“A lack of transparency results in distrust and a deep sense of insecurity” – Dalai Lama
I hope this quote doesn’t set too serious a tone for this blog, but much like the probable impact of the most recent election, change is in the air. Over the past couple of years, we have seen a concept emerge which, as one of my favorite clients would say, is “counter-intuitive.” That concept is referred to as seller due diligence (also at times referred to as a Quality of Earnings report) and it is increasing in popularity in mid -market M&A transactions. In the past, we were often approached by investment bankers or companies considering a sale to perform either an audit or a review. But more and more, that request is being modified to incorporate a seller’s due diligence report. But what is it and how does it work? First a little primer.
Accountants are guided by professional standards as to how and what they can say in a report. When it comes to financial statements, the most common accountants’ reports are called audits or reviews. Now the accountants out there will beat me up a bit for my layman’s description, but a review says nothing has come to the accountant’s attention that leads them to believe the financials are not fairly stated. This is often referred to as “negative assurance.” (We are accountants and not literary geniuses.) In an audit, which is more expensive and requires a lot more work, the accountant states in their opinion the financial statements are fairly stated. So in both cases, the focus is basically on the fair statement of the financials and those horribly worded phrases called footnotes. It is more that the numbers appear OK versus what do they really say.
In a due diligence report, there is more color as to the why. For example, an audit or review will show that margins this year may be lower than last year but there is no explanation as to why. A due diligence report would cover this as well as trends, details on balance sheet components and other analysis of the business. So right now, you might have two questions:
- Why not get a due diligence report vs. an audit or review?
- Why show a potential buyer your weaknesses by providing such a report? Keep in mind, this type of report highlights both the good and the bad.
To answer the first question, the audit and review both provide some assurance that the numbers are fairly stated. There is no such assurance (even limited as in the case of a review) in a report on due diligence. More and more, we are being asked to do both a review and a sellers’ due diligence report.
As to the second point, most transaction professionals will properly advise their clients that big checks are not written by buyers without a due diligence report, so why not make it easier for a potential buyer to understand the inner workings of a target. Being prepared on your own terms for this process is becoming a “best practice” for companies seeking substantial investment or a full exit.
So if you are contemplating this type of transaction, consider a seller due diligence report. I just completed a deal and am convinced its use helped to both identify a serious buyer more quickly and significantly expedite the whole transaction process.