a provision in the shareholders’ agreement it could avoid complications come completion.

Likewise, think carefully about offshore trusts. These may diminish the attractiveness of a business.

Operational matters

One of the crucial aspects to creating value in a business is that the business is separate from you. I explore this idea elsewhere at…. The value can be enhanced by having a good management team capable of running the business without you. What would happen to your business if you took three months holiday? This is a key test of the strength of the managers. It means the buyer can run the business effectively without your ongoing involvement after the sale.

Where a business has been run by a few persons making key decisions, it is difficult to bring in an outsider. However, the appointment of a non-executive director can help in a number of ways:

• It is likely they will have been involved in a sale process and can guide you through to avoid pitfalls.
• They can look at the plan for the business development as a critical friend through their business acumen; and
• It could add to the credibility of your business.

It is appreciated the appointment may cause disruption to the existing relationships with managers and so the person could remain in the background helping you with the transition.

A buyer would like to purchase the business knowing there is visibility of earnings. Easier said than done.

So, the report should cover an assessment of the quality of your business’ earnings and the risk profile.

Are there contracts to support these? What are distributors agreements worth? How much is recurring income and what type?

A concentration of customers and indeed suppliers will be one of the first areas a buyer will review. An overdependence will pull down their valuation. So, in preparing for a sale there should be sufficient time to achieve a good spread of customers and suppliers.

Vendor due diligence

There is obviously a cost involved in preparing such a report. These can be expensive and a quotation or at least a fee induction should be sought before appointing someone to do this. Once these numbers are known you can then undertake a cost benefit analysis as for small businesses this may not be worthwhile. Hopefully the above will provide you with a short checklist of considerations.

These reports can look into many matters. It is important to agree terms of reference with the provider so as to ensure other matters you do not require are excluded.

Who should prepare the report? There are two issues using your existing auditor or accountant:

1. It will adversely impact on its credibility due to your pre-existing relationship; and
2. Where a report is produced, the intention is usually for the purchaser to adopt it. They will use it as part of their due diligence rather than commissioning another report. If your people have drafted the report, it will reduce the chances of this happening.

So, vendor due diligence is a term used when, you, the owner of your business has made up your mind you wish to move onto the next stage of your life. In essence it is “kicking the tyres and looking under the bonnet when buying a used car”.

It is an independent assessment of your business from the point of view of what it looks like to a buyer. The report will give you the seller an opportunity to put your business into a state the buyer will understand before the sale of the business is started.

It has two distinct advantages:

• Any problems to the buyer are identified at an early stage and reduction in value is avoided; and
• It makes the sale process itself as smooth as possible.

Most buyers and sellers become hung-up on the deal itself. So many deals fail to deliver the value both parties expect as not enough time is spent on planning the integration of the two businesses. By focusing less time in “doing the deal” and more time on the integration there is a better chance the deal will succeed in delivering the values each party expects at the outset.

Buyers may benefit from a vendor due diligence exercise since it adds provenance to the business knowing an independent review has been conducted. I say may, since it may not be appropriate in all cases to disclose the report. However certain aspects could be disclosed as weaknesses and then the impact of the changes can be shown. So, planning well in advance of a sale is vital in these cases. It will maximise the value of the business being sold and makes the transaction as smooth as possible.