Reverse Due Diligence in M&A Transactions - [Ultimate Guide]

When it comes to mergers and acquisitions, you seldom think about turning the tables on yourself and becoming the prospective buyer with tens of potential questions or concerns.

If you were the person buying your company, would it be attractive enough? Are there any red flags that would discourage you?

To answer such questions, you would have to do reverse due diligence. But what is it? How can it protect your business goals?

Remaining objective during the process can be difficult, which makes working with an external M&A team important.

What Does Reverse Due Diligence Mean in an M&A Transactions?

Also called sell-side due diligence, reverse due diligence is a close examination of your own company as if you were the buyer. The process assesses your company's overall health and value to gauge its strengths and weaknesses, especially close to a sale.

Types of Reverse Due Diligence

You can delve deep into the following types of reverse diligence:

• Financial due diligence: Review your financial statements, accounting procedures, balance sheets, and quality of earnings to assess your potential risks, profitability, and financial health.

• Commercial or business due diligence: Evaluate your company's main business, competitors, customer base, exploitable market gaps, and positioning. Such diligence is essential if your projected future revenues are crucial to selling your company.

• Legal due diligence: Shield your buyer from lawsuits arising from existing contractual obligations, possible liabilities, threatened legal proceedings, or government litigations.

• Tax due diligence: Review your tax returns for the last 3-5 years. Do you have any historical tax liabilities? Are there tax carryforwards the buyer may benefit from?

• Human resources due diligence: Evaluate your employment contracts, turnkey employees, human resource policies, and the general workforce.

• Operational due diligence: Check for operational inefficiencies in your supply chain, IT infrastructure, sales system, organizational structure, or production processes. 

• Environmental due diligence: Check for potential environmental concerns about complying with environmental regulations, practices, or permits. 

Reverse Due Diligence vs. Traditional Due Diligence

Traditionally, potential buyers do buy-side due diligence to assess the overall health of a company they are interested in. In recent times, sellers conduct reverse due diligence to evaluate their company's health and attractiveness to potential buyers.

One crucial aspect common to both reverse and traditional due diligence is the inclusion of soft due diligence alongside hard due diligence.

Soft due diligence considers qualitative issues like human resources, customer base loyalty, quality of management, and company culture.

Traditional due diligence usually focuses on hard aspects like potential benefits, liabilities, costs, and current assets.

Why is Reverse Due Diligence Necessary?

Reverse due diligence is necessary for the following reasons:

• You can gauge your company's financial strength to set up the right sale price.

• You can see if your business would appeal to prospective buyers.

• You can maximize your company's sale price. When you validate the quality of your earnings, justify your forecasts, and address potential concerns, you limit the buyer's capacity to renegotiate the sale price.

• You'll minimize surprises. When you disclose any concerns in advance, your transparency improves your credibility and makes potential buyers more confident, especially if you show the remedies you set up.

• Sharing information first puts you in a power position during negotiations.

Key Stakeholders in Reverse Due Diligence

The reverse due diligence process involves key stakeholders, such as business or corporate lawyers, accountants, business brokers, and tax experts.

While you can use your company's internal team for reverse due diligence, it’s best to use a third party for absolute objectivity.

Reverse Due Diligence Checklist

Since reverse due diligence is extensive, you'll want a simple checklist to guide you so you don't miss any crucial part. Here's a quick checklist to follow.

1. General Corporate Information Documents

Have the following documents ready to show the structure of your company.

Organization documents as applicable, including:

• Organizational chart

• List of locations you are authorized to operate in

• Certificate of Good Standing

• Restructuring documents, if any

• List of partnerships

• Corporate structure documents

• Article of incorporation.

Business documents, including:

• Annual reports for the last 3-5 years

• Business plans

• Corporate bylaws.

2. Financial and Accounting Documents

Prepare the following to show your long-run profitability.

Financial information, including:

• Income statements for the last 2-5 years

• Bank statements for your company accounts

• Equity and market capitalization documents. Include balance sheets, deferred revenue, cash flow statements, and any stock purchase agreements.

• Budgets, including capital and operating budgets

• General ledger, showing accounts receivable and accounts payable

• 3-5 years of unaudited and audited financial statements

• Credit information, including loans and lines of credit. 

Tax details, including:

• Government audits

• Tax returns and tax structure for the last three years

• Property tax statements, if any

• Tax benefits, tax sharing, or tax transfer agreements.

3. Human Resource Information

Prepare HR details to show integration opportunities and noteworthy talents.

Employee information, including:

• Curriculum vitae of turnkey employees

• Current employees and their demographics

• Employee benefits.

HR contracts, including:

• Employment contracts

• Non-solicitation, non-compete, and non-disclosure agreements

• HR practices and policies

• Payroll information, pension plans, and deferred employee compensation

• Labor disputes

• Employee competence and skills assessments.

4. Legal Information

Prepare legal information to mitigate litigation risks.

Legal details such as:

• Ended, ongoing, threatened, or pending litigations against your company or those you have initiated

• Governmental investigations, if any.

Material contracts and agreements, including:

• Licensing and franchise agreements

• Indemnification agreements

• Correspondence between your company's auditors and attorneys

• Business consulting agreements and contracts.

