What to prepare today for tomorrow’s exit: The importance of sell-side due diligence

This content originally appeared on TechCrunch.com. It was sponsored by CohnReznick and created by TechCrunch Brand Studio. 

Right now the merger and acquisition market is frothier than a cappuccino from your favorite coffee startup (soon to be bought by Big Candy). We’re seeing high volumes of transactions and significant amounts of private capital flowing toward companies of all sizes, not just a few standouts. High value sources are trickling and spreading. Strategic investors are looking for new technologies and markets to break through, and “the urge to merge” is alive and well. 

But is your company actually ready for a transaction? For most technology companies, the answer is no. You may know you’re ready for a transaction (i.e., anything from raising capital to full sale of your company), but do you know what your potential investor is looking for? 

Do you know where all your skeletons might lie? 

While M&A activity in the U.S. has increased, getting to the finish line is elusive as ever. This is often because companies fail to effectively identify and address gaps or weaknesses in their processes, management team, or business model before they decide to pursue an M&A transaction or capital raise. It’s only after the potential buyer or investor does their due diligence that critical issues surface, and compromise the deal. According to Asael Meir, partner and leader of CohnReznick’s national Technology Industry Practice, “There’s one process that companies should do well before investors come calling: It’s called sell-side due diligence.”

Sell-side due diligence is the process by which you review your financials, business model, management team, and processes prior to a transaction. That way you can identify issues and take action on anything that may come up during a similar process conducted on the investor’s side. This means an in-depth resurrection of key performance indicators like revenue, user base growth, EBITDA, working capital, customer acquisition costs, and product margins. It might also include tax, HR, or IT and cybersecurity assessments.

Sell-side due diligence means including all of these metrics in your investor materials in a format that actually means something to a prospective investor or buyer. Think of sell-side due diligence comprehensively. You want to holistically and accurately represent your revenue model, business strategy, personnel, and financials in one report. Merely reporting earnings and potential won’t do. Projections and forecasts are routed in historical financials, which should be presented consistently with acceptable reporting standards, especially for revenue recognition, accruals, and deferred costs. You should be able to present buyers with an organized, clearly-stated starting-off point to explain the methodology behind your financial projections. 

“Sell-side due diligence is your chance to catch a red flag before an investor or potential buyer does,” says Alex Castelli , Managing Partner of the Emerging Markets Industry Group at CohnReznick. “This is not to say that your company needs to be pristine, but if you miss key challenges on your end, it could jeopardize the deal, impact the valuation of your company, or result in monies held in escrow.”
Doing sell-side due diligence can make transactions of all scales smoother and more likely to close. Here’s what you should consider doing before a prospective transaction, respective of the stage of your company.

Early-stage companies

Status: Your company is generating revenue, and you’re planning to raise your first round with institutional investors.

Target: VCs

What to focus on in due diligence: Take a close look at your revenue model and customer pipeline, along with key metrics like recurring revenue, non-recurring revenue, customer/product margins, and customer acquisition costs. Beyond financials, VCs want to know about the anticipated unit economics of the product or service. Map out a single instance of your product or service with details that include LTV (lifetime value) of a customer, the cost to you, and the margin you make on it. Generally, this should inform an underlying thesis for your company. Why (and how) do you need to exist?

What to expect: Investors will want to know about more than your method for recognizing revenue. They’ll be interested in understanding business growth potential and time to scale. Expect them to dig deep into your management team’s track record and previous execution.

Growth-stage companies

Status: You’re in need of growth capital.

Target: Late-stage VC, private equity, or strategic buyers

What to focus on in due diligence: As your business expands into new products and markets, be sure that you’re tracking product development costs, especially if you are expensing them rather than capitalizing. You may have been growing for a few years now, and it’s time to make sure there are no gaps in critical areas as you look for money to expand your operations. Is your customer pipeline strong? Are you poised internally for growth? Are you developing new products and services to continue to sell into your customer base? Ultimately you want to showcase your growth, so metrics that indicate consumer base growth and recognizability are key at this stage. If you have new product offerings, explain how they can help increase your LTV.

What to expect: Investors will want to be comfortable with your past financial results and your ability to forecast future results, especially since you are looking for capital to expand your operations. They’ll want to see period-over-period analysis that shows variances in revenue and changes in your business. Expect investors to want every cell filled, and every metric accurate. There should be nothing in your financial statements that is out of the norm compared to others in your industry sector.

Later-stage companies

Status: You’re considering an IPO, SPAC , or private equity transaction.

Target: Private equity, SPAC sponsors, or public markets

What to focus on in due diligence: Do you have strong systems and personnel to continue to grow? Have you identified acquisition targets who can take you into new markets or allow you to expand internationally? As an established company, your ability to maintain revenue growth and profitability will become a central focus for many buyers and investors. “Any weaknesses in your management team will be apparent,” explains Meir. “The expectation will be that your company is poised to continue to grow, especially with the infusion of additional capital.”

At this point, your due diligence should point to why there is comparable appetite in public and private markets for your company. You want to prove the reliability of the internal processes and systems you have in place, and the ways in which they mimic those of other public companies.

What to expect: Assume your audience is interested in knowing how every dollar is spent, with strong, quantitative defenses for why. Investors will scrutinize effective headcount management, growth, and cap table management. For later-stage companies, there will be higher expectations of you and your leadership team. You’ll want to call in advisors to make sure there is nothing out there that could derail or delay a deal.

Here’s what you can do now, regardless of your size:

• Evaluate your management team and key personnel. Are there gaps in key positions? Are people in key positions ready and able to take on new challenges as your company grows?
• Invest in financial systems and processes that provide robust, comprehensive data. Ensure your financial results are accurate and complete. The sooner you organize in a single system, the better. If you need to upgrade your systems, consider doing so now – before you start thinking about a transaction.
• Take a close look at potential weaknesses or areas of exposure. Identify which types of questions could arise from somebody looking into your company. It may be difficult to face, but now is the time to address those trouble spots. If you haven’t been paying taxes in certain states, hire a tax professional to prepare a nexus study and identify where you may have tax liabilities. Failure to catch issues like this now could result in bigger issues down the road. Your deal might lose momentum, especially in a transaction in which money will need to be put in escrow until issues are resolved.
• Identify expenses or transactions that could be questioned, such as personal expenses or transactions involving individuals related to your company such as shareholders and affiliates. It is better to bring those items to everyone’s attention before an investor or buyer starts due diligence rather than have them question the reliability of your financials. Remember that the credibility of your financials will go a long way in alleviating unwarranted concerns.

Before thinking about your next transaction, recognize that sell-side due diligence is an ongoing process, and one that needs to be baked into your everyday work. This could look different company to company depending on size and stage, but the goals are basically the same. Ensure that your side of the deal is as clear and comprehensive as the other side – if not more.