The IT Factor: An IT Due Diligence Checklist and Guide for M&A Deals
Sell-Side Due Diligence Report Checklist and Guide for M&A and Other Transactions
A transaction on the horizon means it’s time to put your best foot forward. You have to dot all your I’s, cross those pesky T’s, and generally put an appealing but accurate sheen on your enterprise. After all, you’re not the only company that’s caught the attention of the M&A crowd, so you really have to wow that investment group and convince them that it’s your company, not the ones down the street, that deserves the spotlight.
Unfortunately, that’s where things tend to get a bit murky. With so much to prepare for, a laundry list of questions to answer from potential buyers, and a disconcerting lack of reliable information for sellers, it can all be a bit overwhelming. However, that’s where having an ace-in-the-hole like Embark can be so beneficial, providing both guidance and real-world, tangible help that you can put to immediate use.
For any organization beginning the often laborious and stressful process of attracting a merger, acquisition, or even investment capital, we’re here to offer you a two-fer for the ages:
- A detailed checklist to make certain you’re addressing every item critical to a seller’s due diligence process
- Our sage guidance and best practices to use throughout the process
Suffice it to say, a specific and deliberate approach can not only help organize your financials as you prepare for a full due diligence report and possible transaction, but also allow you to state your case on why your organization is worth the M&A attention in the first place.
As you’ll see after downloading our financial due diligence checklist, Embark suggests sellers complete a wide range of tasks that, collectively, address the many topics within a financial due diligence report to investors. While we designed our checklist to be flexible enough to adapt to virtually any financial due diligence report, most business owners will – at the very least – want to include a few specific topics/sections in their report for buyers:
- Executive Summary
- Quality of Earnings
- Working Capital
- Income Statement
- Balance Sheet
- Supplemental Analysis
Remember, these topics don’t have to adhere to GAAP standards but, instead, should concentrate on revenue, EBITDA, and other non-GAAP data and profitability metrics important to any buyer or investor. Therefore, the resulting report toes the line between highlighting the most attractive aspects of your organization, and reliable, quantitative insights that prospective buyers use as part of their decision-making process.
You want to be flattering to yourself but authentic, demonstrate what makes your company unique and worthy of the attention, but unfailingly accurate and truthful as well. Granted, this isn’t the easiest balance to find, but that’s why we’ve prepared our due diligence checklist and these best practices in the first place. In fact, our checklist aligns with the third-party reports potential buyers use for their own financial due diligence on a seller’s company.
How’s that for real-world, practical insights? In other words, our checklist helps make sure you have your ducks in a row before assembling your report – or even contacting a broker, for that matter. So on that note, let’s dive into the most common report sections and develop some context for our detailed checklist.
Although elevator pitch is almost a cliche at this point given its popularity in modern business-speak, it’s still a perfect fit for this purpose. To that point, think of the executive summary section of your financial report to buyers as your elevator pitch, a concise synopsis that summarizes all of the key items within the diligence report that might impact the deal value – and deal itself. This would include different metrics and statements as well as virtually any other information that might distinguish your organization.
Find a balance between brevity and thoroughness in your executive summary, viewing it more as a snapshot for the rest of the report rather than a source of deep insight. Like it or not, your company most likely isn’t the only one that the prospective investors are interested in, which means they have a lot on their due diligence plate.
Therefore, rather than reading the entire report, just assume the reader will take their time with the executive summary and reserve deeper dives for any particular sections that might pique their interest.
Quality of Earnings
Embark uses the Quality of Earnings (QofE) analysis to begin the quantitative sections of the presentation to buyers or investors. It serves as an insightful companion piece to the income statement and working capital sections, revealing a clearer picture of your operations and financial stability.
We mainly accomplish this by eliminating non-recurring items from EBITDA, including large compensation bonuses, one-time purchases, or nearly anything else that isn’t a part of your normal operations, yet skews your financial statements to arrive at an adjusted EBITDA.