Loan details such as:

• List of your lenders, banks, or creditors

• Outstanding debt, guarantees, or indemnification documents

• Copies of leases, security agreements, letters of credit, or mortgages.

5. Sales and Marketing Information

You'll need the following to show your company can realize the profits you forecast. 

Customer information, including:

• Customer analysis

• Your best current and past customers and their revenue records

• Copies of customer contracts 

• Warranty claims.

Product information such as: 

• Sales analytics

• Advertising materials like press releases, television ads, and brochures

• List of current business products and services

• List of unreleased business products and services.

Marketing information such as:

• Market research

• Top resellers, distributors, or suppliers

• Marketing plans and agreements.

6. Assets Information

List your physical and intangible assets to help determine your sale value. 

Tangible company property information such as:

• List of owned and leased properties, fixed assets, and real estate. Indicate their location, date of acquiry, and more.

• Copies of your inventory at the end of your fiscal month and year

• Property deeds.

Intangible company property such as:

• Patent applications, trade secrets, and granted patents

• Copies of collaboration files, licensing, and research and development related to patents

• Material and unregistered trademarks, copyrights, and trade names

• List of your company's social media accounts and websites.

How to Conduct Effective Reverse Due Diligence 

You have two options—use your internal audit team or hire impartial third-party professionals. 

Regardless of the method, the following steps ensure your success:

• Define the scope and objectives of your reverse due diligence to focus on the most crucial aspects. 

• Think like a buyer so you can remove any blinders that would prevent you from finding faults in your company. 

• Create a checklist based on the scope.

• Conduct the examination, striking completed items off the checklist. 

• Identify opportunities and risks. Specify the risks that may break a purchase offer. Outline the opportunities for maximizing the value of your business. 

• Act on the findings and recommendations of the diligence team. 

• Repeat the process, if necessary, to ensure a continuous state of being always ready to sell your company. 

• Add the diligence report to the online data room, including any remedies you've put in place for issues prospective buyers may encounter.

To maintain objectivity and credibility, it's best to outsource the entire reverse due diligence process to a third party. 

Strategies for Presenting Your Company to Potential Buyers

One way to present your company to potential buyers is to notify competitors that it is for sale. 

Alternatively, market your business online on social media, your company website, and industry and business forums. 

Let potential buyers know you have expedited the process by conducting reverse due diligence and that you’ll share the results in the online data room after a non-disclosure agreement.

The best strategy is to let the professional third party you hired present your company. They already have a large pool of prospective buyers. They can also design appropriate negotiation strategies based on their extensive M&A experience.

Pitfalls in Reverse Due Diligence and Ways to Avoid Them

Seeing that reverse due diligence involves scrutinizing your own company, you may experience pitfalls that could lower the chances of a successful business sale.

• You might take the results of reverse diligence personally and go on the defensive. Instead, the report guides you through the various issues you should fix. You should start applying applicable remedies right away to increase your company's value. 

• You might have human bias, hence interpreting information subjectively. Instead, hire impartial third-party professionals to maintain objectivity during the process and in the report. 

• You might lose focus as the information in the process can be overwhelming. To remedy this, rely on the expertise and judgment of industry experts to obtain a complete perspective. 

• You might be tempted to keep potential issues from your prospective buyers. Such a lack of transparency could ruin a sale if the buyer discovers you knew these issues beforehand. 

Frequently Asked Questions (FAQs)

Here are some questions an owner may have on reverse due diligence. 

How Does Reverse Due Diligence Impact Mergers and Acquisitions?

Reverse due diligence helps maximize a company's value. You can find opportunities to improve your business and raise its value. Additionally, addressing potential buyers' concerns in advance can reduce the buyers' ability to renegotiate the sale terms or sale price. 

Reverse diligence also smoothens the sales process. The buyer conducts their due diligence faster and compares it with your own, leading to a shorter sale time. 

What Role Do Financial Advisors Play in Reverse Due Diligence?

Financial advisors prepare a detailed report that they present to interested buyers to show that an objective third party has evaluated the company on sale. You can win the confidence of prospective buyers this way. 

Financial advisors also formulate favorable negotiation strategies in light of the potential issues they discover during reverse due diligence.

How Can Reverse Due Diligence Influence Investment Decisions?

Reverse due diligence can make buyers trust you more once they see your initiative, honesty, and transparency. They may pay your asking price without extensive negotiations. 

Potential investors can also finalize the deal sooner because your reverse diligence reduces the time they need to conduct their own investigations.

What Are the Legal Implications of Reverse Due Diligence?

Reverse due diligence can have both positive and negative legal implications. 

If you find a significant issue and fail to rectify it or report it to the buyer, they might later sue you for dishonesty or lack of transparency. 

On a positive note, reverse diligence can save you if the buyer doesn't do any or does due diligence poorly and later faces massive challenges. If these stem from an issue you disclosed to them and agreed upon, you'll be on the safer side. 

Conclusion

You now know the essentials of reverse due diligence, what it is, and how it can protect your business goals. 

Author(s): Brian Dukes, Managing Partner

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