That dollar figure, whether written on a napkin over coffee, or floated in a conversation, is not a binding offer. Any potential acquirer will need to conduct a due diligence investigation before they can enter into a definitive agreement to buy your business. Initial indications can be tactically inflated to ensure the acquirer gains access to your confidential information after which this price is systematically reduced, citing negative findings during due diligence – also known as the "due diligence grind."
There are a number of strategies to neutralize this tactic.
Execute a Structured Sale Process
The importance of competitive tension cannot be overstated. Competitive tension can be established by having several interested parties concurrently competing to buy your business through a controlled auction. By structuring the sale process in such a way, completion and valuation risks are spread among multiple bidders. Acquirers facing the risk of losing a coveted business to a competitor tend to act on their best behavior. The result? Enforceable deadlines, shorter due diligence and less aggressive grinding, if any.
Hold Bidders to their Valuation Assumptions
The due diligence grind is based on due diligence findings that are below the bidder’s initial expectations. Preliminary indications are always based on incomplete information. If bidders are silent on the assumptions that were made when they provided a preliminary price, they have unlimited latitude to invoke this argument. A preliminary indication that includes clear disclosure of:
- the valuation methodology the bidder applied in arriving at their price,
- the metric and multiple they assumed, and
- the information they relied upon when they determined their price,
is far less susceptible to arbitrary declarations that things looked worse than they initially thought. While grinding behavior does exist, bidders are also cognizant that developing a reputation for grinding is detrimental to their deal sourcing and credibility in negotiations. Holding bidders to assumptions explicitly stated prior to due diligence can tangibly improve behavior as the embarrassment factor from self-contradiction is too great.
Prepare Comprehensive, Coherent Materials
During the due diligence process, it’s in your best interest to respond quickly to reasonable requests for information from potential acquirers. This means having secure, thorough, reliable fact-based materials at the ready, and personnel to respond to requests.
Quick turnaround time establishes the credibility and competence of your management team, instills confidence in the bidders, accelerates the overall process, maintains interest in your business and minimizes completion and valuation risks. Furthermore, acquirers may use due diligence as a deliberate tactic to prolong the process. This provides them the low risk option of probing for weaknesses to reduce valuation without having to commit material time or capital. By responding quickly to requested information, the buyer loses this opportunity. Of course, part of managing the due diligence grind is entering the sale process thoroughly prepared.
- Ensure the information about your business is complete, coherent and that it addresses all anticipated questions without causing delay. Make this information available to potential bidders through a secure VDR, hosted by a reliable service provider.
- Proactively address risks to the business performance and outlook. Any outstanding risks should be acknowledged and explained. Forecasts are best able to withstand scrutiny when realistic assumptions are supported by facts, credible third parties and empirical evidence. Unrealistic forecasts based on superficial analysis are usually discarded. What’s worse, presenting information that proves disingenuous hurts the credibility to the seller, prompting mistrust which in turn invites more thorough due diligence. Under certain circumstances, having a third party conduct some form of seller due diligence or publish a quality of earnings report can provide additional comfort to acquirers and their financing sources.
- Show the skeletons. One way or another, it all comes out eventually. With rare exceptions, any definitive agreement will contain a seller representation that you have disclosed all relevant information to the buyer. If material information is withheld and this term of the agreement forces the issue, you will be faced with two unappealing choices: suffer the embarrassment of coming clean and risk the transaction, or worse, take your chances and risk a lawsuit should the issues surface once the buyer has control of the business post-closing. On a personal note, I would never condone the latter course of action and would disavow myself and my firm from any such behavior.
- Bench strength matters. An important aspect of due diligence management is entering the process equipped with sufficient "bench strength" to ensure rapid and competent response. While most of the standard information will have been prepared prior to launching the sale process, an acquirer will invariably ask for information that wasn’t previously compiled. Before entering a into a sale process, ensure that your team has the necessary capacity to respond to ad hoc due diligence requests.
- Triage requests. Particularly if there are multiple bidders performing due diligence, it is important that requests be prioritized to ensure that the most important items are being addressed as quickly and completely as possible. Other items may be less important. Some are simply inappropriate and may violate privacy and other laws. A financial advisor can be invaluable with directing traffic and pushing back against unreasonable requests.
Above all, the due diligence process must not drag on. Circumstances impacting the business can change during due diligence, which impacts valuation and completion risk.
A longer transaction results in a greater window of vulnerability, during which time your business is exposed to a number of risks. We explore the consequences of a lengthy sale process in more detail in our article, “The Window of Vunerability in an M&A Transaction.”