The QofE gives you the chance to explain those one-off items, justify their exclusion, and provide your financial suitor with a more accurate perspective of your operations and EBITDA. For a more thorough discussion of the Quality of Earnings analysis and some salient best practices, take a look at our previous musings on the topic, including the sample report we walk you through.
No matter the industry, your net working capital (NWC) is going to be upfront and center throughout negotiations. It’s a uniquely insightful report that, ideally, will provide you with a defense against purchase price erosion. To paraphrase an oldie but goodie, cash flow is king, so sufficient working capital – as discussed in a NWC analysis – goes a long way in demonstrating the company’s short-term ability to cover its operational obligations.
From a broader perspective, the idea of NWC in a sell-side report is to put certain items on the table for discussion, keeping in mind that our focus is to highlight things the seller should be aware of as they go into negotiations. Thus, the NWC analysis in the report isn’t necessarily what the buyer receives for review.
The NWC analysis also helps establish an ‘NWC peg’ which, based on an average of the previous 12 months, is what the seller is responsible for delivering at closing. Thus, if the NWC analysis in the sell-side due diligence report demonstrates robust working capital, the seller needs to meet that lofty NWC peg. Otherwise, the difference is a 1:1 reduction to the purchase price. So while healthy NWC certainly helps attract buyers, it can be a double-edged sword since the sellers must now meet that appealing NWC peg.
Income Statement and Balance Sheet
There’s nothing terribly earth-shattering about the financial information in the Income Statement or Balance Sheet sections of your financial due diligence report. They are, however, the ideal place to provide insights and in-depth perspectives to potential buyers or investors that might otherwise get lost in the sea of line items within your audited financials.
For the Income Statement, this is the chance to tell the story behind those line items, to flesh out the numbers with additional information regarding everything from your different sources of revenue to an explanation of your COGS and operating expenses. The seller often includes analysis and discussion of revenue recognition, revenue by customer or product offering, and proof of cash, among other topics, in this section to further expand the insights a buyer can gather.
Also, to avoid confusion or annoying the buyer, we always present the income statement on an adjusted basis, keeping everything as straightforward and clean as possible. Remember, if we’re trying to tell a story with an income statement, unnecessary exposition will only muddy the narrative.
The Balance Sheet section employs a similar tactic, providing in-depth information that a reader might miss in your audited financials. Here, we include everything from cash conversion cycle metrics and discussion of intangible assets – like intellectual property – to accounts receivable and accounts payable aging.
Further, both the Income Statement and Balance Sheet sections should include adjusted figures with thorough explanations for any stated adjustments from the audited financials, along with QofE adjustments. Granted, this could work for or against you depending on the nature of the adjustments, but certainly helps clarify the overall picture. In reality, nearly any adjustment that negatively impacts key metrics – like your margins, for instance – would turn up in the buyer’s due diligence anyway.
A Supplemental Financial Analysis section is another opportunity for your management team to thoroughly explain your operations, emphasize any particularly insightful metrics, and distinguish yourself from other market participants. A Key Customer Matrix, for example, might demonstrate a well-balanced customer base that doesn’t rely on any particular customer for the majority of your revenue, thus, mitigating risk for your company.
Similarly, a Revenue Bridge Analysis lets you break down the changes in revenue between periods for existing, new, and lost customers. These types of illustrations are uniquely capable of providing granular data points that aren’t readily available in the standard set of financials. Along with the other sections of a due diligence report, these supplemental illustrations paint a fuller picture of your business and operations for a buyer or investor.
Other Best Practices
Between our accompanying seller’s report checklist and our insights on relevant topics, you already have a good head start in appealing to a hyper-selective M&A market. That said, we still have a few real-world best practices we want you to keep in mind as you proceed.
Have Your Ducks in a Row
The financial transaction process is both complex and time-consuming. An investment group will always have experts ready to look through every aspect of your company and operations with a mammoth-sized magnifying glass, constantly looking for potential issues. Therefore, it only makes sense to bring in outside professional services specialists for further guidance where needed.
Using such guidance as a compass, go through your contracts, books, records, and anything else that might play a role in your M&A transaction’s ultimate success. Also, an experienced transaction advisory partner will identify particular points and potential weaknesses that a strategic buyer will focus on, helping you prepare in advance and, thus, increase the chances of a purchase price that makes everyone happy.
