What Is Vendor Due Diligence?

No professional M&A deal proceeds without due diligence, the process during which the company and its assets are carefully examined. The assessment often reveals aspects that make the company appear less attractive to buyers. In the opinion of corporate M&A bosses, investment bankers, and M&A consultants, negative due diligence findings are among the most important deal-breakers.

Due diligence translates into money. M&A transactions in medium-sized companies can quickly add up to six-figure amounts in costs for in-house employees, but above all for external consultants such as auditors, lawyers, and M&A advisors. In bigger M&A deals worth billions, due diligence costs can run into the millions, especially if the target company is complex and operates worldwide. Such extensive due diligence checks quickly become one of the most important ongoing projects in a company and enjoy a high level of attention from the management and supervisory boards and shareholders. Some companies are already responding by expanding their in-house due diligence teams.

Preparing for the Sale

True to the adage that not everything that glitters is gold, company acquisitions, in whole or in part, often turn out to be “fool’s gold” because the company’s strengths, weaknesses, opportunities, and risks were not adequately examined, analyzed, and evaluated. This failure may have significant negative economic effects on the buyer. In the worst case, the buyer’s board of directors or management will be confronted with warranty risks from the purchase contract due to a lack of adequate commercial due diligence.

Due diligence process on the buyer’s or seller’s (vendor’s) side is critical to the planned transaction. In addition to the “classic” financial and (tax) legal investigations, thorough due diligence includes examination and assessment of operational risks and value creation potential (also called operational due diligence). This aspect plays a central role, especially for private equity investors and investment companies–in addition to the required return on equity and sustainable cash flows–since the future potential for value growth and the associated exit strategy are decisive for this buying group.

A buyer’s due diligence aims to create a secure basis for decision-making, differentiated according to the respective buyer group (financial or strategic investor).

Usually, the buyer puts the target company through its paces as part of the due diligence process. Vendor due diligence deviates from this pattern: the seller collects the most important information about the company before an M&A deal. Many business owners shy away from the effort and costs involved, not because they assume that they are already familiar with their own companies.

In practice, after extensive due diligence, the buyer unearths details about the company that thus far remained hidden from the seller. That usually costs the seller a lot of money in the form of a reduced purchase price. Vendor due diligence can compensate for this information deficit and the potential negative consequences for the sales process.

With vendor due diligence, the seller receives comprehensive and up-to-date insight into the opportunities and risks of his own company–a great advantage for later price negotiations. From his analysis, the seller is already aware of possible weak points in the company, which imparts a more realistic view of the company and helps in rebutting allegations made by potential buyers. Vendor due diligence may even allow the seller time to fix minor weaknesses in advance.

Complementing the Buyer’s Due Diligence

Understand that vendor due diligence does not substitute for comprehensive due diligence by the buyer. The informational memorandum from the vendor owing diligence differs from the report drawn up by the bank that manages the M&A process. Although the vendor’s due diligence covers similar areas to the buyer’s due diligence, it is designed as a sales document to arouse the interest of potential buyers.

The depth of information in the seller’s due diligence memorandum cannot replace the buyer’s due diligence, but it can complement it in a meaningful way. Vendor due diligence is often created for particular areas, such as taxes, the environment, or law. Vendor due diligence can be an essential starting point for a buyer when deciding whether or not to pursue an M&A deal. If interest persists, the vendor due diligence may give prospective buyers tips on which areas of the target company they should examine more deeply.

Not only can the investment in vendor due diligence be justified by the tactical advantages on subsequent purchase price negotiations, but such a project can also accelerate the M&A process in other aspects. Anyone who works on vendor due diligence in parallel to providing data for the M&A deal often makes better and more detailed material available to the buyer and the buyer’s team of advisors. This increases the chances of concluding the entire M&A process sooner.

Limiting Damage

Vendor due diligence helps sellers build trust with potential buyers and partners because such transparency and candor show the prospective buyer the company’s weak points without subterfuge.

Ideally, the seller can even score points for having taken the first steps to improve the situation. Dealing openly with complex topics is more conducive to the process than if the prospective buyer encounters problems that hitherto remained hidden from the seller.

Being More Useful

Vendor due diligence enables the seller to clarify details of the company to be sold. This is particularly useful if the target company has not previously focused on the group’s interests and has primarily acted independently.

It can also make sense for a financial investor to examine the target company in detail before it is offered on the market since financial investors are not always thoroughly familiar with the strategic aspects of their portfolio companies.

As a rule, the acquirer will carry out buyer due diligence and obtain detailed knowledge of the target company’s circumstances. This can lead to an information gap to the detriment of the seller. Vendor due diligence closes that gap.

The seller does not sell the company without knowing its actual value. With vendor due diligence, the seller can better assess which information will interest a potential buyer. The information made available in the due diligence is, therefore of higher quality.

Furthermore, the previous examination of your own company offers the opportunity to identify problems and resolve them. Where resolution is not possible, the seller has the opportunity to develop a strategy for dealing with the business’ shortcomings and will not be taken by surprise when the buyer’s due diligence reveals those problems. This prevents excessive discounts on the business’s value and purchase price, so contract negotiations are on equal footing.

Last but certainly not least, vendor due diligence can be used in an auction process. The vendor due diligence report can be made available to the bidders. In this way, buyers do not carry out redundant, time-consuming due diligence checks themselves, which incurs expense and ties up human resources on the part of the target company. However, in these cases, it will have to be negotiated regularly whether the seller issues a so-called “reliance letter” for the findings from the due diligence report.

Vendor Due Diligence Makes Sense

As a rule, a detailed examination of every aspect of the business before a transaction is strongly recommended. Although expensive, the costs incurred by vendor due diligence can be a sensible investment if it streamlines the overall transaction process and yields a higher purchase price.