Seller’s Due Diligence – An Emerging Tool in the Sales Process

“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:

  1. Why not get a due diligence report vs. an audit or review?
  2. 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.

Equity Plans Part II – Are We There Yet?

Most of you will recognize this oft repeated question which parents have heard for years. Popularized in the movie and television show by the same name as well as the movie Shrek, it is the question that sends a chill down any parent’s spine; especially when asked by a 5-year old on a long road trip. So why do I use it here especially considering Part I of this blog cited “the time has come” from Dr. Seuss? Well as they say, timing is everything and so it is with Equity Plans as well. So let me explain.

Very few people would ask someone to marry them after just one or two dates, even if they believe that person may be the “love of their life.” Yet I deal with loads of startups where the second conversation an owner has with a key potential hire turns to sharing ownership. Worse yet, without thinking through what they are offering, many offer too much equity only to find they lack enough for others (fast forward to “The Producers” by Mel Brooks – “what percent of Springtime for Hitler do they own?”) or worse yet; that key hire does not work out.

So I spend a great deal of time fixing these issues and there is nothing enjoyable about it. Legal agreements are usually incomplete; the process turns into a he said he said deal and then there are tax consequences to muscle through. It always comes down to having a well-documented equity plan and in all cases, the company “wasn’t there yet.”

So what do I advise? Very simply, have a plan. (You can look at my blog of December 19, 2013 Equity Sharing 101 for Startups for more guidance.) Of course a good attorney is the key here and while many of the documents are somewhat “boilerplate,” you must have a handle on the key provisions. So two quick cases.

In the first, a CTO was brought into a startup, and within a month, the CEO thought enough of him to offer him 10% of the Company in “Founders’ Shares” (no vesting). The CTO was focused more on coding than job satisfaction and within a year, realized he did not want to be there anymore. Fortunately, the CTO was so focused on getting out he never considered the potential value of what he had, and he basically gave back the shares and moved on. No agreements were in place; that CEO just lucked out.

In the second case, it was a similar fact pattern except the key person granted equity had been there a bit longer and felt he had substantially contributed to the Company in the five years he was there. This was another case of an early grant of equity and no provisions for separation. There was a falling out and a “settlement” is still in process. The CEO is spending a great deal of emotional time addressing this not to mention legal and consulting bills. It is not a pretty sight.

So please consider a bit of a delay to provide time for thought to make sure “you are there” before you enter an equity plan. But once you decide, move quickly and purposefully in concluding your plan and getting it all signed and delivered.