The Do’s and Don’ts of Sell-Side Due Diligence
- What founders should and shouldn't do during ad hoc and detailed due diligence when selling their business
- How founders should interface with buyers/investors during the diligence phase
Due diligence is the process whereby a strategic buyer or investor verifies the position of a selling company in an M&A or capital raise transaction.
If you as a founder are preparing to engage with buyers/investors (called buyers for the rest of this article) during due diligence, know that the process of diligence is like inspecting an old sweater—if a buyer identifies loose threads and gives a tug, then your position is likely to unravel.
Unfortunately sell-side due diligence is an uncomfortable experience every founder will have to go through during a transaction. Buyers are going to dig into your company until they see it in its raw, unmanicured form. In search of the "original source of truth," buyers will audit your charts and summaries down to the most granular level of data.
With this level of scrutiny, you’ll want to be prepared when the diligence process starts.
When does diligence begin?
The diligence process formally begins after the selling company (your company) provides information to buyers in the form of a confidential information presentation (CIP). The CIP is an in-depth document roughly 30 pages in length that sets the main stage for buyers. After buyers review the CIP, they will have additional questions, and thus the due diligence process begins.
When done right, diligence lasts 3-6 weeks, but could take 2-5 months if the buyer is driving the process. Typical diligence comes in two main stages: ad hoc and detailed diligence. To minimize the discomfort of diligence, you should apply the following guidelines in each stage.
Ad Hoc Due Diligence
Ad hoc due diligence begins after sharing your CIP and the goal is to respond to high-level questions from buyers. During this stage, buyers are doing some basic information gathering to evaluate the opportunity and clarify the points you presented in your CIP.
On the sell-side of the table, you as the founder and your investment banker are just starting to familiarize yourselves with the buyers. As such, you don’t want to over-exert yourself by providing too much information to buyers you may not end up being interested in or who may not be interested in you.
Here are some best practices to follow in the ad hoc stage.
What founders should and shouldn’t do during ad hoc diligence
Do be consistent. When providing information to various buyers, work from the same information base. Every diligence relationship should be built from the same set of documents. Sharing different information with different parties will happen, but sharing different versions of the same information can complicate negotiations.
Do provide high-level projections. Every buyer is going to be interested in how you project revenue growth over the next X period.
Don’t provide projections that are more granular than yearly or further out than 12-24 months (biased towards a shorter period). When buyers ask for more (either more granular projections or a longer projected time period), just say that you are on pace or ahead of pace (whichever is true) and say that you can provide more granular or lengthy projections in the next phase of diligence. Buyers should be satisfied with 12-24 months at this phase because unlike VC firms, they’re evaluating companies on an 18-month time frame of projected performance.
When providing projections, do make sure you can hit them during the timeframe of the transaction process (3-5 months). Doing so will strengthen your credibility.
Do value requests for additional information from buyers because their requests indicate interest. At the same time, don’t indulge every request. With 10-20 buyers at this stage of the process, you will exhaust yourself if you answer every request for information.
Don’t spend excessive time pulling together metrics in this stage. If the requested information would take you more than a couple days to pull together, hold off until the next stage of diligence.
Do let your investment banker mediate the interaction between your company and the buyer. Don’t engage with the buyer directly. You as the selling company shouldn’t engage directly with the buyer because:
- Your investment banker sets the tone of the transaction. When founders involve investment bankers during the transaction process, buyers recognize that the process will be serious and will put their best foot forward.
- You want to present a unified front with your investment banker. If you’re going around your investment banker and working directly with the buyer, you’re clouding up the message and the path to close.
- Your investment banker can act as the bad cop, allowing for more leverage in negotiations. You don’t want to undermine their negotiating power.
If you’re worried about not having the opportunity to interact with a future partner or owner of your business, know that you will be able to interact directly with buyers during management presentations and half-day on-site meetings later in the process.
Do provide context for any obvious irregularities a buyer might notice in the information you provide. When working with your investment banker to market your business, you will frame the metrics in ways that more accurately represent the nature of your business but may not be readily apparent to buyers.
For example, you may tier customers into revenue buckets when calculating retention rates for your CIP. If you don’t provide this context and just send over raw customer revenue data to your buyers, they are going to come to their own conclusions and potentially question the retention rates shown in the CIP.
Misinterpretation of metrics is particularly harmful in the case of retention rates, as these play a major factor in valuing a company. Always provide context.
Following ad hoc diligence, buyers will provide first-round bids in the form of an indication of interest (IOI). Your investment banker will help you narrow down your buyer list to 3-5 of the top buyers so you can move on to detailed due diligence with those buyers.
Detailed Due Diligence
The primary goal of detailed diligence is for buyers to better understand the business as they think about submitting final bids. At the tail end of detailed due diligence, you will enter into exclusivity with one of the buyers, in which they will conduct their final audits to verify the credibility of your information.
