Vendor Due Diligence
Definition and Key Elements
The term“due diligence”originates from English and means “due care.” In the context of an M&A transaction, the company up for sale is thoroughly examined and analyzed from various perspectives to identify potential risks and opportunities associated with the target company and to assess its operational performance. This process is typically commissioned by the buyer (“buy-side due diligence”) and is intended to assist the buyer in determining the purchase price and drafting the contract.
Particularly in the context of acquisitions of medium-sized companies, so-called “vendor due diligence” is increasingly being commissioned by the current owner in the run-up to the actual transaction process. Unlike a “financial factbook,” which merely compiles and presents existing financial data, vendor due diligence involves a comprehensive analysis conducted by external service providers (including auditors, tax advisors, strategy consulting firms, and attorneys).
Depending on the business model, this typically encompasses the sub-areas of financial due diligence, commercial due diligence, legal due diligence, and tax due diligence. The compiled information—particularly the financial data—is reviewed for completeness and accuracy. In addition to the operational analysis of the company, vendor due diligence involves critically scrutinizing and validating management’s medium-term plans from the perspective of an external third party, based on the target company’s historical performance adjusted for one-time items. The goal is to determine the company’s sustainable earning power in order to substantiate the purchase price expectations.
Reasons for Commissioning a Vendor Due Diligence
By having an external third party analyze the company with regard to key transaction-related issues, the subsequent sales process can be structured more efficiently and completed more quickly. The primary objective of this review is, on the one hand, to provide potential buyers with detailed information about the relevant aspects of the target company. On the other hand, by commissioning this review, the seller can increase transparency and transaction security in the run-up to the sale, as any issues that might arise during buyer-initiated due diligence can be proactively resolved before the company is put on the market. Fundamental, previously unknown deficiencies can either deter a buyer from the acquisition entirely or substantially reduce the achievable purchase price.
Vendor due diligence also increases transaction efficiency for the buyer, as the necessary information is already available. Buy-side due diligence can build on the findings of the vendor due diligence, thereby accelerating the process and making it more cost-effective for the buyer. The results of vendor due diligence serve to prepare the seller for the sale and provide a basis for transaction structuring, price negotiations, and the due diligence process on the buyer’s side.
The disadvantages of commissioning vendor due diligence include the costs that the seller must bear regardless of the transaction’s success, as well as the commitment of management resources. Particularly for small and medium-sized businesses, costs can be managed by keeping the scope of due diligence moderate and selecting the right due diligence provider. Avoiding purchase price discounts can, in turn, offset these costs.