Sellers, here are 7 ways to prepare for due diligence before a transaction kicks off

Some mergers and acquisitions are like chess: very calculating and slow. Some are like tennis: a hard-hitting back and forth. But while chess and tennis are mostly individual sports, transactions are a team sport — and it’s critical to have the right people on your side.

Your team should be just as experienced as the buyer’s team, which means you need more than just your tax preparer and your real estate attorney to guide you through a transaction successfully. Transaction advisers have navigated many deals, and they can help you prepare and succeed. There are several major ways they’ll help as part of your team when it comes to preparation.

Preparing you for due diligence and quality of earnings

Transaction advisers see varying degrees of readiness for the due diligence and quality of earnings (QOE) process. In most middle-market deals (under $10 million in enterprise value to $100 million), it’s common to find mostly but not quite 100% GAAP accounting on a monthly basis, with an annual reckoning of GAAP accounting for year-end reporting.

Performing an audit or review annually will not get you fully ready for the level of scrutiny and inspection of due diligence. It also won’t prepare your team for the stripping down to the core business operation and financial reporting involved in the QOE.

The following is a quick-hitting list that you can address with your team so that you can level up.

1. Corporate, tax and HR documents

Buyers will be asking for all tax filings, minutes, stock certificates, organization documents, reseller certificates, S-Corp acceptance, etc. Make sure you fill in these gaps ahead of time.

2. Consistent accounting

Consistent accounting is key. Even if your accounting hasn’t been the greatest, it’s better to be consistent than erratic or ever-changing. Predictability is much better during diligence.

3. Adjusted EBITDA

Non-core business, owner perks and one-time addbacks to your financial statement can help normalize your EBITDA, which stands for earnings before interest, taxes, depreciation and amortization. You will want to adjust to a solid expectable earnings level going forward.

Note that you will be diametrically opposed to the buyer on this. The buyer and their diligence provider will be looking for ways to adjust your earnings down and find expenses not properly recorded, while you are trying to show less expenses. A proper sell-side QOE report will properly vet and prepare your earnings presentation and speed up the buyer’s diligence.

4. Revenue growth

Matching your operational story of growth with your financial statements is crucial. If you are able to track your backlog and pipeline with accuracy and predictability, you can drive both value and speed of deal closing. Showing how growth continues post-closing is key. Businesses that are at the peak growth plateau, with only the decrease in front of them, will not get the highest value. Selling on the upswing presents the best buyer scenario.

5. Margin stability or margin increasing

Margin by sales segment, region, customer, and service or item sold continues to be a huge driver of value. Many businesses in the middle market have a difficult time tracking this component. The time spent will be worth the effort and will show in the purchase price.

6. Cybersecurity

You will need to have a cybersecurity threat assessment performed. This has become important to all facets of the transaction, including insurance providers, financial institutions and the buyer. Cybersecurity issues can disrupt or cancel the deal. As assessment can help you identify and close gaps before the due diligence begins.

7. State and local tax (SALT)

SALT and its proper compliance are important in both stock deals and asset deals. Liabilities, penalties and voluntary compliance rules can put a pause on a deal. In many cases, they cause price reductions or large holdbacks for multiple years, reducing your cash payout at the deal closing date. Performing a basic SALT assessment is well worth the effort to get in compliance.

What about net working capital?

Sellers often ask their advisers, “The buyer is offering me a multiple on the last 12 months EBITDA, but what are they going to pay me for my working capital? My receivables and inventory?” The answer is simple: nothing. This is where net working capital comes into the transaction.

The buyer expects a normal working capital to be delivered at closing for the multiple they are paying on EBITDA. As a concept, net working capital suggests that there is a normal level of current assets (less current liabilities) that are necessary to drive the EBITDA that the business is valued upon.

This is typically formulaic in nature. If the business is being valued on the last 12 months EBITDA, the normal net working capital will be examined over those same 12 months. Net working capital is traditionally calculated without cash in the current assets and without short-term debt in the current liabilities in the calculation. In its most simple form, the calculation is: accounts receivable plus inventory less accounts payable and accrued expenses.

Preparing this calculation with your accountants and consultants pre-deal is key to understanding that normal level. Although it sounds simple, this concept is one of the most haggled, negotiated, arbitrated and litigated concepts in a transaction. Why? Because swings in the normal net working capital will have purchase price implications.

If you deliver less than the normal working capital at close, it will reduce your closing proceeds dollar for dollar. If you deliver more than the normal working capital at close, it will increase the purchase price for the buyer and increase your proceeds dollar for dollar. Net working capital is a fairness concept to keep everyone operating business as usual and allows flexibility in your decision making as the transaction day gets closer.

For example, if you have to stock up on inventory due to recent supply chain issues and you deliver more than the normal working capital inventory, net working capital means that (and all else being relative) you would be paid for that additional inventory above the normal. This concept has a “true-up mechanism” typically 60-120 days out after the transaction closing to reconcile any timing differences that could not be accounted for with proper cut-off at the closing date. True ups have gone wrong because the seller didn’t understand them or didn’t ask the right team the right questions.

Make sure you’re prepared

Seller readiness is the key to a successful transaction, and one of the best ways to prepare is with a seller QOE engagement with Wipfli. We can give you the tools, tracking and knowledge to be proactive for when the right buyer comes calling. Contact us to learn more.

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