In order to mitigate the risk of a company entering exclusivity and then not closing (which eats up roughly a month of your time and will unequivocally raise questions among other buyers why you didn’t close with your first choice), you will want to disclose anything potentially negative before exclusivity.
Here are some best practices to follow in the detailed stage.
What founders should and shouldn’t do during detailed diligence
Do provide all information through a secure data room. A data room is an online portal for sharing information in a confidential manner so buyers can access the information they need to evaluate a company. The benefits of sharing data exclusively through a data room include:
- Confidentiality. Data rooms are secure and will keep your information confidential.
- Accessibility. Data rooms allow you to control who can access information before and after a transaction closes.
- Version control. Version control makes it possible to manage updated versions of information you provide to buyers.
Don’t start detailed diligence until you have a populated data room. Selling companies will usually open a data room immediately after management presentations or after the initial bid date at the latest. (The timing of when to open your data room will depend on several factors, including inbound interest, the parties involved, your desired speed to close, and other concerns.)
While you’ll be adding new information throughout detailed diligence, you want to make sure you have a full data room to open immediately after bids so buyers know the process is organized and competitive. The information included in the data room will be robust, including:
- Compensation schedules
- Customer contracts
- Employment contracts
- Board meeting minutes
- And more
Do be responsive when your investment banker requests additional information to populate the data room. As bankers ourselves, we at Vista Point understand information takes time to pull. However, given the level of detail buyers expect, you should never leave buyers hanging—even if data takes several days to pull, make sure to provide interim updates so that your banker/buyer doesn’t go 24 hours without hearing from someone.
Do be timely about delivering data. The faster you can get information to your banker, the sooner he can review and get that to the buyer, which means less time in diligence and a lower likelihood the buyer will find issues in the data.
Do, where possible, assign someone internally at your company to provide information to your investment banker. Having a dedicated person expedites the exchange of information and keeps the process organized. Sometimes the CEO/founder can fill this role, but someone in an operational role is usually better equipped.
Do prioritize information gathering based on the diligence checklist provided by your banker. At Vista Point, we provide our clients with a comprehensive diligence checklist in a Google Sheet outlining what information buyers need. Each item is given a high, medium, or low priority level. As the selling company, you should focus on high priority items first and make sure to update the status of information gathering for each item in the sheet. At Vista Point, we upload the checklist with each item’s status to the data room each evening for buyers, so having updated information is important.
At this stage with fewer buyers deeper in the process, your investment banker will create more tailored analyses for specific buyers. Don’t proactively share these analyses with other buyers. Instead, rely on your banker to know when to share information with each buyer, as they are constantly monitoring those relationships to maximize leverage and minimize risk.
Don’t worry if a buyer requests a specific piece of information you don’t have, as suitable alternatives almost always exist.
Don’t provide any information to the buyer except what they request. Founders often think they’re just being helpful by providing additional information, but the effect of doing so is to delay the process and open new issues the buyer didn’t need to worry about.
Trust us, the buyer will ask for everything they need and 50% more. If a buyer asks for the top 10 contracts, don’t sprinkle in a few smaller contracts for a new product to show traction. There’s no need to volunteer information.
Don’t get too caught up in planning out how to integrate your company with a buyer. If you focus too much on one buyer, then you can lose sight of other opportunities.
Above all, don’t interact directly with buyers outside of management presentations and in-person meetings. Let your investment banker manage the relationship.
The Do’s and Don’ts of Interfacing with Buyers
For the most part, you as a founder will want to rely on your investment banker to interact with buyers. But at a few points during the process, you will have the opportunity to interact face-to-face with buyers, both virtually and in person. Here are some tips for when that opportunity arises.
Buyers will probably want to meet more than just the founders. Do restrict who buyers meet to the management team and any department heads or key personnel who make sense.
When buyers ask questions, answer as if you’re being deposed: give the details the buyer needs and that’s all. Don’t lose focus and go off on a tangent—stay calm and provide only the information they ask for.
While you want to be concise, do be interactive and ask questions of your own because you are searching for a good fit just as much as the buyers are.
Do try to develop good relationships with buyers. Although the diligence process will be painful, the founder may be asked to stick around following the transaction to help transition the business, in which case you don’t want any bitterness on either side. You can rely on your banker to be the go-between on topics you worry could place a wedge between you and the buyer.
Do not discuss valuation, that’s your banker’s job.
Don’t close yourself off to buyers with specific transaction structures. Even if you have a strong preference for a minority/majority/full sale transaction, running a broad competitive process will result in a better outcome than a narrow one because you’ll have multiple options to choose from and terms to negotiate on.
Last of all, do project a positive attitude with excitement about the future, even if you’re not planning on sticking around. Buyers will reflect your positivity.
You’ll Make It Through, Don’t Worry
Overall, don’t get frustrated by the diligence process. This step is one of the most annoying parts of the process for founders, but keep your eye on the prize and you’ll make it through. As you rely on your investment banker, they will help you oversee the entire process and lead you to a successful outcome.