As part of the process of preparing for the sale of a company, most investment bankers perform a level of due diligence on their client’s business before they go to market. This diligence can be an essential exercise to preserve and even drive value.
We believe the best defense is a strong offense.
Retain value, deal with issues upfront
Recently, we evaluated a client preparing for the sales process and discovered their financial system was significantly outdated. We highlighted the potential issue to the client and ensured it was explicitly pointed out as an area that may need attention from a new acquirer. We again made it a minor point of discussion during management presentations.
In flagging the issue, we were able to leverage the competitive process to drive valuation, despite this potential shortcoming. In a competitive process, most buyers will either read past modest operational issues, or note the concern but focus on the competitive dynamic of losing a deal over an operational issue that easily can be addressed.
Now, that didn’t stop the buyer from calling for a price reduction post diligence. Since we had laid this out up front, their position was weak. Our client prevailed.
Don’t let it ride
Many would have let the situation ride, waiting to see if the buyer even determined there was an issue. In our opinion, these issues are almost always discovered.
Isn’t it better to be in a position of strength than waiting until you can no longer drive the deal dynamics?
Presenting potential issues, challenges, and value detractors early in the process also helps build credibility with potential buyers.
Representation and warranty insurance
Sometimes there is no way to know the unknown. While buyers worry about this acutely, sellers also do not like the potential liability hovering over their heads.
Sourcing representation and warranty insurance in advance of a sale allows the market to assess the potential support needed and provide a high-level cost estimate for a policy to support a transaction. We speed up the process by sharing a CIM and quality of earnings report with our insurance advisor. This allows them to vet the level of interest, identify unique issues to address in advance, and get a sense of pricing. We share the feedback on interest from underwriters and pricing as part of the Letter of Intent due diligence process. We can dictate the use of representation and warranty insurance while adding to the buyer’s confidence that an insurer is open to supporting a transaction.
With a total cost of 2% to 3% of the indemnity limit, this can be a very attractive alternative to escrowing 7% to 10% of the transaction value for 18 to 24 months to support representations and warranties.
For buyers, the ability to pursue a potential claim with an institution rather than individual sellers proves to deal more in facts versus emotions.
Another area where upfront work can pay significant dividends relates to environmental matters. Environmental issues are not well understood in the U.S., and regulations can differ significantly from state to state. The lack of understanding can often frighten buyers or have them take an unnecessarily conservative position when bidding.
During the post indication of interest diligence, we often provide information on the scope of environmental issues as well as describing the regulatory process for managing any environmental legal exposure of the buyer. The concept of a Baseline Environmental Assessment (“BEA”), environmental insurance and other unique structuring required to provide buyers protection are specialized areas. Since most buyers do not have this insight, we provide the framework upfront to provide understanding and lowering the risk profile. Many may pass on an opportunity without the education, not realizing there is an easy resolution.
If the problem is severe enough, we often encourage sellers to have their own environmental consultant perform an upfront assessment and identify potential remediation costs. This has two advantages:
- You have a sense of the order of magnitude and have a handle of the problem to counter the point of view with the buyer’s environmental consultant.
- This information allows you to assess whether you will address the problem upfront or leave it to the buyer.
The best defense is a good offense
No matter the client or the situation, you need to understand all the potential pitfalls, value detractors and potential red flags for prospective buyers.
Only when you understand these issues can you create plans to either drive value or preserve value proactively from a position of negotiating strength
Read the full version of this article here.