Get Organized and Think Like the Buy-Side
Any buyer is likely to have an extensive list of document requests and questions for you once their due diligence begins. In anticipation of this inevitability, go through all of your documentation to make sure you have quick access to the most current versions of your documents, complete with all necessary signatures, attachments, and schedules.
In short, being well-organized ahead of time can save you a good deal of frustration down the road. Just keep in mind that Embark is always here to help with this process, providing support to sellers and their teams for more technical or specific accounting matters.
Once you decide to sell your company or attract investment capital, there’s much work to be done and usually not enough time to do it. You can streamline the process and save time by delegating particular responsibilities and tasks to individuals or teams within your organization.
A clear and concise workflow chart that’s accessible to every employee involved will maximize efficiency and impact along the way. Remember, you still have a business to run during a sale, and there’s only so much time and resources to go around.
Align Your Narrative Across Partners
To state the obvious, there are numerous moving parts in a typical transaction. Thus, with so much to get done and several partners involved, it’s important to align data, narratives, or even direction across your team, both internal and external.
For example, the investment banking folks are the ones marketing the business, preparing the confidential information memorandum (CIM), and speaking directly to potential buyers. That’s why we work very closely with the investment bankers, making certain our numbers align and stories match.
Skipping this crucial detail can make everyone look unprofessional, unorganized, or even suspicious when the misalignments are significant. And that obviously isn’t conducive to a successful transaction.
Be Descriptive With File Names
This tip is a bit on the granular side, but you’ll thank us once your sell-side diligence begins. As we said, a buyer is going to request a mountain of documentation from you, so the faster you provide them exactly what they need, the quicker you can reach an agreement.
Part of your pre-sale organization efforts should include adopting a system of highly descriptive file names and reference numbers so you can quickly locate any file needed by its filename and, thus, avoid having to read through 250 documents to find the right one.
Although you always want to put your best foot forward and dazzle financial suitors with sparkling sales metrics, don’t forget the privacy agreements you have with your existing customer base. As you organize, prepare, and distribute documents to potential buyers, be sure to redact names and information when appropriate to avoid violating those privacy agreements.
Privacy and confidentiality are especially important at the beginning of the process when everything is still a bit up in the air on the sales front. It goes without saying that your customer base is one of your most valuable assets and something you must sufficiently protect, especially during a sale. Thus, obtaining signed NDAs from potential buyers or investors is always a good idea, not to mention hefty cybersecurity and other must-have protections for the digital world.
Retain Your Data for Future Use
Deals fall through all the time, often for no obvious reasons. As you wade into the due diligence waters and prepare information for a prospective buyer, keep all of that data handy in case things go sideways. That way, you have everything ready to go for the next buyer and won’t have to reinvent the due diligence wheel with each possible sale. That meticulous documentation can also be a lifesaver if a deal does go through but issues arise after the fact, letting you quickly find any information created or provided throughout the process.
The Right Partner Is an Ace in the Hole
Embark understands that it might seem like sellers are living in a distinctly buyer’s world. But that’s exactly why we provided our checklist and these best practices – to give sellers valuable information that isn’t easy to come by elsewhere.
Therefore, whether you use our due diligence checklist as a means of early preparation for an eventual sale or investment, or as a window into the sort of items every buyer will look through, we’re certain you’ll find it uniquely insightful and beneficial to the process.
Of course, given the importance of the sale process on the future of your enterprise, employees, and even customers, an upcoming transaction is no time to leave any financial stone unturned. So while our checklist goes an awfully long way in helping your preparation for a potential acquisition or merger, the due diligence report it drives is really what gets the closing ball rolling.
Thankfully, Embark’s team of acquisition and divestiture gurus can take the data you’ve assembled with our checklist and craft a seller’s report that shines the best possible light on your organization. As we go, we’ll anticipate buy-side needs – including buy-side due diligence findings – and significantly increasing the chances of a purchase price that leaves you with a smile on your face.